Ending Oil Subsidies Serves China's Oil Security

It will bear strongly not only on the country’s oil market and but also on its oil security. The two regulators will need to closely examine the pros and cons.

 The Pros�/span>

Support for subsidies arises from two groups. Some proponents base their support on their sympathy with the nature of the two NOCs�losses. They point out that the refining losses are policy-induced rather than operational and therefore, they contend, should be covered by the government. Specifically, while crude prices in China are dictated by world market prices, oil product prices are still administratively set. Theoretically, oil product prices in China are pegged to the weighted average of the Brent, Dubai and Minas crude oil prices, taking into account processing costs, distribution costs, and refineries�profit margins. However, inflation worries mean that rarely does the NDRC permit domestic oil product prices to move with the fluctuations of international prices. Domestic oil product prices lag behind international prices and domestic refineries dependent on imported feedstock operate at a loss when international crude prices surge. All of China’s crude imports-3.3 million barrels a day-are processed by refineries of Sinopec and CNPC, with the Sinopec handling 80 percent of the total. According to the General Administration of Customs, for the first ten months of 2007, Sinopec and CNPC imported crude at an average price of $63 per barrel; however, the breakeven point for their refineries was around $60 per barrel, meaning for every barrel they refined they took an average loss of $3.

Other proponents maintain that the lack of government subsidy to cover Sinopec and CNPC’s refining losses would harm both the country’s oil security and its economy. The absence of government subsidies, they argue, would force these NOCs to produce more oil at home, accelerating the depletion of domestic petroleum reserves. Scrapping government subsidies would require a complete overhaul of the domestic oil product market, and thereby pass the financial burden through to Chinese consumers, jack up inflation, and slow down the domestic economy. Sinopec and CNPC, they say, have suffered losses in their downstream operations through the sacrifice of their commercial interests in the interest of the country’s economic growth and the nation’s oil security. In the light of this signal contribution, it would be at the least ungrateful of the central government not to pick up the tab.

Ah, but the cons�/span>

No surprise, but there is another side to this story. While the losses in their refining operations have been real, the petrochemical and especially upstream operations of the two NOCs have been excessively profitable, due to their exclusive right to tap the country’s petroleum reserves. Take their upstream businesses as an example. Exploration and production (E&P) costs in China are less than $20 per barrel, the petroleum resource tax ranges between $2 and $4 per barrel, and windfall taxes average $2.5 per barrel when crude prices are above $60 per barrel. Total production costs, therefore, actually hover around $26.5 per barrel. Now, the two NOCs sell their crude at international prices, which are currently above $90 per barrel. The two NOC’s refining losses are far more than offset by their profits from their petrochemical and upstream operations, yielding both companies deliciously handsome profits. While Sinopec reported an operating loss of 5.3 billion yuan ($715 million) in its refining division in the third quarter, its overall net profit rose 5.5 percent from a year earlier on higher oil and gas output.

And not only are subsidies unnecessary to keep Sinopec and CNPC in the clover, they also wreak havoc on the Chinese energy economy. On the one hand, the current oil product pricing mechanism, which proponents claim justifies subsidies to Sinopec and CNPC, constitutes a threat to the reliable and sufficient oil supplies at home. As evidenced by the recent artificial fuel shortages in China and those that occurred in 2005 and 2006, the skewed relationship between domestic oil product prices and international crude prices generates perverse incentives for domestic refineries, i.e. to export their oil products for higher prices even when supply falls short of demand at home. For example, though the country’s demand for oil products between January and November remained buoyant, imports of oil products into China dropped by 9 percent and exports out of the country jumped by 28 percent compared with the same period of last year. Sinopec and CNPC refineries�exports of oil products directly contributed to the artificial shortage by forcing reduction of sales of oil products to private gas stations and the cutting off crude supplies to private refineries.  The two then suspiciously suspended their refining activities under the pretext of "regular maintenance."

Further, NOC subsidies are harmful to the Chinese energy economy for three reasons. First, they reinforce NOC dependency on the state and rob them of incentive to become competitive. Second, subsidies carry embedded unfairness to the country’s private refineries which must operate at a loss without the subsidies.  They enable the NOCs to reduce private refineries�market share or even wipe them out. Third, subsidies contradict the country’s endeavor to reduce energy usage promote energy conservation because, if doled out at the producer’s end of the market, they don’t lower consumption at all. In fact, together with the artificial suppression of oil product prices, subsidies encourage both excess consumption and inefficiency, which works against the country’s attempt to achieve oil security when it is increasingly dependent upon foreign imports.

What to do, what to do?

The NDRC and MoF need to end subsidies to Sinopec and CNPC and replace them with measures to create an open oil market. These measures should afford private oil companies in China a level playing field by allowing them to engage in upstream E&P, guaranteeing their feedstock supplies from the NOCs at home, removing barriers to their direct imports of crude, and scrapping import quotas. Most importantly, the NDRC should establish an oil pricing mechanism reflecting the scarcity of petroleum reserves. This would introduce a fuel tax that encourages fuel conservation, require the NDRC to integrate domestic oil product prices with international prices, and bring domestic petroleum taxes in line with the international levels.  

As the NDRC and MOF contemplate the enhancement of China’s oil security, the changing nature of the global oil market is worth reflecting upon. Since the first oil crisis in 1973, the international oil market has become a global and integrated enterprise and oil has become a fungible commodity. Consequently, oil has lost its characteristic as a strategic commodity in that anyone can buy the same barrel of oil of the same quality at the same price anywhere in the world. On the other hand, a disruption anywhere on the global oil market affects everyone, regardless of a particular nation’s level of import dependence from a specific source. Instead of state-subsidized NOCs, it is an open oil market where oil could be efficiently produced and traded that would ensure oil security. State interventions in the forms of import or price controls constitute impediments to oil security.  The oil market, if left unencumbered, can establish an equilibrium between supply and demand. The NDRC and MoF need to make up their minds to adopt measures promoting a well-functioning oil market rather than to introduce more distortions by showering subsidies on Sinopec and CNPC.