China's Shrunken Thirst for Oil

The pain of record-high crude plus Beijing policies that squeeze refiners are sinking demand -- and may help speed the yuan's revaluation

Even China's enormous thirst for energy appears to have its limits. Evidence has mounted across Asia in recent days that oil prices have finally grown too rich for China, which accounted for more than 40% of total growth in world demand in 2004 and is expected to feed even more explosive demand this year. But on July 18, OPEC cut 150,000 barrels a day from its forecast for oil-demand growth this year, citing China's weakening appetite for crude.

Consumption of crude and refined products in China is widely felt to have been a key factor behind record-beating crude-oil futures prices in 2004 and so far in 2005. But traders, analysts, and industry sources around Asia contacted by Platts Global Alert say the latest spike in crude futures, to an all-time nominal high of $62.10 for the benchmark West Texas Intermediate grade on July 7, seems to have burst China's demand bubble. (Platts, like BusinessWeek and Standard & Poor's, is a unit of The McGraw-Hill Companies (MHP ).) According to sources in China, the lurch higher in crude futures for much of early July created substantial pain at almost every level in the Middle Kingdom's oil sector by dragging Asian crude benchmarks higher as well.


  Fundamentally, sources say the reluctance of China's government to allow significant increases for domestic "guidance prices" for important retail products like diesel and gasoline has pushed the country's state-owned and independent refiners to the breaking point. The disparity between high Asian benchmark crude-oil prices and closely controlled prices for the products that are refined from that crude oil have forced significant cuts in production runs at refineries and have eaten into Chinese crude demand.

Moreover, artificially low domestic retail prices have also turned China into an exporter of products that are usually in tight supply. Its major trading companies, China Oil and Unipec, have been exporting significant extra volumes of "gasoil" (heating oil and diesel fuel) in recent weeks, a product that China ordinarily imports in volume. In other refined-product markets where China normally falls short on domestic production, importers have stopped buying foreign products altogether.

Meanwhile, domestic resale values in China for other hydrocarbons -- fuel oil, propane, and butane -- have run below import prices for large chunks of 2005, a phenomenon referred to in China as dao gua. During spells of dao gua, fuel oil and liquefied petroleum gas importers normally put product into stock. Stocks are now so high in some ports that importers have stopped buying altogether for weeks on end -- causing a second major dent in China's apparent oil demand, on top of diminished crude-oil runs.


  The phenomenon has spilled over into international estimates of Chinese demand, which recently took a very bearish turn for the oil markets. In its latest monthly oil report, the International Energy Agency (IEA) estimated that Chinese demand had weakened "considerably" because of the country's policies for oil products and electricity. Low electricity tariffs have put oil-fired power stations in Southern and Eastern China into the same boat as some of the refiners -- to stop generation or face selling electricity at a loss.

The IEA report said net oil-product imports appeared to have fallen to just 150,000 barrels per day, well below the 730,000-barrel rate for May, 2004. Maybe most tellingly, the IEA's analysis showed that China's apparent demand for crude oil and refined products for the entire second quarter of 2005 ran at an estimated 6.47 million barrels per day -- down 60,000 barrels (or almost 1%) from the second quarter of 2004. A drop in second-quarter demand would be dramatic news, if final numbers show the same fall.

A senior source with one of China's major state-owned refiners, on condition of anonymity, told Platts that China's twin refining giants, Sinopec (SNP ) and PetroChina (PTR ), have been engaged in intensive cost-cutting measures for more than a year to ease the pain of razor-thin refining and resale margins effectively imposed by the government. Those cost-cutting actions have, coincidentally, often doubled as energy-efficiency measures, and have included limitations on air-conditioning usage and lighting in industrial and office space.


  "We hope that the government will let us escape this pain, at least for a while," said the source, when asked if Chinese industrial-regulatory authorities were likely to allow continued run cuts if domestic supplies of gasoline or diesel start to be low. In fact, one of the oddities of China's oil economy in 2005 is that domestic gasoline and diesel suppliers have complained of tight supplies in China's major Southern gasoline and diesel markets this year, even as refineries have cut runs or shut down entirely.

Sinopec, which accounts for 55% of China's 5.8 million barrels per day of refining capacity, is said to have decreased runs by as much as 400,000 barrels daily below normal operating rates of about 2.9 million barrels per day. PetroChina, which operates more refineries than Sinopec over a wider geographic area, accounts for less overall capacity, with just 38% of China's refining capacity. It's understood to be operating at 140,000 barrels per day below typical run rates of about 2 million barrels per day.

Strong anecdotal evidence now exists of widespread power disruptions and major energy-saving initiatives, including a notable switch to smaller cars. Gideon Lo, a Hong Kong-based analyst with DBS Vickers, says the spike in fuel-oil prices this year has forced some large fuel-oil-powered plant operators to reconfigure to burn coal. If China is to hit earlier forecasts for 6.5% growth in oil demand this year, he says, second-half demand would have to rise by more than 6%. This is quite unlikely, according to Lo, especially since it was already at a high level in second-half 2004.


  Industry sources now believe that China's dominant refiners will be allowed to operating at reduced rates, drawing down instead on commercial stocks and enforcing energy-savings measures among customers, until the Chinese government gives the green light for the yuan's revaluation. Such a move, which could see the Chinese currency gain as much as 10% in value against the U.S. dollar, would make crude oil cheaper to buy for Chinese refiners and restore much of their lost margins.

China has fiercely resisted calls from the U.S. and Europe for a firm timetable for revaluing its currency. Western nations believe the cheap yuan has given Chinese exporters an unfair advantage in textiles and manufactured goods, driving some Western industrial groups to the brink of bankruptcy. A prompt revaluation would certainly take the edge off tense Sino-U.S. relations, which are currently frosty after the negative U.S. political reaction to the bid by China's CNOOC (CEO ) for U.S. oil and gas outfit Unocal (UCL ).

Oil-market sources in Asia believe that China will allow a controlled revaluation of the yuan soon, possibly within months. A 10% appreciation would boost margins for Chinese refiners in a single step, by reducing the yuan value of imported crude oil while leaving domestic refined-product prices -- already priced in yuan -- unchanged.


  Where does Chinese oil demand go from here? Predictions by industry experts are at odds. In its June oil report, the IEA said it expected a recovery in second-half 2005. For next year, the IEA expects Chinese apparent demand to grow by 490,000 barrels per day, or 7.2%.

But others aren't so sanguine. In a widely reported analysis in mid-July, Hong Kong-based economist Andy Xie of Morgan Stanley (MWD ) said he believed the current "oil bubble" would burst "as the weak economic data and oil-demand data pour in from Asia." Xie's report sounded an ominous note for oil bulls: "At some point, the market will abandon the fiction of endless Asian or Chinese demand."

From Platts Global Alert

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