Catching the Dragon's oil and gas trend

Author: EIC | Economic Intelligence Center
Published in Bangkok Post/Asia In Depth: Asia Focus section, 17 July 2017

The Chinese oil and gas sector is undergoing structural transformation. In the past it was dominated by large state-owned oil companies occupying the entire supply chain, including oil production, pipeline construction and operation, oil refining, and trading. However, following economic restructuring the Chinese government will let privately-owned and foreign companies participate more actively in the market.

Meanwhile, the downsizing of industrial sectors, especially those that are energy-intensive, and a growing service sector may alter the fundamentals of the Chinese oil market. As China is the world's second largest oil consumer, any changes will inevitably have major impacts on oil markets in Asia overall. 

In this edition of Asia Focus, let us take a look at two important trends that will have key implications on oil and gas prices and trade in Asia. The first one is capacity expansion by teapot refineries, and the second is China’s self-reliance on domestic natural gas.

Independent teapot refineries will play an increasingly important role in refining, as their production capacity is set to expand substantially. Teapots are privately-owned refiners who tend to be much smaller than giant state-owned enterprise (SOE) refiners like Sinopec and PetroChina. In a bid to support more competition in the Chinese oil market, over the past two years the government has allowed teapots to import crude oil for refining, and also to export oil products.

The ability to import crude oil at global market prices provides teapots a competitive edge over SOE refiners who either import at a high fixed price under long-term contracts, or buy crude from their own subsidiaries at a high price. As a result, teapots can produce gasoline and diesel at around 10 USD per barrel cheaper than their larger counterparts.

By 2020, Chinese refineries will have expanded their capacity by 2.4 million barrels per day. This expansion by teapots will include greenfield plants, upgraded efficiency, and the removal of polluting plants. As such, the teapot market share in China’s oil refining market will rise from 23% in 2016 to 30% in 2020.

As supply is increasing faster than demand, China is expected to export more oil products, suppressing refining margins in the region. In 2017, the supply of oil products in China is projected to grow by 4.3%, surpassing demand, which will grow at 2.2%. Given excess capacity and surplus production, Chinese refineries will maintain only a 78% utilization rate, compared to an 83% global average.

The Chinese government has encouraged the export of surplus oil production. China’s net exports of oil products this year totals 900,000 barrel per day, a 20% jump from the same period last year. A major contributor is the export of diesel fuel, which has expanded by 50%, reaching 450,000 barrel per day. As the trend continues, the rise in Chinese exports is expected to reduce refining margins in the region to around 5-6 USD per barrel through 2020.

Thai refineries rely on China as one of their major export markets, with Thai exports of oil products to China accounting for 11% of total exports in this product group. Thailand’s exports will therefore be undoubtedly affected, not only by the fall in Chinese imports, but also by heightened competition from Chinese exports to Asia. Indeed, Thailand’s diesel and gasoline export volume to China have declined over the past two years by as much as 62% and 35%, respectively.

Other Asian nations that would be impacted by lower Chinese imports of oil products include South Korea and Singapore, China's first and second largest trading partners in oil products, who account for 30% and 14% shares respectively. Meanwhile, the CLMV countries (Cambodia, Laos, Myanmar, and Vietnam) will benefit from lower prices of oil products, as they are net importers who tend to import more as their economies grow.

Regarding natural gas, China is expected to be self-sufficient thanks to the vast amount of available shale gas reserves. Currently, China’s self-sufficiency ratio for natural gas is 70%, meaning that the country produces 70% of domestic natural gas consumption. The ratio is only 40% for oil. In 2030, the country is projected to be completely self-sufficient regarding natural gas and become a net exporter of the product. This is thanks to its expansive shale gas production, more advanced drilling techniques, and open-door policy for foreign investment in shale gas. Moreover, shale gas reserves in China total 130 billion cubic meters, almost 80% larger than those of the United States, currently the largest producer of shale gas. As a result, LNG prices in Asia will likely fall once China becomes a net exporter of natural gas.

The Chinese government is encouraging higher consumption of natural gas to support the growth of shale gas production. According to its five-year plan for energy (2016-2020), the Chinese government hopes to boost consumption of natural gas, particularly in transportation and as feedstock for power plants in place of coal. A goal has been set to raise the share of natural gas in total energy consumption from the current 6% to 10% by 2020. To reach that goal, end user gas prices or distribution charges will be cut, a plan that has already been implemented by regional governments in Guangzhou, Beijing, Shanghai, and Xiamen. 

The demand for natural gas in China is expected to rise by 6% in 2017, on the back of city gas and transportation growth. Nevertheless, the attempt to speed up natural gas consumption still faces challenges from the lack of infrastructure, such as gas pipelines and storage. Moreover, the transportation and distribution cost of natural gas remains high.

When future infrastructure is in place in China, including liquefaction plants and LNG terminals, Chinese natural gas exports will benefit Thailand, which relies increasingly on LNG imports as the natural gas supply from the Gulf of Thailand becomes depleted. Other beneficiaries include countries such as Vietnam, Malaysia, the Philippines, and India, whose power sectors also rely on LNG imports.

At the same time, the encouragement of the Chinese transportation sector to substitute natural gas like CNG for fuel will dampen domestic demand for oil. This will add to the supply of Chinese oil products exported, lowering gross margins for the refining industry in Asia in the long run. Hence, refineries will have to be particularly cautious in this new business landscape.

The changing trends in the oil and gas industry in China can have both positive and negative impacts on players in Asia, who will have to promptly adapt in order to survive.