Talking Point

Fuelling concerns

Oil major Sinopec tries coffee, as oil is hit by a Saudi Arabian storm

Aramco-Coffee-w

Prior to the attack on Saudi oil infrastructure, Sinopec’s main strategic concern was its new coffee venture

The most discussed topic among China’s car drivers last week was where they could buy the cheapest fuel. That was because state-owned oil majors CNPC and Sinopec had squared up in a rare price war in many major cities. In some filling stations in Shanghai gasoline and diesel were being offered at a 20% discount to the standard prices. “The biggest promotion in 20 years” was how Shanghai Securities News put it.

The campaign was driven by two main factors: a supply glut of domestic fuel, coupled with global crude prices that had been placid for the majority of the year so far.

CNPC and Sinopec are also alive to the need to defend their market share in the face of new competition from private sector firms and foreign retailers. And adding a new element to their rivalry at the pumps: coffee. That beverage got the public’s attention earlier this month when Sinopec decided to launch its own coffee brand.

Yet talk of lattes and discounted petrol was soon superseded by a dramatic change of mood that occurred last Saturday after a drone attack damaged Saudi Arabia’s major oil production facility.

Instead of discussing who had the cheaper fuel or the better coffee, the focus turned quickly to whether rapidly rising oil prices might add to inflationary pressures (already bubbling away in China because of surging pork prices). Also up for debate: whether an announcement that China was investing in Iran’s oil industry could further damage Beijing’s relations with Washington.

What happened in Saudi?

The Chinese were celebrating Mid-Autumn Festival, a time of family get-togethers, when a swarm of drones set the Khurais oilfield alight in the early hours of September 14.

While Saudi Arabian oil facilities have been raided in the past, the latest attack was of a different magnitude, hitting some of the most important fields and refineries of Saudi Aramco, the kingdom’s oil giant.

Initial reports suggested oil flows had been disrupted by about 5 million barrels a day, or nearly half of projected daily output. That equates to about 5% of global crude supply. It was thought Aramco would need months to repair the damage.

Houthi rebels, which have been fighting a Saudi-backed military coalition in Yemen, claimed responsibility but Washington pointed fingers at Iran, which supports the Houthis. Without mentioning the Iranians by name, US President Donald Trump announced on Twitter that he had “reason to believe that we know the culprit” and he also signalled retaliation, saying that the US was “locked and loaded”, and awaiting verification of the attacker by Saudi Arabia.

Tensions in the Middle East have risen since the US tore up an international deal governing Iran’s nuclear development. Washington has reintroduced economic sanctions on Tehran, which has triggered a chain reaction of events, including a series of incidents over shipping in and around the Persian Gulf. The situation has also contributed to a worsening of the Sino-US tech and trade war as well, after Huawei was blacklisted in the US ­– and its CFO Meng Wenzhou detained in Canada ­– on allegations that it had breached American sanctions (see WiC453).

How did markets in China respond to the drone attack?

Last weekend analysts scrambled to make projections on how the market would react once trading resumed on Monday. Wang Nengquan, a senior energy researcher at SinoChem, highlighted forecasts that crude prices could even shoot back to more than $100 a barrel, although that prediction has turned out to be too aggressive – at least for the time being.

Brent crude futures, the international benchmark, surged as much as 19.5% to $71.95 per barrel at the open on Monday, the biggest spike ever, but oil contract prices closed the day up 14.6% at $69.02.

Many of the yuan-denominated oil futures on the Shanghai International Energy Exchange (INE), which started trading in the city’s free trade zone last year, also edged up by the 8% daily limit.

The most actively traded contract – known as SC1919 – closed up 6% higher on Monday at Rmb470.3 per barrel (equivalent to $66.30 a barrel).

The reverberations soon reached the stock markets too. After falling to an all-time low of Rmb6.02 in the final week of August, the A-shares of PetroChina (CNPC’s key listed unit) rebounded nearly 4% on Monday.

Sinopec notched similar gains, while CNOOC, another state-owned energy major, surged more than 8%.

Other stocks headed in the opposite direction: weighed down by concerns over higher fuel costs, the shares of major airlines such as Air China nosedived, for instance.

But the A-share market in general has been fairly resilient over the week, dropping only a handful of points. It helped that sentiment was stabilised after indications from Aramco that it would only need a few weeks to get back to its full capacity. All the same, commodity market volatility has led to major losses for some of the Chinese majors in the past. A slew of airlines and shipping firms reported hefty hedging losses in 2008 when Brent hit an all-time high. Even in a calmer period for oil prices last year, Sinopec rattled investors by reporting a Rmb4.65 billion loss on hedging in the fourth quarter.

What about the wider impact?

One concern is inflation, which is already running at its quickest pace since 2013.

The consumer price index (CPI) rose 2.8% year-on-year in August (the same rate as in July) with a vicious outbreak of African swine fever driving pork price nearly 50% higher (see page 8). The oil price hasn’t been as high on Chinese planner’s agenda since it eased off from $100 a barrel in September 2014. But a return to triple digit prices would complicate the government’s efforts to keep the economy growing above 6%.

“Pricier oil, on top of out-of-control food prices, makes devaluing the yuan even riskier than it already was,” the Wall Street Journal suggested. “Expensive oil makes looser monetary policy riskier too.”

Other analysts were anxious about how events might unfold over the medium term, especially in the political relationships between the parties concerned.

“The attack on Saudi was a very sensitive event coming at a very sensitive time,” SinoChem’s Wang wrote in an article published in Caijing magazine, noting that the drone attack came just after Trump had sacked his hawkish national security advisor John Bolton, amid speculation that the president might hold talks with Afghanistan’s Taliban plus Iran.

“How would it affect the Americans’ relations with Iran and Saudi?” Wang further reflected of last Saturday’s events. “More details and more time is needed before drawing a conclusion.”

Is China turning to Iran?

Beijing has tried to position itself as a neutral party in the Middle East for years. That said, the Chinese haven’t taken much of the initiative in brokering peace efforts in the region, instead finding themselves befriending countries that are deadly rivals.

Beijing regards both Saudi Arabia and Iran as key partners in the Belt and Road Initiative, for instance. And just weeks after the Saudis severed diplomatic ties with Iran in early 2016 (tensions flared sharply following the execution of a popular Saudi cleric in Iran), Chinese President Xi Jinping made state visits to the capitals of both nations.

The tour saw China inking separate “comprehensive strategic partnerships” with both countries. The deals involved loose commitments from China to invest in both nations over an extended period of time. Yet it was the arrangements with Tehran that have been attracting the most attention.

In the wake of a visit by Iran’s foreign minister to his Chinese counterpart Wang Yi last month, Petroleum Economist reported that an updated strategic partnership would see China invest $280 billion in the Iranian energy sector over the next five years (see WiC466). There will be another $120 billion of investment in Iranian transport and manufacturing infrastructure, the energy magazine revealed. And as the main buyer of Iran’s scaled-up oil output China will get a reported 12% discount on benchmark crude prices.

These trades will be denominated in renminbi and “other currencies” rather than the US dollar, the customary choice for oil sales.

The Petroleum Economist report prompted international media to question whether Beijing now found itself in a delicate position amid the tensions generated by the Saudi attack – and the US accusations of Iranian culpability.

What’s clear is that the Iranians are counting on the Chinese as a key customer, allowing them to ride out some of the impact of the US sanctions. At current output, the Chinese could import virtually all of Iran’s oil and gas production, which might also grow substantially with investment from the Chinese state oil firms.

The problem for Tehran is that the gargantuan contracts signed by Chinese diplomats overseas don’t always come to fruition. Sometimes they get bogged down in detail once they leave the negotiating table: the latest deal with Iran has been under discussion since at least 2016, for instance, as part of a wider agreement to expand bilateral trade to more than $600 billion over a 10-year time frame.

Projects are also prone to stops and starts as the operators wrangle over the terms. However, at least a hundred large Chinese companies are already investing in Iran’s key economic sectors, Alex Vatanka wrote in The Diplomat this month. And there are specific signs of movement in the energy industry as well. In August Iran’s Ministry of Petroleum reported that the Chinese had “re-engaged” in three key projects in the oil and gas sector: the South Pars gas field; the Yadavaran oil field; and the Jask oil terminal.

How will the current situation affect China’s energy security?

Any disruption in daily supply is a concern to the Chinese, who surpassed the US for the first time as the world’s biggest oil importer in 2017.

China topped the chart again last year with a 10.1% increase in imports to 462 million tonnes. It also takes about 15% of Saudi Arabia’s exports – the kingdom has been its biggest supplier over the past two years, according to Securities Daily. That means that China is also likely to be the most affected country, should Aramco’s production capacity be materially disrupted.

Washington is less concerned about an oil shock, Securities Daily believes, because the US possesses a sizable strategic reserve that comprises more than 700 million barrels. The Chinese government doesn’t provide regular updates on the extent of its own strategic oil reserve (which we first reported on back in 2009, after a major purchase from Syria; see WiC6), although it is generally understood that Beijing has been adding to its reserves in periods when global crude prices were languishing at bear market levels. However, it still trails its rivals: in March the Global Times reported that both Japan and the US were believed to have built up reserves equivalent to at least 140 days of net imports. It said China’s reserve held only about 40 days of net import cover (90 days has been the international standard).

“The attack [on Aramco’s oilfield] has once again highlighted the importance of building up our strategic oil reserve,” Securities Daily said.

In the longer term, the Chinese want to secure more supply from their own oil firms and Securities Daily also reported on a high-level meeting of the National Energy Administration back in May, when the state giants were urged to step up their efforts in oil and gas exploration. For example, CNPC was tasked with spending at least Rmb5 billion a year (up from Rmb500 million) between 2019 and 2025 on exploration.

Despite higher levels of investment in previous years, imports still accounted for up to 70% of China’s oil consumption in 2018. That was up from 60% in 2015.

Simply put, rising demand for energy combined with a continued reliance on foreign supply has Chinese planners feeling insecure. Perhaps that puts more onus on them to establish deeper-rooted relations with countries like Iran. And certainly, if the Iranians get the investment promised, their oil and gas output would spike significantly. Some of this could dovetail with Beijing’s Belt and Road infrastructure plan: Iranian gas might be funnelled through the Turkmenistan-China gas pipeline, for instance. That would be another positive for Chinese energy strategists in skirting the dangers of a maritime blockade of the Gulf and in reducing Chinese reliance on US-friendly suppliers like the UAE, Brunei and Saudi itself.

On the other hand, the opening up of a major new supply line of Iranian oil would incense the Trump administration, which is conducting a policy of ‘maximum pressure’ against the Iranian regime. Despite regular rebukes that American sanctions are an affront to the sovereign rights of other nations, the Chinese have paid attention to Washington’s warnings against unrestricted commerce with Iran. The figures for the first five months of this year show that trade with Iran was down significantly on the same period in 2018 – and that was before the end of a waiver period that allowed the imports of some Iranian oil.

The question now is whether Beijing is going to plough more investment into the Iranian energy sector and risk the repercussions of a wider clash with Washington. Perhaps the trade row will make them less conciliatory in their approach than they have been in the past. Alternatively, the issue might just be fudged by both parties as they look for a solution to their own disagreements. Asked by reporters for clarity on the $400 billion deal with Tehran, foreign ministry spokesman Geng Shuang seemed to downplay the news, saying he wasn’t able to provide an answer and confirming only that “China has very good relations with Iran”.

Meanwhile the BBC reported on Wednesday a Saudi government claim that there was Iranian “involvement” in the attack based on analysis of the weapons’ debris.

And finally: why is Sinopec getting into coffee?

Away from oil price volatility, CNPC and Sinopec have been looking for ways to defend their leading share of China’s retail market for petrol. Foreign players have started to get licences, including Gulf Oil, whose first fully-owned petrol station in Guangzhou debuted with fuel priced 25% below Sinopec’s last year (although it would soon raise prices nearer the reference levels set by the National Development and Reform Commission; see WiC427).

The newcomers have been looking for other ways to monetise their new petrol stations, including BP’s “Wild Bean” coffee brand, which has also been introduced to Chinese customers. Shell offers coffee at its in-store cafe “deli by Shell” too, selling about 250 million cups of coffee worldwide every year, according to ThePaper.cn.

The Chinese incumbents have taken note: CNPC is offering coffee at its uSmile retail stores and Sinopec launched its own coffee brand “Yijie” this month. The name loosely translates into “Easy Jet” and is a pun on the brand name of its retail stores, Easy Joy.

China’s best known coffee start-up is Luckin. Positioning itself as a challenger to Starbucks, it took just three years for the Nasdaq-listed firm to grow into a national chain with more than 3,000 outlets (for more on Luckin, see this week’s “China Consumer”). Yet Luckin is a veritable minnow compared to the 28,000 outlets housing Sinopec’s petrol pumps. Adding an Easy Jet cafe to each would create one of the world’s biggest coffee chains (Starbucks has just over 30,000 outlets).

Up to this point non-fuel sales have accounted for about 5% of revenues at Sinopec’s petrol stations – compared with more than 50% for the likes of BP and Shell. That suggests the diversification has a lot of potential upside for Sinopec’s investors. Then again, Sinopec has a tendency for PR blunders (see WiC207) and already some of its customers have mocked its coffee online – likening its taste to oil.


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