“I’m a (Not so) Little Teapot” – The Changing and Growing Influence of Teapot Refineries in China

By Robert Auers and John Auers

The so-called “Teapot” refineries in China have acquired a significant increase in their public profile and indeed in their impact on both crude and product markets since they were first granted the right to import crude oil in 2014.  They have grown to make up more than 20% of total Chinese refining runs and have become a major driver of increases in both Chinese crude imports and product exports in recent months.  They have also changed in their very make-up, in many cases becoming as large and complex as their government owned competitors.  That leads us to what a teapot refinery truly is, and that is any independently owned facility.  They have traditionally been thought of as small (<100,000 BPD), low complexity facilities (hence the designation “teapot”), serving local markets in northeast China.  However, as capacity rationalizations continue at the smaller plants and upgrades are completed at the larger ones, this dynamic is changing.  The largest teapot refinery currently in operation has a capacity of around 250,000 BPD and significant upgrading capacity, including an FCC and coker.  In addition, two large (~400,000 BPD) teapot refineries are under construction and due for completion in the next 2-3 years (officially late next year, but these timelines seem optimistic).  These plants, located in Liaoning (just west of the Korean Peninsula, near Beijing) and Zoushan (near Shanghai), will both be complex facilities with resid hydrocracking capacity and will be tied to integrated petrochemical plants.  At the same time, we expect continued rationalization of the least efficient teapots.  This will result in continued increases in teapot complexity, size, and utilization rates, but likely much lower (if any) increases in total teapot capacity.

“I’m a Little Teapot, Short and Stout”

We’ll start with a short history of independent refiners in China.  Most were built originally as small, simple facilities in the 1960s and 1970s, typically near oil fields or ports.  Still today, roughly 70% of teapots are located in the Shandong province (just across from the Korean Peninsula, between Shanghai and Beijing), which is also home to the Shengli oil field, China’s second largest.  Most of the remaining teapots are also located in the northern half of China, with Liaoning, Jilin and Heilongjiang also having significant independent refining capacity.  Very few teapots are located in the south of the country.  The national government of China has historically favored their NOCs (CNPC, Sinopec, and CNOOC), but the teapots have survived by utilizing operational flexibility and the help of local governments (who value them as important sources of tax revenues and employment).  However, the government’s push to force teapot refinery closures didn’t really pick up steam until the reform of China’s NOCs in the late 1990s, which looked to strengthen them into globally competitive integrated oil firms.  As a result of policies stemming from these reforms, the number of teapots in China was reduced by more than 50% over the two decades beginning in 1995.

“I Am a Very Special Pot”

However, by 2014, under the direction of Xi Jinping, the Chinese government began considering a different approach towards the teapots.  This ultimately led to the government granting direct crude oil import quotas to Teapots that were deemed large and complex enough to be deserving of them.  Prior to this, teapots were forced to run on a mix domestic crude and unwanted intermediates (especially fuel oil) from the NOCs.  This new policy ultimately led to teapots being granted nearly 1.5 MMBPD of crude import licenses in 2016 and, as a result, china’s crude oil imports growing by double digits YoY in 2016 and 1H 2017.  Moreover, teapots have roughly doubled their utilization rates, from near 30% in 2014 to around 60% in 2016 and 1H 2017.  This still compares unfavorably, however, to the average utilization rates of Sinopec and CNPC facilities (around 75-80%) during the same time period.

The government’s motivation for this policy shift was twofold.  First, they wanted to continue to force the rationalization of the simplest teapots by refusing to grant them crude oil import licenses – placing them at a further competitive disadvantage to their larger peers.  Second, the government wanted to increase the competition for the NOCs in order to boost their operational efficiency.  Moreover, the NOCs have been relatively quiet on the issue, as to not draw too much attention to themselves due to the fact that they have already been some of the chief targets of Jinping’s ongoing anti-corruption campaign.  Still, the benefits of this policy change to the independents have likely been much greater than policymakers anticipated.   China typically resets product prices every ten days to reflect changes in global crude oil prices.  However, as a result of the oil price crash and to protect the profitability of its NOCs, China has chosen not to reset prices if crude dips below $40 per barrel.  A side effect of this policy has been increased profitability of teapots when crude has dipped below this threshold, as they are able to buy crude at cheap international prices and sell products at comparatively high domestic prices.

“Here is an Example of What I Can Do”

Nevertheless, teapots have also faced some notable challenges in entering the global arena over the past two and a half years.  Due to their lack of international crude trading experience, poor credit, and limited infrastructure, teapots have at times had trouble securing crude.  In fact, it was reported that one tanker waited offshore near Qingdao, Shandong (the main port of the province) and never offloaded its cargo because the buyer was unable to obtain a letter of credit to pay for it.  As a result of these types of incidences, 16 Shandong teapot refiners have formed an alliance to strengthen their bargaining power and ease concerns over credit risk.  In addition, several teapot refiners are helping finance an expansion of the port at Qingdao to enable the currently overwhelmed port to handle the increased crude oil volumes.  Furthermore, in late 2016, the Chinese government announced inspections would take place at all of the facilities that had been granted crude oil import licenses to confirm refiners’ compliance with their end of the deal, which included shutting down older units, upgrading some remaining units, building natural gas storage capacity, and ensuring all taxes were paid in full.  No major violations were found, though these inspections did result in about $145 million worth of fines to the sector.  More importantly, no crude oil export licenses were reduced or rescinded.

Still, the most important factor limiting the competiveness of teapots going forward is likely the government’s refusal to grant them product export licenses thus far in 2017.  In 2016, the Chinese government granted modest volumes of product export quotas to independent refiners, but in order to strengthen the profitability of the NOCs and keep the teapots “in check”, the government decided to no longer grant any in 2017.  This has forced teapots to sell the majority of their products to NOCs at discounted prices due to their own undersized or non-existent marketing/retail arms. It is unclear if the Chinese government will maintain this policy regarding exports going forward.  It is clear, however, that while the Chinese government does not appear to be trying to eliminate all independent refiners, it does want to ensure that the NOCs continue to be profitable and dominate the downstream sector in China.  As a result, the eventual fate of teapots will be largely tied to government policy.

Despite this, since 2014, teapots have become a force to reckon with in international markets, both on the crude and product side.  They were a main driver of China’s double digit growth in crude imports last year and so far this year, with U.S. crude starting to become an important component of those imports in recent months.  They have also been a major contributor to a surge in Chinese product exports, which almost doubled last year and were up by 20% in the first half of this year.  As we look forward we certainly have to consider this added presence in our Crude and Refined Products Outlook, in which we monitor changes and projected changes in pricing and supply and demand across the globe for crude and petroleum products. In addition, in our World Refinery Construction Outlook, we provide more detail regarding the projects mentioned in this blog and all announced refinery projects across the globe, with a 1-5 probability rating assigned to each project to estimate the likelihood of its eventual completion.  More information on these publications and our other work involving oil industry developments and dynamics can be obtained by contacting us, visiting our website at turnermason.com or calling Shanda Thomas at 214-754-0898.