www.poten.

com 26 October 2012

China’s Teapot Refineries Face Regulatory Challenges

China’s independent petroleum refining industry comprises an estimated one-fifth of

China trying to
rationalize refinery
capacity growth, but…
…teapots challenging
Beijing
the nation’s nameplate capacity – or some 2 mbpd. Many of these independent plants
have a capacity of around 40 kbpd (2 mtpa) or less, and are typically referred to
pejoratively as “teapots.” These small refineries fell into the cross-sights of Beijing’s
regulators a few years ago, as they sought to rein in an industry segment whose growth
had overheated. To cool this segment, China’s economic planners mandated the
closure of dozens of teapot refineries with a capacity less than 2 mtpa by the end of
2013. It now seems, however, that owners of some of these plants are planning to
boost their capacities above this threshold as a means of continuing operation.

Slowing oil demand

growth and rising
refining capacity
pressuring utilizations

Source: Poten & Partners, Various

While planning more capacity is one thing and building it quite another, the intertwined
role of these refineries in China’s petroleum market ultimately cascades into the lives of
tanker owners. As the chart above highlights, China’s 2011-12 increases in refining
capacity has been met by lower utilization rates country-wide.

Outcome of 2013 How the closing of some teapot refineries in late 2013 and the possible expansion of
regulations still unclear others will impact China’s need to move imported water-borne oil is presently not clear.
The country’s independent refineries have traditionally played a key swing role in

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 supplying domestic refined products. When refining margins are strong, teapots runs
Teapots as refining rise to help alleviate product shortages. At times of weak margins, processing rates
opportunists lessen. On average, though, these refineries typically see utilization rates of around
40%.

For plants able to dodge the regulator’s bullet, their acquisition by major Chinese oil
refiners seems possible as raising their processing rates may offer an economic
Teapots offer enticing alternative to building new capacity. All the chatter swirling around extending the
targets for Chinese longevity of the teapots, however, is being muffled by the collision of China’s recent
Majors
spurt of refinery capacity additions with its recent somewhat muted domestic product
demand growth. Moreover, larger independent refineries may fit better in the portfolio
of China’s oil majors than the scattered teapots and hence these small plants may lack
suitors.

Chinese Fuel Oil Trade

Net Imports / (Exports)
800

600
Chinese fuel oil trade
balance slowing 400
kbpd

200

-200

-400
Jan-08 Jan-09 Jan-10 Jan-11 Jan-12
Exports Imports Net Imports

Source: Chinese Customs, Poten

Historically, Beijing had sought to control the growth of teapots by restricting their
access to crude oil imports, leaving them reliant on fuel oil as a feedstock, supporting
import demand. As shown in the above chart, Chinese fuel oil net imports have been
Slowing Chinese declining slightly over the past few years, from a modest easing in imports and slight
economic activity cut gains in exports. A recent slowdown in Chinese economic activity cut import demand
import demand
across several commodity classes, featuring a dramatic collapse in iron imports a nd
prices. Fuel oil imports experienced a similar decline, with August imports hitting multi-
year lows, but rebounded in September, in conjunction with other commodity imports
into China.

For tanker owners bringing feedstocks – fuel oil and some crude oil – into the Shandong
Shift in demand
patterns? and Guangdong provinces for those teapot refineries that use imports, trade flows seem
poised to change. As the chart on the following page illustrates, fuel oil movements

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 from the Caribbean to the Far East and South East Asia were more prevalent in the past
than they are now even though China continues to import sizeable quantities of this
Weaning Off Fuel Oil
product. This recent shift in fixtures may allude to teapot refinery economics now
favouring the upgrading crude oil or fuel oil from other areas.

Less fuel oil, more crude

oil flowing East

Source: Poten & Partners

Growing teapots would
only add to refinery
margin woes
With China’s potentially slower oil demand growth trajectory, the current refinery
capacity expansion plans of the Chinese majors already pose a threat to domestic and
international refining margins. Entrenched teapot refiners looking to expand would only
add to these woes. Given the essential role the nation’s independent refiners play in
refined product supply, the larger independents may get even larger – with or without
the help of China’s oil majors. Meanwhile, in the event that China’s top-down policy
planners prevail over entrenched local interests and resistance, some appreciable
rationalization of the inefficient and polluting teapot refinery capacity appears
inevitable.

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