China’s independent refiners—the so-called teapots—have enjoyed comfortable profit margins since they were allowed to directly import crude oil in 2015.
But the good times for the teapots may be over as new tax rules have started to stifle their profit margins and could limit their purchases of crude oil, potentially affecting demand growth in the world’s largest crude oil importer.
The ‘teapots’ import quotas and the fact that they started buying crude oil directly from the world’s oil exporting nations put them firmly on the international map three years ago and made them an important player in the global oil market. The purchases by independent refiners have grown to account for around a fifth of China’s total crude imports.
The teapots have become instrumental in China’s growing thirst for crude oil. And between 2015 and earlier this year, the independents were living it up in good times—they were allocated annual and semi-annual crude oil import quotas, and crude oil prices were still in the ‘lower for longer’ region. Teapots also used various loopholes in China’s tax regime to underpay, underreport, and even evade taxes.
But as of March 1, China introduced new tax regulations and reporting mechanisms in a crackdown on the tax evasion practices of independent refiners. The new tax rules benefit the big state-held Chinese refiners and have started to cut into the profit margins of the independents.
China is now using a new tax reporting system that tightens transaction monitoring, and it is trying to make tax collection more effective by eliminating the role of the provincial governments. Independent refiners have so far enjoyed the protection of their respective local governments, who have been gaining economic benefits from the teapots. While all tax revenue has gone to the central government, provinces have given tax breaks to the teapots in order to ensure local employment and continuous income. “It’s really hard to give exact figures on how much the costs have increased, but it is clear that the real hard time has yet to come,” a Beijing-based analyst told Platts in April, commenting on the effects of the new tax rules.
Independent refiners will have to cut costs to stay profitable, and some of them may be forced to fold following the tighter tax regulation, according to an executive at one of those refiners.
“We’re going to see an industry reshuffle … it will not be about one plant merging with another, we may see some plants fold up,” Xu Yuan, general manager at Haike Petrochemical, said at an industry event in the ‘capital’ of the Chinese teapots, the Shandong province in eastern China.
According to Xu, independents will try to tweak their crude oil mix purchases and use more hedging to cut costs. Yet, many of the small independent refiners don’t have much experience in sophisticated hedging strategies.
The teapots are also said to have resumed buying fuel oil as feedstock instead of crude oil, because fuel oil is cheaper and gets them a tax deduction later. Before they were allowed to import crude oil, independent refiners used straight-run fuel oil (SRFO)—the residue left after crude oil has been initially distilled in a refinery. Now they are switching back to SRFO because of the higher crude oil prices and because of the new tax regulations.
“Processing fuel oil gives better margins than (refining) crude oil as plants can get tax deducted (when selling refined fuel) later,” an official with an independent refiner seeking fuel oil told Reuters last month.
“Buying SRFO may not necessarily save tax cost as the buyer needs to pay up-front the (fuel oil) consumption tax, but obviously plants are exploring the old trade as the government’s tax stick is really a hard one this time,” an executive with a western trader told Reuters.
While China’s new tax rules benefit its biggest state-run oil refiners, some of the smaller independent plants may start limiting their crude oil purchases, which could affect the demand growth in the world’s top oil importer.