FOCUS

China struggles to satisfy oil demand

High oil prices and low economic growth are likely to depress any increase in world oil demand this year. The one market that appears to buck the trend is China, where demand seems to be rising at a healthy 5 per cent a year: nearly four times the rate most forecasters predict for the rest of the world in 2003. Assessing Chinese demand is difficult in the absence of reliable official figures. Some of the rise in China’s demand is more likely to be stockpiling in advance of the expected US-led war with Iraq. China is nevertheless attracting growing attention from oil exporters as one of the world’s most desirable and dynamic markets.

Imports on the rise

Much of the immediate attention on China is focused on the recent rise in crude-oil imports. During the whole of 2002, China appears to have imported 1.4 mn bpd of crude: a rise of more than 15% over 2001. Last November, imports even touched 1.8 mn bpd before falling seasonally in advance of February’s lunar new-year holiday. Economic growth for 2002 was reported at a healthy 7%. Growth in oil demand, however, may have been significantly lower than the economic and oil import numbers appear to suggest.

Table A
China: supply, demand, & trade balance, 2002
	Volume (th bpd)
Production	3 400
Imports
Crude	1 400
Products	410
Exports
Crude	90
Products	100
Net trade (imports)	1 620
Apparent demand	5 020
Source: Pearl Oil

The lack of reliable official statistics on Chinese demand means that it has normally to be estimated from data on production and net trade. These suggest demand of just over 5 mn bpd in 2002 (see Table A). This figure ignores oil smuggled in both directions across China’s borders. The principal trade in bootleg oil is the import of refined products into China’s most rapidly growing provinces in the south. The net effect of smuggling may be to add another 200,000 bpd to China’s apparent demand.

The other main complication in arriving at a figure for demand is the lack of any proper data on stock levels. Some of China’s oil buying late in 2002 was undoubtedly to build up inventories in advance of any disruption in supplies later this year as a result of war in the Middle East, from where China obtains 56% of its crude oil (see Table B).

Growing stockpiles

During 2002, China’s two main state oil companies, PetroChina and Sinopec, raised their stock cover from 10 to 15 days’ forward consumption, resulting in a stockbuild of some 24 mn bbl. Strategic crude stocks amounted to about 75 mn bbl in January 2003, with a similar volume held in refined products. Buying for stock has continued this year, with increasing emphasis on China’s principal non-Middle Eastern supply source, Africa (see Table B).

Taking the effects of stockbuilding and smuggling into account, China’s actual product consumption in 2002 appears to have been about 5.1 mn bpd, of which nearly 4.6 mn bpd was refined domestically and the remainder imported, officially or otherwise. A similar calculation for 2001 suggests apparent demand of 4.9 mn bpd, giving annual growth of 0.2 mn bpd, or 4.1%. Growth of a similar magnitude looks likely during 2003.

Meeting oil demand

Western estimates generally put China’s crude distillation capacity at just over 4.5 mn bpd. This figure covers some 94 refineries operated by PetroChina and Sinopec plus a foreign joint-venture plant at Dalian. In addition to the above, China has unspecified numbers of small, simple distillation units, many of which operate illegally (see ‘The Month in Brief’, July 2002). Capacity utilization rates are nevertheless high and the entire system is under increasing strain.

Table B
China: crude-oil imports, 2002
	Volume (th bpd)	Share (%)
Middle East
Iran	217	17.9
Kuwait	29	2.4
Oman	164	13.6
Qatar	28	2.3
Saudi Arabia	175	14.5
UAE	13	1.1
Yemen	46	3.8
Others	7	0.6
Total	679	56.2
Africa
Angola	77	6.4
Congo	13	1.1
Nigeria	16	1.3
Others	167	13.8
Total	273	22.6
Others	257	21.3
Total	1 209	100.0
NB: totals rounded
Source: World Oil Trade, 2002

The short-term solution is for China to import more refined products: a task made easier by the growing surplus of refinery capacity elsewhere. in Asia (see ‘Focus’, August 2002). The government prefers, however, to import more crude and to manufacture products domestically. The state oil companies, on the other hand, lack the resources to build new refineries quickly enough, and China’s record in attracting foreign refinery investors has been mixed, to say the least. In 1996, Total took a 20% share of the new 100,000bpd Wepec joint-venture refinery at Dalian, China’s first such venture with an overseas refiner. No sooner had the refinery opened in October of that year than Total and its Chinese partners were embroiled in disputes about whether the products could be exported or not.

Two years earlier, Arco had obtained a 9.9% stake in the 160,000bpd Zhenhai refinery when the government floated 25% of the Zhenhai Refining and Chemical Company on the Hong Kong Stock Exchange. In 1996, the US company increased its shareholding. It was not, however, offered a seat on the board or any active role in Zhenhai’s management. Several other companies tried to develop refinery schemes in conjunction with China’s state oil companies, but the result was usually a series of protracted negotiations ending in no agreement. Some foreign firms with no refining background, including a Hong Kong property company, tried to develop new refineries: again, without success. Foreign interest in China’s downstream sector has not entirely disappeared, but the emphasis now appears to be on petrochemicals or refined products retailing. Late last year, Shell announced approval for a $4.3bn petrochemical complex in Canton after several years of negotiations. BP meanwhile has been investing in schemes to make a range of chemicals including ethylene, purified terephthalic acid (PTA) and acetic acid. Both companies also want to develop retailing networks in China.

More refineries needed

China’s refining industry is dominated by two state-owned, vertically-integrated oil giants, PetroChina and Sinopec. These were originally the state upstream and downstream companies, respectively, but were reorganized as vertically-integrated entities in 1998. The new firms were re-established as regional monopolies: PetroChina in northern China and Sinopec in the south, but since then, they have started to compete on each other territories. Foreign competition is scheduled to follow as part of the terms for China’s entry to the World Trade Organization (WTO).

Both PetroChina and Sinopec appear determined to keep out competitors in their regional heartlands for as long as possible. Last year, Sinopec overpaid heavily for a small refinery in China simply to keep PetroChina out of its territory. Company officials hinted at the time that foreign refinery investors would receive a similarly hostile reception. Two other national oil companies, state oil trader, Sinochem and the China National Offshore Oil Company (CNOOC), also plan forays into domestic refining. Sinochem already has a share in the Wepec joint-venture and wants to acquire more downstream capacity. Its ambitions may nevertheless exceed its budget, especially since it also wants to move into the upstream sector. CNOOC, which produces most of China’s offshore oil, has announced plans for a 240,000bpd refinery at Huizhou in Canton, but it too is in danger of dissipating its energies in space. It has ambitious plans to be an international gas producer, LNG importer, chemical producer and petrol retailer inside China.

Chinese refiners have three main issues to face over the next few years. First of all, they need to raise crude distillation capacity in order to keep pace with demand. Secondly, they need to improve their operating efficiency in order to compete in the deregulated market environment required from next year onwards as a result of China’s WTO membership. Thirdly, they must invest heavily in upgrading units to enable them to satisfy domestic demand for cleaner fuels.

China’s main refinery system is already operating close to nameplate capacity. The only thing preventing widespread product shortages is the presence of about 80 small crude distillation units outside the main system. Whilst the 95 principal refineries have a combined capacity of 4.5 mn pd, the remaining 80 or so between them only account for a further 0.9 mn bpd. Many of the latter are units of less than 10,000 bpd and a significant proportion of this subsidiary capacity is unusable. Even the main refining system includes several plants ranging in size from 2,000–6,000 bpd. Most of these are simple pipestills located on oilfields, well away from markets. The majority of Chinese refineries, in fact, are in the northern half of the country where most of the oil is produced, rather than in the south where most of the demand growth is.

Closure of the small plants is required not only for reasons of operating efficiency but also for environmental reasons since they are major sources of groundwater- and air-pollution. Their high operating costs are a drain on both Sinopec and PetroChina, which both face competition from imported refined products from 2004. The government has traditionally protected its state refineries from cheaper imports by stringent import quotas, but these are due to disappear next year as part of the WTO entry-process. This is undoubtedly a reason why the two main state oil companies are reluctant to embark on major programmes of refinery expansion.

Even if crude distillation capacity does not rise sharply, upgrading capacity will almost certainly have to. China faces the need to improve the quality of its refined products just as its crude oil slate is changing. Sulphur levels pose a particular challenge. Chinese demand for low-sulphur products is rising just as the supply of domestically-produced sweet crude is reaching its upper limits. Thus, more low-sulphur products must be made using imported crudes, and these tend to be sour crudes from the Persian Gulf. China’s refiners are trying to buy time by raising their purchases of sweet crudes from Africa, but most of the increase in crude demand over the longer term will have to come from Middle Eastern imports. China’s desulphurization capacity is currently less than half the world average. It will also need more reforming capacity to process the increasing naphtha volumes produced by running more Gulf crudes, along with extra alkylation and isomerization units to meet the demand for increased octane levels in motor spirit. Sinopec, PetroChina, CNOOC, and foreign refiners alike may decide to risk as little of their investment capital as possible until it becomes clear how much of China’s increased demand can be met by product imports from 2004 onwards. It looks increasingly unlikely, for instance, that either CNOOC’s Huizhou refinery or a new 200,000bpd unit planned by Sinopec at Qingdao will be built before 2010. PetroChina and Sinopec plan between them to increase distillation capacity by only 410,000 bpd between now and 2005. In the same period, demand is likely to increase by at least 600,000 bpd.

One short-term solution, however, may be beginning to emerge. Sinochem has just signed a processing deal with Taiwanese refiner Formosa Petrochemical under which the Chinese state trader will supply crude oil to Formosa’s Mailiao refinery and take back refined products. Another processing deal was signed in 2002 with Taiwan’s other refiner, the Chinese Petroleum Corporation (CPC). Here PetroChina supplies CPC’s Kaohsiung refinery with crude from its own production in Sudan in return for light products (see ‘The Month in Brief’, September 2002). Refiners in the Republic of Korea and Japan also have spare capacity and further Chinese deals could follow.

More oil or more gas?

Another way of alleviating pressure on China’s refinery system is to substitute some of the refined product demand with natural gas. Two of the main areas where this could happen are in heavy industry and power generation. Chinese refineries are already unable to meet domestic demand for heavy fuel oil (HFO) and at least one state trading company has increased its contract volumes for fuel oil imports for 2003. Iranian exports of HFO to China will go up by 40% this year to 65,000 bpd. Most of China’s product imports are accounted for by HFO (see Table C).

Table C
China: product import quotas, 2002
	Volume (th tonnes)
Naphtha	1300
Gasoline	200
Jet fuel	1 600
Gasoil	1 000
Waxy oil	900
HFO	17 000
Total	22 000
Source: Chinese State Economic & Trade Commission

Gas consumption is set to rise sharply thanks in part to higher domestic production, but mainly as a result of a number of large new import schemes involving both pipeline gas and LNG. Gas at present accounts for only 3% of China’s primary energy consumption, compared with oil’s share of nearly 28% (see Table D). In 2010, gas is supposed to be up at the 10% mark. By that time, China will have begun to import LNG. The first import terminal is due to come into operation in 2005. There should also be at least one major new gas trunk-line connecting the Tarim Basin in western China with the cities of the east. Further transmission lines are proposed by CNOOC to connect gas fields on the continental shelf with the mainland. Cross-border pipeline links are being discussed with Russia, Turkmenistan, and Kazakhstan, but progress is slow, and without a well-developed transmission system, gas will not be able to substitute for oil as quickly as China’s planners want..

Table D
China: primary energy balance, 2001
Fuel	Consumption
	(mn toe)	(%)
Coal	520.6	62.0
Oil	231.9	27.6
Hydro-electricity	58.3	6.9
Natural gas	24.9	3.0
Nuclear power	4.0	0.5
Total	839.7	100.0
Source: BP’s Statistical Review of World Energy, 2002

Slow progress with the transmission system may not be the only factor inhibiting the substitution of oil by natural gas. The government is also anxious to see gas make substantial inroads into the coal market, which at present makes up 62% of the country’s primary energy balance. Coal’s pollution problems far exceed those of oil both in terms of sulphur and carbon emissions. Most of the mines are uneconomic and the government wants to shut large numbers of smaller pits. Gas cannot replace substantial tranches of oil and coal together. If the decision is to use it primarily as a substitute for coal, the shortage of refining capacity will return once more to haunt the oil industry.