China's teapot refiners down again, but not out

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China's small, independent refineries have since the second quarter been operating at below half their capacity, struggling to stay afloat amid record oil prices. But once again many have found a way to reinvent their future, this time as outsourcing arms of the two top oil firms.

These plants, making up nearly one-fifth of China's total refining capacity, have gone through ebbs and troughs in the past decade when the world's second-largset oil user saw rapid fuel demand growth that has partly fuelled oil's six-year rally.

The recent crude spike to mid-July's above $147 a barrel may have forced the tiniest ones to fold up, but many of the relatively bigger ones have managed to survive by taking advantage of the plight faced by the country's refining giants.

Ranging from 40,000 bpd to 120,000 bpd, they have found a new niche -- processing crude on behalf of Sinopec Corp (0386.HK: Quote, Profile, Research) and PetroChina (0857.HK: Quote, Profile, Research), which opted to curb output amid heavy losses processing market-priced crude into below-market fuel.

"They are like migrant workers -- a cheap labour. It costs probably half that of big oil firms for processing each tonne of crude," said Qi Fang, vice president of Petroleum Association under the China Chamber of Commerce, and also a retailer of a dozen petrol stations.

"The big guys have been spitting blood in recent months. It's better to ask independents to process than processing themselves."

A decade ago these small plants in east China's Shandong, northern Shaanxi province as well as northeast China, dubbed "teapots" due to their size, were under pressure from Beijing to shut down in order to help clean the air.

But they flourished in China's oil boom in 2004 when demand rocketed at 15 percent. They struggled in 2005 and came back to life in 2006 and 2007, when they nearly doubled capacity.

The amount of crude supplied by the oil duopoly is not available and may be small versus the independents' total capacity of roughly 1.6 million barrels per day, but the new business allowed China to cut back imports of costly fuel oil.

China, Asia's number-one buyer of the fuel oil used by many teapots as feedstock, cut imports by 17 percent less in the first seven months, Chinese customs has said, dampening Asian market.

Four of the five teapots in Shandong province had run under 50 percent and all had halted productions in recent weeks due to perceived seasonal demand dip for diesel, sources at these refineries told Reuters.

BLESSING, HOPES

While crude's $30 slide in the last month may offer a window for them to reopen as soon as the autumn harvest season kicks in and diesel demand rises, independents pin their long-term hope on Beijing to fully link its fuel prices with global markets.

Beijing, on a long but clear road towards energy price reform, is likely to announce another fuel price hike as soon as within weeks, following an up to 18 percent increase in June, taking advantage of lower crude oil prices, analysts say.

"Long-term, domestic prices won't always lag behind market. Refined fuel prices will definitely go up more," said Jiang Yong, deputy general manager of Dongming Petrochemical, a 60,000-bpd independent.

For now, Beijing's price controls that have cut deep into state refiners' margins, turned out to be the teapots' blessing.

"Because of the government price control, it's a test for efficiency. It created space for efficient independents like those in Shandong," says Qi. "The hard truth is: Sinopec, PetroChina have nurtured the growth of these plants."

Top refiner Sinopec Corp is expected to announce a 81 percent fall in first-half earnings, while second-largest refiner PetroChina's earnings could fall by a third, analysts have forecast.

Independents survived also because they are shielded by local governments, which value these players as a necessary part in supplying the regional market in addition to their tax contributions, industry officials said.

Local authorities often turned a blind eye to independent retailers when they charge pump rates above the state-set ceilings, effectively offering a fatter marketing margin for small processors.

Some set their eyes on possible buyouts by the country's up-and-coming state-owned firms poised to challenge the duopoly, such as CNOOC and Sinochem Corp, both of which are building their refining muscles and distribution networks.

"It's unlikely that the government will force the plants to close down, but likely to influence our survival environment through other means -- possibly through acquisition by the big oil firms," said a manager at Haike Petrochemical in Shandong.