Easwaran Kanason

Co - founder of NrgEdge
Last Updated: August 25, 2021
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Business Trends

There is trouble brewing in the Chinese teapot refining industry. Since a liberalisation drive in 2015 allowed the network of private refiners dotted across China’s eastern coastline to import crude directly (based on strict government-issued quotas), the industry has proliferated quickly and wildly. Regulation was loose to begin with and therefore unable to keep up with the new explosion of activity. Fiscal and operational indiscipline set in, as the teapots indulged in a wild scramble that changed China’s fuel balance. But a crackdown has begun. The latest victim is the most high profile one yet – Liaoning Bora Enterprise Group, one of the largest of all teapots – and the consequences of the ongoing drama could shape and reshape all of China’s teapots.

The rise of Chinese private refiners has a rich history that is linked to the delicate state-capitalist balance that China has attempted to thread since Deng Xiao Peng’s economic reform pragmatism of the 1980s. That liberalisation turned China into a manufacturing powerhouse, with thousands upon thousands of factories springing up across the coastline, producing everything from plastic toys to synthetic fabrics to solar panels that were shipped worldwide through giant ports. At that point, supply chains in China’s manufacturing industries were fairly specialised. Raw materials were imported, converted and then exported as finished products. But even within the confines of communism, capitalist tendencies sprung up. The manufacturing entrepreneurs gradually realised that they could greatly boost profit margins and diversify operations if they exerted greater control over their supply chain. So companies that were dependent on hydrocarbon-based raw materials – petrochemicals, textiles, plastics, fertilisers, paints – starting setting up oil refineries of their own, instead of being beholden to state oil refiners for supply. The first private refineries were simple affairs – straightforward CDUs that processed light crudes straight mainly for naphtha, hence the name ‘teapots’. As time went by, sophistication set in. Some began installing more advanced technology such as hydrocrackers to process heavier (and therefore cheaper) crudes. Gradually this changed the makeup of China’s fuel markets. In parallel with the vast processing capacity added by state refiners Sinopec and Petrochina, the teapots were producing increasing quantities of gasoline and diesel. Bit by bit, this surge in crude capacity flipped China into a net exporter of certain fuels, which had ramifications across the Asia-Pacific refining industry across the 2000s.

Up until 2015, teapot refiners were forbidden from procuring crude supplies on their own. But a liberalisation drive change that, with China’s central government introducing a crude import quota system for private refiners that allowed direct sourcing for the first time. Since then, growth in teapot refining (a term that is increasingly incorrect) has been explosive, rivalling even China’s state-owned giants. But with that growth has come mischief. Environmental standards and rules were flouted as teapots expanded their operations. And – even more egregious in the eyes of the Party – taxation loopholes were highly exploited to boost profits. Much of this lies in the fault of loose regulation that allowed the industry to get ‘too big for its britches’, prompting government clampdowns and the introduction of new rules to curb such flouting. It is part of a drive by the Party to re-assert control over an economy that it views as too liberalised, with the tech and finance sectors also coming under increased scrutiny. As just as Alibaba’s Jack Ma was humbled by Xi Jin Ping’s forces, so too have the teapots.

Already in 2021, teapot refineries in Shandong – home to one of the largest concentrations of teapots in China – were brought to heel with the introduction of new financial, fiscal and environmental regulations that all refiners had to sign up to. And then in August, the tax probe initiated against Liaoning Bora Entreprise culminated in a management takeover by government officials from Panjin City, ahead of even heavier possible repercussions such as heavy fines and insolvency. Although Bora is not the only refiner in Panjin being targeted, it is by far the most high profile. With a total crude processing capacity exceeding 400,000 b/d, Bora is one of China’s largest teapots with assets valued at over US$14 billion. In 2019, Bora broke grown on a US$2.5 billion petrochemicals plant in a joint venture with US chemicals giant LyondellBassell Industries – then the largest petrochemicals investment project by far by a teapot refiner. The amount of unpaid taxes is undisclosed but it said to be ‘vast’ and dating back several years. But insolvency may not be the answer sought by the party. Bora is a major employer in Panjin and a collapse could lead to a huge financial and workforce risks. Instead, the government is attempting to restructure Bora while reassuring investors and preserving operations in a continuation of Bora’s own efforts: in July 2021, the company had already sold its stake in a chemicals unit to raise cash. It is unknown at this point what Bora’s fate is, but it is definitely true that a once-jewel of teapot refiners is now severely tarnished. 

The fallout of Liaoning Bora Entreprise Group is being closely watched by traders and processors that have a stake in China’s downstream industry. It is clear from Beijing’s actions that it will no longer tolerate fiscal abuses or the expansion of private firms into conglomerates that could threaten state entities (as well as wealthy individuals building up cults of personalities). But is also clear that Beijing cannot just wipe out the teapot refining industry. There is too much at stake, as the teapots in Shandong and Liaoning now account for a quarter of the country’s overall refining capacity, and have deep integration with crucial industries downstream of petrochemicals and fuels. But the Party can bring them to heel.

If the threat of tax probes and government investigations aren’t enough, then the Party has an even more potent weapon: crude import quotas. Beijing has already begun scaling this back, with the largest round of quota approvals in July being the smallest since 2015. The makeup of the quota allocations is also interesting: some old, more established private refiners haven’t been awarded any volumes this year, while some of the newer generation of teapots – dubbed teapots 2.0 – have been receiving regular new quotas. All this is important because it affects China’s overall appetite for imported crude, particularly lighter grades that have higher yields for petrochemicals feedstock. This could affect everything from US shale exports to freight rates originating from China. After several years in a free-for-all (and rather profitable) wilderness, the crows are coming home to roost for China’s teapot refiners. Some may survive, some may not. But those that remain will live in caution, since the Party is now watching.

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High Oil Prices and Indonesia’s Ban on Oil Palm Exports

Supply chains are currently in crisis. They have been for a long time now, ever since the start of the Covid-19 pandemic reshaped the way the world works. Stressed shipping networks and operational blockages – coupled with China’s insistence on a Covid-zero policy – means that cargo tanker rates are at an all-time high and that there just aren’t enough of them. McDonalds and KFCs in Asia are running out of French fries to sell, not because there aren’t enough potatoes in Idaho, but because there aren’t enough ships to deliver them to Japan or to Singapore from Los Angeles. The war in Ukraine has placed a particular emphasis on food supply chains by disrupting global wheat and sunflower oil supply chains and kicking off distressingly high levels of food price inflation across North Africa, the Middle East and Asia. It was against this backdrop that Indonesia announced a complete ban on palm oil exports. That nuclear option shocked the markets, set off a potential new supply chain crisis and has particular implications on future of crude oil pricing and biofuels in Asia.  

A brief recap. Like most of Asia, Indonesia has been grappling with food price inflation as consequence of Covid-19. Like most of Asia, Indonesia has been attempting to control this through a combination of shielding its most vulnerable citizens through continued subsidies while attempting to optimise supply chains. Like most of Asia, Indonesia hasn’t been to control the market at all, because uncoordinated attempts across a wide spectrum of countries to achieve a similar level of individual protectionism is self-defeating.

Cooking oil is a major product of sensitive importance in Indonesia, and one that it is self-sufficient in as a result of its status as the world’s largest palm oil producer. So large is Indonesia in that regard that its excess palm oil production has been directed to increasingly higher biodiesel mandates, with a B40 mandate – diesel containing 40% of palm material – originally schedule for full implementation this year. But as palm oil prices started rising to all-time highs at the beginning of January, cooking oil started becoming scarcer in Indonesia. The government blamed hoarding and – wary of the Ramadan period and domestic unrest – implemented a Domestic Market Obligation on palm oil refineries, directing them to devote 20% of projected exports for domestic use. Increasingly stricter terms for the DMO continued over February and March, only for an abrupt U-turn in mid-March that removed the DMO completely. But as the war in Ukraine drove prices even further, Indonesia shocked the market by announcing an total ban on palm oil exports in late April. Chaotically, the ban was first clarified to be palm olein only (straight refining cooking oil), but then flip-flopped into a total ban of crude palm oil as well. Markets went haywire, prices jumped to historical highs and Indonesia’s trading partners reacted with alarm.

Joko Widodo has said that the ban will be indefinite until domestic cooking oil prices ‘moderate’. With the global situation as it is, ‘moderate’ is unlikely to be achieved until the end of 2022 at least, if ‘moderate’ is taken to be the previous level of palm oil prices – roughly half of current pricing. Logistically, Indonesia cannot hold out on the ban for more than two months. Only a third of Indonesia’s monthly palm oil production is consumed domestically; the rest is exported. An indefinite ban means that not only fill storage tanks up beyond capacity and estates forced to let fruit rot, but Indonesia will be missing out on crucial revenue from its crude palm oil export tax. Which is used to fund its biodiesel subsidies.

And that’s where the implications on oil come in. Indonesia’s ham-fisted attempt at protectionism has dire implications on biofuels policies in Asia. Palm oil prices within Indonesia might sink as long as surplus volumes can’t make it beyond the borders, but international palm oil prices will remain high as consuming countries pivot to producers like Malaysia, Thailand, Papua New Guinea, West Africa and Latin America. That in turn, threatens the biodiesel mandates in Thailand and Malaysia. The Thai government has already expressed concern over palm-led food price inflation and associated pressure on its (subsidised) biodiesel programme, launching efforts to mitigate the worst effects. Malaysia – which has a more direct approach to subsidised fuels – is also feeling the pinch. Thailand’s move to B10 and Malaysia’s move to B20 is now in jeopardy; in fact, Thailand has regressed its national mandate from B7 to B5. And the reason is that the differential between the bio- and the diesel portion of the biodiesel is now so disparate that subsidy regimes break down. It would be far cheaper – for the government, the tax-payers and consumers – to use straight diesel instead of biodiesel, as evidenced by Thailand’s reversal in mandates.

That, in turn, has implications on crude pricing. While OPEC+ is stubbornly sticking to its gentle approach to managing global crude supply, the stunning rebound in Asian demand has already kept the consumption side tight to match that supply. Crude prices above US$100/b are a recipe for demand destruction, and Asian economies have been preparing for this by looking at alternatives; biofuels for example. In the past four years, Indonesia has converted some of its oil refineries into biodiesel plants; in China, stricter crude import quotas are paving the way for China to clamp down on its status of a fuels exporter in favour of self-sustainability. But what happens when crude prices are high, but the prices of alternatives are higher? That is the case for palm oil now, where the gasoil-palm spread is now triple the previous average.

Part of this situation is due to market dynamics. Part of it is due to geopolitical effects. But part of it is also due to Indonesia’s knee-jerk reaction. Supply disruption at the level of a blanket ban is always seismic and kicks off a chain of unintended consequences; see the OPEC oil shocks of the 70s. Indonesia’s palm oil export ban is almost at that level. ‘Indefinite’ is a vague term and offers no consolation to markets looking for direction. Damage will be done, even if the ban lasts a month. But the longer it lasts – Indonesian general elections are due in February 2024 – the more serious the consequences could be. And the more the oil and refining industry in Asia will have to think about their preconceived notions of the future of oil in the region.

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Market Outlook:

  • Crude price trading range: Brent – US$110-1113/b, WTI – US$105-110/b
  • As the war in Ukraine becomes increasingly entrenched, the pressure on global crude prices as Russian energy exports remain curtailed; OPEC+ is offering little hope to consumers of displaced Russian crude, with no indication that it is ready to drastically increase supply beyond its current gentle approach
  • In the US, the so-called NOPEC bill is moving ahead, paving the way for the US to sue the OPEC+ group under antitrust rules for market manipulation, setting up a tense next few months as international geopolitics and trade relations are re-evaluated

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