US-China oil deal dictated by a market that hates it

The ‘big beautiful monster’ Phase One trade deal between the United States and China may end up being truly beautiful for US exports on paper only—at least as far as energy is concerned.

Analysts have largely concurred that the Chinese promise to buy additional $52.4 billion worth of US energy products in 2020 and 2021 on top of the 2017 levels of Chinese energy imports is most likely unachievable, even if China intends to fulfill all its pledges in the deal.

Just read the fine print in the phase-one deal, which could undermine the promise of a US energy export boom to China.

“The Parties acknowledge that purchases will be made at market prices based on commercial considerations and that market conditions, particularly in the case of agricultural goods, may dictate the timing of purchases within any given year,” the trade deal reads.

At the signing of the deal, Chinese Vice Premier Liu He also explicitly said that China’s purchases will be “based on the market demand in China, in line with market terms.”

In other words, China says its purchases will be driven by market conditions.

If this turns out to be the case, China will not rush into buying huge volumes of crude oil and liquefied natural gas (LNG), due to both governmental and market circumstances in energy trade, at least right now. Chinese tariffs on some US energy products are still in place, market demand this year is becoming increasingly difficult to quantify with the coronavirus outbreak, and even the ongoing refinery capacity expansion in China is not geared toward processing America’s light US oil.

China’s Tariffs on US Energy Weigh on Market

The problem with the market-driven imports of US energy products is that China—despite signing the phase one trade deal—has not yet removed its tariffs on US energy imports. Nor has it hinted after the signing of the deal that removal of those tariffs is imminent.

China still has a 5-percent import tariff on US crude oil, and another, much steeper, 25-percent tariff on imports of LNG. And the Chinese have not signaled yet they would consider removing those tariffs, which essentially make oil and natural gas imports in China uneconomical for many companies.

While state-owned major oil corporations could be directed by the Chinese government to buy US crude and swallow weak refining margins due to the higher price of imports with the tariff, China’s independent refiners—the so-called teapots—are likely to continue to shun US oil, according to Alan Gelder, vice president, refining, at Wood Mackenzie.

The 5-percent tariff, if it’s not removed, would weigh on refining margins at a time when China promises to buy so much more US oil, Gelder said last week.

“This would discourage the country’s independent refiners from processing large volumes of US crude,” he noted.

The national oil companies (NOCs) in China, on the other hand, have more wiggle room to stomach weaker refining margins from importing US oil plus the 5-percent tariff in their large and complex operations, according to Gelder.

Growing Chinese Refining Capacity Not Geared to Process US Light Oil

Another market-driven consideration in China’s promise to significantly boost its imports of US crude oil is the fact that although China continues to expand its refining capacity, most new refineries that have come online over the past two years are configured to process medium high-sulfur crude grades, typically imported from the Middle East, rather than light low-sulfur crudes from the United States.

“Baseloads for the new refineries are mainly Middle Eastern grades so US flows will likely push out West African or North Sea oil [of similar quality],” Michal Meidan, director of the China energy program at the Oxford Institute of Energy Studies (OIES), told Reuters, commenting on China’s new refinery additions and oil trade flows in the US-China trade deal.

“Now, political fiat will have to defy market fundamentals—as China has yet to lift tariffs on US energy goods or grant exemptions to buyers—to ensure enough crude, LNG, LPG, ethanol and coal flow from the US to China,” Meidan wrote in OIES’s ‘China: Key themes for 2020’ report earlier this month.

Still, total US energy flows to China are set to increase from the current very low levels, Meidan and other analysts concur—they just don’t see China meeting its ambitious pledges in the phase-one trade deal.

Sliding Oil Prices and Coronavirus Outbreak

“At current WTI prices, to meet targets, China would need to buy about 1.1 million b/d of US crude per year in 2020 and 2021, equal to an additional $24 billion per annum,” Gavin Thompson, Vice Chairman, Energy – Asia Pacific at Wood Mackenzie, wrote in an opinion post last week.

To compare, the record for US oil exports to China was set in March 2018, when the US shipped 469,000 bpd of oil to China.

Moreover, at the time when WoodMac’s Thompson quantified ten days ago the volumes necessary for China to reach its target, the ‘current WTI Crude’ prices were still comfortably trading at around $58 a barrel. After the coronavirus outbreak—which threw the markets in panic over expected weakening of already weak oil demand growth—WTI Crude traded at around $52 a barrel early on Thursday.

The low oil prices may lead to demand creation in nations heavily dependent on imports, especially the world’s largest oil importer, China. But the lower the price of oil, the more volumes China needs to buy to reach the target in the deal, which is set in US dollars, not in barrels per day.

Sure, China could significantly boost imports of US LNG to meet the US dollar target of energy purchases, but the current 25-percent tariff is utterly prohibitive for importers, especially at a time when LNG spot prices are at a decade low.

Until China removes tariffs on its energy imports from the United States, there is little room for a US oil and gas export boom on the Chinese market.

This article was originally published on Oilprice.com