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China’s “Teapot” Refineries: Example Of The Bigger Picture

Business, China, Company Strategy, Oil & Gas, US
By John Richardson on 30-May-2016


By John Richardson

IT is all about jobs, jobs and more jobs in politics. Promising to create and maintain employment is how politicians win office. And delivering on these two pledges keeps them in power.

But let’s not by cynical about this. You can make a very strong argument that whilst keeping a particular factory open might not make sense in terms of the standalone economics of the factory, the benefits to the wider economy of keeping that factory open make overwhelming sense. Politicians are thus doing the right thing by taking into account the wider economic picture.

These benefits obviously include both the direct and indirect jobs that depend on the survival of a factory. Indirect jobs include those at companies that supply raw materials and components to the factory, plus of course all the restaurants and jobs that would otherwise not be in business.

Then think about healthcare. When people lose their jobs, with little hope of finding alternative employment, a lot of research shows they are more likely to suffer psychological and physical illnesses. Extra government healthcare costs have to thus also be taken into account.

You can add to this wider picture the damage to an economy that can be caused by people taking to the streets to protest against job losses.

The problem, though, is that these things are incredibly hard to measure and so some people tend not to measure them at all. They instead only look at standalone economics. In the case of an oil refinery or a chemicals plant, people only look at the forecast costs of raw materials, of logistics, of production costs and of finished-product prices. From these measures, and these measures only, they then decide whether a particular plant will shut down or stay open.

History is full of examples of how this kind of cost-per-tonne analysis, whilst of great value, doesn’t tell the whole story.

And I believe that this type of wider analysis is going to become more and more important as a result of the end of the Economic Supercycle. This will apply across many countries and regions, no matter what their economic and political systems. In the “free market” US, for instance, employment has become a major issue in this year’s presidential election. What will the outcome of the election mean for global free trade?

In the case of China, of course, everyone knows – or at least they should know – that jobs have always come before the economic efficiency of a specific manufacturing facility, and/or the wider industry in which it operates.

But where some people are today going wrong is in assuming that economic reforms will inevitability lead to China adopting Western free market theory. It is much, much more complicated than this.

Let’s take recent events relating to China’s “teapot” refineries as an excellent example of this complexity:

  • On paper, these refineries – which are run by privately-owned companies as opposed to state-owned giants Sinopec and PetroChina – are sub world-scale and so uneconomic.
  • They have traditionally only been allowed to import heavy fuel oil with limited access to domestic crudes, as this Eurasia Review article points out.
  • You might thus have thought they would be shut down as part of China’s rationalisation of inefficient manufacturing in general.
  • But from July of last year, China began granting licenses allowing some of the refineries to import higher-quality crude.
  • This crude is being processed, sold into local gasoline markets and exported as diesel. The above two charts illustrate the resulting rise in Chinese diesel exports and the decline in Asian diesel crack spreads.
  • What is adding further momentum to diesel exports is the slowdown in China’s old investment-led economy. Whilst gasoline and jet fuel demand continue to grow very rapidly in China because of the surge in consumer spending, diesel demand growth was flat in 2015.

China had the choice of letting these smaller refineries go to the wall. But the benefits of taking the opposite approach have been big, as this Reuters report makes clear:

The rise of the teapots, now able to refine imported crude in much greater quantities into high-value products such as gasoline, is reshaping the local economy in dilapidated rural parts of eastern Shandong province, where most are located.

At Boxing, a new Volkswagen dealership and freshly painted condos line a four-lane highway leading to the Chambroad refinery, where smoke-stacks rise above swathes of farmland.

As a very important aside, the port of Qingdao in Shandong province has seen a surge in crude imports to the highest levels since data was first collected in 2011. Do you think that today’s oil price recovery is partly about a Chinese economic recovery? Think again. It could instead be about importing oil, mainly for the sake of re-exporting diesel. The net effect on global oil and oil products demand could thus be deflationary rather than inflationary.

This wider bigger picture analysis is, as I said, incredibly difficult. But just because something is difficult doesn’t mean that it shouldn’t be attempted. What is needed to get over this barrier is investment in expensive and very good people on the ground in markets such as China, who have excellent relationships and a wider understanding of the social, political and economic context.

Just imagine, therefore, that you are an overseas refiner with these types of people already on the ground in China. You might have known that the regulations regarding teapot refineries were about to be changed well ahead of your competitors.

And I can guarantee you that stories similar to that of China’s teapot refineries will become far more frequent in many parts of the world, thanks to the end of the Economic Supercycle.