China’s refining sector continually struggles to come to grips with government control of the price of fuel and the incessant volatility of oil prices amidst global monetary stress. Asia’s leading refiner and China’s second-biggest oil firm China Petroleum & Chemical Corp (ADR) (NYSE:SNP), otherwise known as Sinopec, posted a dip in annual profits as it was hit by fuel price controls at its home in the face of rising oil prices.
The Chinese government has suppressed refined-fuel prices – not allowing the price to rise even though by its own control mechanism a price hike was warranted – out of fear of price inflation. This damaged the profitability of Chinese refiners.
But China Petroleum & Chemical Corp (ADR) (NYSE:SNP), much like PetroChina Company Limited (ADR) (NYSE:PTR), is now looking to expand its foothold overseas, move toward commercial shale output while a more market-oriented oil-pricing policy being adopted by the government will finally free its refining business from the shackles of politics – mostly.
The Chinese government recently released some of the pressure on China Petroleum & Chemical Corp (ADR) (NYSE:SNP) and PetroChina Company Limited (ADR) (NYSE:PTR) – the second-biggest national refiner and China’s largest oil firm – when it increased fuel prices on Feb. 25 after not doing so for more than five months. Both gasoline and diesel prices were increased by $48.27 and $46.67 per ton, respectively.
More importantly, the Chinese government has finally responded to the calls of its refiners. The National Development and Reform Commission (NDRC), which is responsible for setting fuel prices in the country, previously used a 22-day moving average of the price of a basket of crude grades to determine refined-fuel prices. Moreover, there would be no trigger unless this 22-day average moved less than 4%. After that the NDRC would have the opportunity to raise or lower prices.
But that time period has now been reduced to 10 days, which makes the system more responsive and the 4% rule has also been abolished. So now the setting of prices, while not truly set based on marginal changes in supply and demand in a true market environment, has been greatly liberalized. However, the option to curb fuel prices to tackle inflation can still be exercised, so politics has not been abolished from the system.
Volatility and turnarounds
This means there are going to be more frequent price changes so that fuel prices will now more accurately reflect changes in the international pricing for oil. Following the 3.6% decline in the United States Brent Oil Fund, LP (NYSEMKT:BNO), NDRC reduced the diesel and gasoline prices by $49.88 and $48.27 per ton, respectively, in the final week of March. Brent Crude prices were caught in the backlash recently of deteriorating economic indicators coming out of China, the U.S. and Europe as well as the massive drop in the price of the SPDR Gold Trust (ETF) (NYSEARCA:GLD).
Since Brent and gold prices are highly correlated, moves in one necessitate moves in the other. I expect gold to be especially volatile in the coming months as the tug of war between physical demand and the fragile futures markets intensifies. This will do nothing to help the volatility of oil prices – and commodity prices in general. So, China’s liberalizing the fuel-pricing system could not have come at a better time for both China Petroleum & Chemical Corp (ADR) (NYSE:SNP) and PetroChina Company Limited (ADR) (NYSE:PTR).
Meanwhile, besides the expected turnaround of its refining business, there are some positives coming out of Sinopec’s shale-gas operations as well, located at Fuling in Sichuan province. Several successful tests have been conducted and the company is anticipating touching its target of producing 35.1 billion cubic feet (1 billion cubic meters) of gas by 2015. The flexible fuel price policy is also coming at a good time since it will increase China Petroleum & Chemical Corp (ADR) (NYSE:SNP)’s profitability allowing it to focus on the extraordinary expensive task of drilling for shale gas.
Now that the controlled-price mechanism is (mostly) out, there is reason to be optimistic about both of these firms, but Sinopec in particular. This change to the pricing structure along with the proposed changes to the tax laws, which will see both PetroChina Company Limited (ADR) (NYSE:PTR) and Sinopec turnover a larger proportion of their profits to the Chinese government, are developments pulling the firms in opposite directions from an investor’s perspective.
Sinopec’s commitment to broadening its base of operations I think are the right moves long term. The price of Brent will be a political football in the West for the rest of 2013 as keeping its price under control is important to continue the narrative of slow but steady recovery in the U.S. while a strengthening Euro will help struggling European economies to recover with low food-and-energy imports.
For Sinopec and PetroChina Company Limited (ADR) (NYSE:PTR), given that the long-term picture in China involves a huge increase in the demand for oil, this pricing system change will allow both firms to more rationally prepare for that and re-balance the way in which the Chinese economy grows in the next decade. Like the removal of the huge diesel and cooking gas subsidies in India, this bodes well for purging the excesses of the past.
The article Chinese Refiners Are Free to Make a Profit originally appeared on Fool.com and is written by Peter Pham.
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