New Pricing Mechanism
At the end of 2009 speculation started that the National Development and Reform Commission (NDRC) of China was contemplating implementing a new mechanism to price refined products during the first quarter of 2010. The NDRC regulates the Chinese domestic refined product market by imposing a “price ceiling” on the wholesale price. NDRC adjusts the price levels of the refined products if the 22-day moving average of a basket of crude prices DOB at Brent, Dubai and Cinta, moves more than the threshold of 4%. The current pricing mechanism by NDRC is in an attempt to smooth out the fluctuations of domestic products and ensure the refineries in China a positive profit margin on average. The NDRC adjusted Chinese product prices 9 times in 2009.
PetroChina (NYSE:PTR) and Sinopec (NYSE:SNP) have criticized the current pricing mechanism for being too simplistic and open to manipulation. The current mechanism encourages speculative activities, such as hoarding ahead of the scheduled upwards adjustment and dumping ahead of price reduction. Moreover, under the current pricing system, refineries in general operate at a loss when crude prices go above US $75bbl.
NRDC acknowledged on December 23, 2009 that it is in the process of reviewing the pricing mechanism. It is expected that the reformulated pricing mechanism will shorten the 22-day adjustment period while keep the prerequisite of 4 %-change on benchmark prices. A frequent price adjustment will leave little room for the speculators to effectively take advantage of the price movement.
Petrochina and Sinopec dominate the Chinese domestic refined product market. Sinopec accounted for 84.3% of total refined product sales in 2009. Sinopec imported 138 million MT crude in 2009, or 70% of the total crude imported into China. The cost of the crude imported is often based on floating formulas, from a number of suppliers. Hence, the average total costs often fluctuate with the international market.
As a classical case of a regulatory body residing over the monopolistic enterprises, NRDC must strike a balance between achieving higher output than the monopolists’ profit-maximizing output, while limiting the amount of subsidies. A timely and speedy adjustment will allow NRDC to set the regulated price ceiling within a tighter proximity to average total costs. The reformulated pricing mechanism, once implemented, will decrease the likelihood that the refineries operate at a loss and hence reduce the subsidies.
The second policy change that the NDRC is reportedly considering is increasing the fuel surcharge tax. At the end of 2008, NDRC implemented the current pricing scheme while simultaneously introducing the fuel tax. The fuel tax was implemented to replace toll charges on roads. This tax has generated RMB ¥228.1 Billion in revenue during the first 10 months of 2009.
Compared to higher fuel consumption surcharges elsewhere (300% in France, 120% in Japan, and 30% in USA), the Chinese levies of less than 20% leave plenty of room for future tax hikes. Considering the approximately RMB ¥1trillion fiscal deficit in 2009 (3% of the Chinese GDP), and its desire to move to a low-carbon economy, a fuel tax hike is a good alternative for the NRDC. Many analysts have praised the effectiveness of fuel surcharge in curbing the carbon emissions and increasing fuel efficiency. However, a fuel tax surcharge will cause demand to suffer, as the Chinese can easily switch to public transportation, which is widely available. In addition, a fuel tax could negatively affect demand in the high profile auto sector.
NRDC’s decision will be critical to the earnings outlook for the Chinese oil sector. Even though the imposed wholesale price ceiling will always undermine the profitability of Sinopec and Petrochina, a more flexible price mechanism will likely be positive news on their future earnings. In spite of some negative effects of a fuel tax surcharge on the oil demand, it is ultimately the consumer who will bear the brunt of the tax burden since the oil is relatively inelastistic. Sinopec and Petrochina are two largest stocks on the Shanghai composite. Should these changes occur, they will provide some leadership to the Chinese stock market.
Disclosure: no positions