The China Factor

Why Won't Crude Oil Prices Come Down? For the past few months, crude oil prices have hovered above OPEC goals despite increases in the availability of additional production. Initial research into the problem suggests a shortage of transportation capacity. It appears that although all refineries are able to obtain as much crude oil as they need to operate, they are not able to import additional crude oil without bidding prices up. It's not good business to pay a higher price for something you intend to store in the future unless you are sure prices will increase. In recent months, refiners seem to be betting on crude oil prices going down. But spot prices continue at high levels. A slightly deeper look into what's happening suggests prices may not go down for two or three years. In fact, they could peak well above current prices unless the international refining community makes some very important operational changes.

The Problem is China's Rapidly Emerging Economy

China's emerging economy is in the process of changing the entire oil supply-demand picture. Until now, the US was the country that provided the marginal demand in the crude oil market. But that was when China produced enough oil to satisfy it's relatively meager demand. Recently, things have changed in China.

China is building refineries at a rapid rate. It's production was keeping up until 1999, when refining capacity exceeded production by just over a million barrels per day.

Critical Environmental Decision Drives Demand for Light Oil

But the most important factor in shaping China's demand for crude oil was the recent decision by Chinese Environmental Protection Department and Technical Supervision Department to implement new specifications for gasoline on July 1, 2000. The requirements were imposed on fuels sold in Beijing, Shanghai, and Guangzhou, but will be applied to other cities January 1, 2003.

The New Specifications lowered the sulfur content of gasoline to 0.10% from .15% for all of China and to .08% for the three main cities. They also cut lead content to 0.005 g/l from 0.013 g/l, and benzene content is set at 2.5 vol %, aromatics at 40 vol %, and olefins at 35 vol %. Effective January 1, the government banned leaded gasoline production in China.

Clearly, China learned from the US to control air pollution from vehicles if they intend to prevent smog, which is a good thing. The problem is that their refineries can't make this type of gasoline without major modifications -- or better quality crude oil. Their current refining system is mostly topping units that produce basic, straight run gasoline. They don't have vacuum towers -- all of the bottoms are coked, which produces an additional small amount of very dirty gasoline. About one third of the refineries have catalytic cracking units.

China's REFINERY Capacity

Unit Type Capacity B/CD No. Units Crude distillation 4,346,800 95 Vacuum Distillation 40,000 1 Coking 290,000 24 Catalytic Cracking 892,000 31 Catalytic Reforming 157,000 23 Cat hydrocracking 122,000 7 Cat Hydrorefining 54,000 2 Cat Hydrotreating 229,000 25 Alkylation 26,500 18 Polomerization/Dim 0 0 Aromatics 0 0 Isomerization 0 0 Lubes 49,000 11 Oxygenates 900 1 Hydrogen 0 0 Coke Tonnes/Day 4585 12 Sulfur Tonnes/Day 300 1

source: Oil & Gas Journal Data Book

China's crude oil is heavy (low API gravity) and low sulfur. It's two major fields are Daqing, which is 33 APIG and .078 % sulfur, and Shengli, which is 24.2 APIG and 1% Sulfur. Since their crude supplies have been low sulfur, they had no need to develop sulfur removal capacity at their refineries. But to process most medium and heavy grade international crudes into gasoline with their new environmental specifications, they must add desulfurization and sulfur production capability.

Daqing crude oil is about 9% gasoline, 28.2% distillates and 62.8% residual. Most of China's refineries mirror these percentages in their configurations. As China introduces automobiles into the economy, it's production of gasoline as a percentage of crude oil distilled must shift toward at least 40% within just a few years.

FOR NOW and in the near term, to meet their new gasoline demand and their new environmental goals, China must purchase the lightest gravity (40+ API), and sweetest (lowest sulfur) crude oil on the market. And that is what they are doing. China's appetite for the best crudes in the world -- primarily those from West Africa --is sustaining prices, and may drive them up further.

OPEC can only drive prices down by adding production to the world market if it can actually increase the production of crudes with gravity greater than 40 degrees API and sulfur less than 1%. The addition of other crudes to the market will have no significant effect on prices.

Can The World Keep Up With China's Expansion?

In 1904, the US was in a similar situation -- poised at the brink of a huge industrial revolution. But growth of the refining industry in the US took thirty four years. By 1938, refineries were able to make 40% of a barrel of oil into gasoline. Today, they make 60% gasoline (with the addition of a small amount of oxygenates such as methanol and ethanol). In the early 20th century, the US industry faced two world wars, limited resources, developing technology, and most importantly -- limited labor. All of these factors slowed the refining expansion to a manageable growth rate.

Source: The Chase National Bank, 1939

Now, at the turn of the 21st century, with WTO approval, China's door opened to the world market and trade agreements are already signed with the US, UK and others. China is poised to repeat the US refinery expansion in a fraction of the time it took the US to grow. There is no world war, no lack of technology, and no lack of resources to slow down the growth process. And with 1.26 billion people, labor should be no problem in China. With current known technology and China's resources, they should be able to build an energy infrastracture FAST. But in the meantime, to sustain the growth, China's demand for imported crude oil will probably skyrocket.

China is replacing the US as the country providing the marginal demand for crude oil in the world market. China's demand will drive prices. And for the next few years, China's demand for light, sweet crude oil will be voracious.

Major Producers of West African crudes include: Chevron/Texaco (largest producers), Mobil, AGIP, ELF, Shell and Statoil. In the near term, profits (for the next couple of years) will accrue to these companies.

Transportation may become a significant constraint as a result of increased demand for imports in China. Already, within the past few months, transportation costs have risen. Long trips from Africa or the North Sea to Asia will reduce overall capacity in the system. Combined with rising demand in Asia, capacity is likely to become a significant constraint.

Demand for Gasoline will Grow with Introduction of Cars

The US Trade Agreement with China will benefit the automotive industry. But it will also hasten the demand for gasoline in China as technology and production move to the huge China market. Under the agreement, auto parts tariffs will be cut. General Motors/Shanghai Motors have already begun a joint venture. They are building Buicks at General Motors China. Production was to increase from 20,000 units in 1999 to 55,000 in 2000, to 100,000 in 2001. This agreement represents only a small fraction of China's potential demand for vehicles. The sale of vehicles could easily double each year for several years. In China, each new car sold probably represents a new car being driven every day (compared to the US, where an additional car in the family may only be driven when another one is not driven). Demand for gasoline will increase directly with auto sales -- and, for now, so will the demand for light, sweet crude oil on the world market.

What About New Crude Oil Discoveries in China?

There have been numerous discoveries in China and the future looks good. In February, China found its largest offshore oil field ever, which has an estimated 600 million tons, in the Bohai Sea. The Penglai oil field was discovered in a joint exploration project between China National Offshore Oil and Phillips Petroleum Co. of the United States. But these new fields must be developed and the infrastructure must be put in place to deliver the oil. That could be two or more years away. Most importantly, if the oil is not light, sweet crude, it will not satisfy the immediate need anyway. In which case, upgrading the refineries becomes a more critical requirement.

Upgrading China's Refinery System

Improving the refining capacity to upgrade crude oil to make gasoline that meet's environmental specifications is clearly the most important hurdle. China has several major projects lined up. Key agreements that will lead to new refining capacity include ExxonMobil, FPCL, and Saudi Aramco, and Shell. These companies will be paired with China's companies to tackle the growth. Sinopec has the largest distribution network for refined products in China: about 1100 bulk storage sites and over 13,700 retail gasoline stations. China National united Oil Corporation (CNINAOIL) is a subsidiary company of China National Petroleum Corporation (CNPC). CNPC, the largest petroleum group in China, is in charge of oil exploration, production, transportation, refinery, and marketing in North China. It owns the larges production fields in China.

Two essential industries must follow refinery expansion: petrochemical and fertilizer plants. These industries use refinery byproducts and prevent unnecessary waste or pollution from improper waste disposal. Plans and agreements are underway for these expansions.

China's companies are looking to the West for financial backing by launching IPO's: PetroChina Co. Ltd (China National Petroleum Corp) and CNOOC Ltd., a unit of China National Offshore Oil Corp; and Sinopec.

How Can the Rest of the World Cope With the China Energy Expansion to Hold Crude Oil Prices Down?

The most significant control option is for US and EU refineries to shift to a heavier crude oil slate. As shown in this week's current forecast, US refiners have already begun to decrease the average APIG of crude feed to refineries. Capacity to process heavier crudes was added to most major US refineries during the 1980s when strategic plans showed a need for this capability in case OPEC reduced or cut off crude oil supplies. Now is the time to crank up the capacity. Unfortunately, recent environmental shifts to reformulated gasoline and low sulfur diesel in the US limit some of that strategically added capacity (more sulfur must be removed from oil products, therefore, less high sulfur crude oil can be processed with the same desulfurization capacity). However, they should still have the capability to minimize the US requirement for imported light, sweet crude oil. But, some independent refiners may not be able to compete in the US gasoline market for lack of adequate capacity to process alternative crudes.

All countries should develop alternative energy. If prices stay above $30/bbl, which it looks like they will, all sorts of alternative energy projects designed during the 1980s will come off the shelves. Any alternatives that can be used to conserve crude oil in the near term will help keep crude oil prices under control.

The industry needs to find and develop new oil fields that produce premium quality oil. This goal is easier said than done. But the more high quality crude oil produced in the next two to four years, the better the situation will be.

On the other hand, producers should guard against overproducing and selling unwanted crude oil -- filling up storage tanks may cause prices to tumble as they did in 1998, which could have a negative impact on the rate of China's expansion.

An additional method of minimizing the impact of crude oil prices to consuming nations might be to unhinge heavier crude oil prices from marker crudes, such as Brent and WTI and let them seek their own level in the market. The reason for doing this is because the supply of medium and heavy grade crudes is more than adequate as long as the refineries can use them. The spread between light sweet crudes and others should widen initially. Then, if demand for light, sweet crudes is tempered, price differences should narrow again.

The Revised Crude Oil Forecast

The forecast is revised to reflect the impact of the increased demand for light sweet crude oil in the current market. It is assumed that the US will continue to shift toward a heavier crude oil slate, that use of alternative energy will increase and that consumers will engage in conservation measures to keep their energy expenses under control. All of these factors will help prevent tight supply during the next few critical years. Nevertheless, it is not unreasonable to assume that at any time -- but most likely next spring - crude oil prices could spike to levels not seen before.

The supply problem may be significantly compounded if India continues on its current path of growth and begins to compete with China for light, sweet crude oil. One instance of this competition occurred in recent months, causing the price of Brent crude oil to spike, pulling up other crude oil prices keyed to the Brent marker.

An International Goal: Better Keep the World Economy Going by Supporting the Development of China's Infrastructure. China is about to set in motion development that will send billions of dollars around the world. As it grows, so will many international partners and supporting industries. Once it gets going, an economic crash in China could draw the whole world into a depression. At this point, guarded optimism and cooperation are probably best prescription.

The problem is not permanent

China's oil production will increase and it's refinery system will be modified to process its own oil within just a few years. Then China's role as the marginal demand player in the market will taper off and the US will again take over that role.

http://www.oil-gasoline.com/doc.asp?ID=645

-- Martin Thompson (mthom1927@aol.com), November 06, 2000