Special from ZeroHedge

One week ago we reported (for the second time) that one of the biggest mysteries for the global oil market, and certainly the biggest wildcard for future oil prices, is the current state of China’s Strategic Petroleum Reserve. As JPM reported , China’s SPR demand was equivalent to approximately 1mm bpd. More importantly, stopping shipments for the reserve would wipe out about 15 percent of the country’s imports. More to the point, according to JPM, and contrary to official data, China’s strategic oil reserve was approaching capacity, which going back to JPM’s June calculation, meant that “our base case assumes China continuing high volumes of (1mbd) SPR builds through August, while factoring in 7% domestic crude production decline and 2% refinery throughput increase. This means 15% mom decline in China’s crude imports in September, or 1.2mbd loss from the China inventory demand. China’s net oil imports ytd has expanded 16% yoy, versus a flat consumption growth.”

This has been cited as one of the reasons why China’s relentless demand for oil, which in early 2016 hit a record level of monthly import, has seen a modest decline in recent months.

However, it appears that the mystery over China’s SPR is no longer the main driver when it comes to the future of Chinese demand. According to Oilchem, a Shandong-based industry researcher, China’s major refineries cut runs to 70.3% of capacity as of September 1, down -1.43% from Aug. 18. To be sure, a big part of the utilization rates decline emerged as the Sinopec Qilu refinery with 8m ton/yr capacity, started maintenance. Oilchem expects the tuns to rebound in mid-Sept. as some plants will resume after works.

That, however, may prove optimistic, because while we don’t doubt that China’s major refiners do come back on line in short notice, the biggest variable for China’s recent oil demand, the blistering pace of refining by China’s smaller, “teapot” refiners, may be about to see a steep decline. The reason is that, as Bloomberg wrote over the weekend, suddenly “everyone wants a share of the world’s hottest oil market, including China’s taxman.”

Which brings us to the teapots: as Bloomberg adds, “purchases by the country’s independent refiners, granted permission last year to buy foreign crude, have soaked up some of the global oil glut and helped revive prices after the biggest collapse in a generation. Sellers from Saudi Arabia to BP Plc have been supplying the plants known as teapots, which account for a third of the nation’s processing capacity.”

And now, the blistering crude oil demand from China may be about to hit a brick wall as a “government tax crackdown threatens to constrain this new source of demand from China, which rivals the U.S. as the world’s biggest importer.”

How much is at stake? No less than a whopping 1.4 million barrels per day in teapot demand, more than all of Saudi Arabia’s supplies to the world’s second-biggest user of oil.

Putting this number in context, China’s oil imports have averaged an unprecedented 7.5 million barrels a day so far this year, boosted by the teapots, government data show. The purchases, along with production outages in Nigeria and Canada, helped benchmark Brent crude jump almost 90 percent from mid-January to June.

Cited by Bloomberg, Wang Pei, a senior analyst at Unipec, the trading unit of China’s largest state-run processor, Sinopec said that the government crackdown “is sort of a warning to independent refiners. It has been tough to implement proper tax compliance among independent refiners.”

One of the reasons why last year’s excess supply surge did not have an even more pronounced impact on prices is thanks to the demand that was brought online by China’s independent refiners: teapots started getting licenses to import foreign crude last year as part of a government effort to boost private investment in China’s energy industry. The refiners previously had to rely on state-owned oil majors including PetroChina  and Sinopec for supplies of crude. They still have to adhere to a quota determining how much they can import. Nonetheless, as the WSJ reported in May, “‘Teapot’ Refineries Shore Up China’s Demand for Crude” and Bloomberg added a month ago that “Oil Refiners Struck by Glut Find Comfort in China Teapot Drought.”

However, that “silver lining” is about to be brushed off as authorities “are clamping down on anyone skirting the rules. The National Development and Reform Commission on Aug. 23 said the government will disqualify license applications or revoke import quotas if companies evade tax or falsify documents. Nobody replied to a fax seeking more details sent to China’s NDRC after regular working hours on Monday or answered calls to the press office.”

To be sure, while it is highly unlikely that all of the 1.4mmbpd in teapot demand could come off line, there will be a substantial cut in demand. Bloomberg notes that while local authorities in Shandong province, where the refineries are clustered, will support the industry, “import licenses granted by the government may drop by the equivalent of 400,000 barrels a day next year to 1 million barrels amid the crackdown on tax evasion, according to consultant Energy Aspects Ltd.”

Processing rates at teapots “will be curbed by the government’s regulation on taxation and operations,” Zhang Liucheng, director and vice president of Shandong Dongming Petrochemical Group, the biggest Chinese private refiner, said in an interview in Singapore on Monday. The company is tax-compliant, having paid 1.7 billion yuan ($255 million) in tax last year and 2.6 billion yuan in the first eight months of 2016 as it started refining imported crude, Zhang said.

Needless to say, for price purposes, a 400,000 bpd drop in global demand is the equivalent of a 400,000 bpd production surplus by OPEC or non-OPEC sources, certainly when it comes to price.

The importance of teapots to what remains a market mired in excess OPEC oversupply, was highlighted earlier this year when one of them purchased a spot cargo from Saudi Arabia, which broke from its usual policy of selling only under long-term contracts. Iran’s state-run oil company is said to be in talks to sell more crude to Trafigura in a strategy that may help it break into the market to supply the independent refiners.

If and when a substantial number of teapots are suddenly put offline by the government, both Saudi Arabia and Iran will scramble to find alternative buyers. To do that, they will have to offer generous price concession.

Among the notable losers from a teapot crackdown would be the independent commodity companies, such as Vitol, Glencore and Trafigura who have generated substantial profits shipping oil from the middle east to these sources of demand. As Chin Hwee Tan, the CEO for Asia-Pacific at Trafigura, said “the advent of the Chinese private refiners as major buyers of crude and exporters of product has been the biggest change in the market since the shale revolution. We’re doing significant business with them.”

Finally, it’s not just taxes: teapots face other headwinds including port and pipeline infrastructure not developing as fast as oil purchases. Chinese imports are also at risk of slowing because of ship traffic and lack of storage capacity. Concern about creditworthiness and lack of experience in international trade are also challenges. Slowing refining profits have forced cuts in processing rates, while the implementation of higher fuel-quality standards could force some of them to shut.

To be sre, some remain optimistic, such as BP, according to Andy Milnes, BP’s CEO of integrated supply and trading for the Eastern Hemisphere. Shandong Dongming last year got crude from the company as part of a long-term supply contract.

In spite of China’s clampdown, the government is still working toward “liberalizing oil markets, and would continue to encourage the operations of independent refiners,” according to Unipec’s Wang. “Many of them perhaps account for 70 to 80 percent of tax revenue in their cities, so the local government will want to keep them alive.” However, if there is one thing that is certain about Chinese “liberalization” reforms it is that things are certain to get much worse before, and if, they ever get better, once the government starts micromanaging every aspect of yet another formerly independent industry’s transition.

* * *

That covers the demand side of the equation. As for the supply side, the store is well-known. As the following chart reveals, most OPEC members are producing more oil now than they were in January, or at any time during the past year.

To summarize: OPEC oil production near record and rising, shale slowly returning on line with every weekly increase in Baker Hughes oil rigs, while demand is about to see a sharp drop due to either China’s SPR nearing capacity, or the crackdown on teapots that is about to cut Chinese demand by as much as nearly half a million in barrels. How this will impact price, we leave to the central bankers to figure out, whose only recourse may be to start buying commodities in the open market, in addition to bonds and stocks, thus nationalizing yet another market.

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