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China's Refiners Caught In A Squeeze

Posted: Jan 16, 2008 11:31 AM by Eugene Bukoveczky

Tickers in this Article: PTR, SHI, CEO

Just when everyone thought China had almost completed its full transformation to a free market economy, a sharp reminder emerged from Beijing last week confirming that the central planners still had their hands firmly on the economic levers. In an effort to dampen down the fires of domestic inflation, which has been rising at the fastest pace in 11 years, Reuters reported that the Chinese imposed a series of price freezes on certain essentials, including energy prices ("HK Shares Hit by China's Price Curbs, Esprit Sinks", January 10, 2008).

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Price Curbs Hits China's Energy Shares
For the local energy duopoly of PetroChina (NYSE:PTR) and Sinopec (NYSE:SHI), these developments were not welcome news. Immediately following the announcement, Sinopec shares skidded 5.7% while PetroChina stock fell 1.3% in Hong Kong trading. Gasoline and diesel fuel have always been semi-regulated in China's mixed economy, but many had expected these restrictions would eventually give way to free market pricing. Now, the announcement of price freezes has forced a dramatic rethink of those expectations.

Fuel Shortages Prompted Refinery Building Blitz
Protected from foreign competition by state-managed barriers to entry, China's domestic oil companies have expanded into world-class integrated operations over the last few years. Recently, rapidly growing demand for motor fuel in China has prompted a scramble to expand its refined product capacity. According to China's official Xinhau news agency, Chinese production of automobiles broke records again last year, rising more than 20% from the previous year. With all these news cars on the road, serious fuel shortages have started to develop, which prompted the major refinery building boom. Three major refineries with a combined capacity of 600,000 barrels per day, two owned by Sinopec and the other by China National Offshore Oil (NYSE:CEO), are set to come on stream in the latter half of this year.

Price Freeze Equals Price Squeeze
In a free market situation, an oil company's move to expand its refined product capacity is generally the right thing to do, so long as the crack spread, or margin between its crude oil costs and refined product selling costs, remains positive. Unfortunately, this does not appear to be the case in China. Price regulation for refined products may actually be making things worse for the consumers it is intended to benefit. The recently announced price freeze promises to make matters even worse by calling into question the economic rationale of having embarked on a major capacity expansion program. <INVESTOPEDIACONTENT>(To learn more about investing in the oil sector, see Oil And Gas Industry Primer and Unearth Profits In Oil Exploration And Production.)</INVESTOPEDIACONTENT>

The Bottom Line
These developments should serve as a lesson that the investment rules in China are not the same as they are elsewhere in the world where free market economics prevail. Investing in the China story still brings with it its own unique set of risks, some of which are tied to the near impossible to predict shifts in the regulatory environment.

By Eugene Bukoveczky

Eugene Bukoveczky is a freelance writer and investment researcher. He holds a CFA designation and has spent several decades working in the investment business in places like Toronto, New York, London and Dubai. He currently resides in Nova Scotia, where, when not writing, he devotes his time to chopping wood, growing his own vegetables, riding his bike to the store, and thinking about other ways to reduce his carbon footprint.

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