October 14, 2015

Low Oil Prices – The Latest from China

In the context of our previous articles on the continuing depression in oil prices, this article takes a brief look at recent developments in the oil & gas industry in China and the significant impact that China has been having on prices, particularly in light of the recent devaluation of the Yuan.

China's decision to devalue its currency was most likely intended to provide a jolt to slowing Chinese exports. However, it is also an indicator that after two decades of phenomenal growth, the country's economy is now slowing down.

The recent currency move has sent a shock through the oil market. In terms of imports, this year China will be challenging the US to be the world’s No. 1 buyer of crude, with the weaker oil prices lowering the cost for China of building their strategic petroleum reserves. In the first seven months of this year, China purchased nearly 11 percent more crude than it had in the first seven months of the previous year.

Oil demand has been growing, but not fast enough to soak up the excess of crude supplies around the world. A weaker Chinese currency will make oil comparatively more expensive for the world’s largest importer. On a straightforward basis, some consider that this may serve to reduce recent demand.

For China however, the currency devaluation may not be such bad news. In fact, it may serve to strengthen their already tight grip on oil markets. Increasingly, China has had the ability to buy and sell millions of barrels of crude oil on the Asian physical market in a matter of minutes through its main trading firms. This has given China so much power that traders elsewhere are often forced to follow its agreed prices. As a result, leading Chinese oil traders, such as Unipec, the trading unit of Sinopec, and Chinaoil, have been able to corner the market on several occasions since October last year.

Market power is shifting towards big consumers, led by the likes of China, with oil output at record highs and global demand slowing. As a result, Chinese oil traders have been able to cherry-pick the best offers and take advantage of cheap oil to build strategic reserves. China’s view of supply security is now increasingly a question of becoming a price maker and of being involved in the entire supply chain globally.

The most obvious evidence of China’s emergence as price maker has been in daily physical crude oil trading. The Chinese traders often dominate daily trading, far surpassing the volumes dealt by Western oil majors. Riding on China’s growth of the past decade, which has not only seen it become a top crude importer but also a large exporter of refined products, companies such as Sinopec and PetroChina have evolved from being passive oil importers to sophisticated traders of crude oil and refined fuels.

The huge volumes exchanged by China’s two major traders have been straining Asia’s benchmark price-finding mechanism in the physical oil market – the Dubai Market-on-Close (MoC). The soaring activity of these traders has often left very little space for other participants to trade in the oil price-making process.

However, turning to other recent developments in China's oil & gas industry, and in potentially more positive news, the Chinese government has slowly been deregulating its import market. In particular, it has been granting more licenses to independent refiners to buy overseas crude, further boosting demand not just for physical crude from the Middle East, but also for the main international crude futures benchmarks Brent and West Texas Intermediate (WTI).

Granting crude import licenses to independent refiners is likely to be a significant step towards deregulating China’s oil industry. It is also likely to boost demand for lighter grades, such as Brent and WTI.