How to reform China's oil industry (iii) - oligarchs and deregulation

As discussed before, China has serious structural problem in its oil price, and SDRC is responsible for this mess. The problem lies not only in its price control, but also in the oligopoly. Furthermore, the coupling of oil extraction, refinery and retail value chain is nullifying any effort to improve efficiency.

Chinese media are also looking at this problem, and reaching similar conclusions. Here are the key points listed in an excellent essay by Chinese economist Sheng Hong (盛洪) about a month ago:

• Sheng argued that gasoline price in China is not too low, it is the lack of competition (and hence low efficiency) that caused the problem. He compared the pre-tax gasoline price for a few countries, in RMB/Liter on August 1st, 2005 (for grade RON 93=PON 89) - I am not sure how Sheng accounted for VAT, but that is only a small percentage compared to fuel duty and does not affect his conclusions (probably also compensated by lower labor/rent cost in China as well)
• USA: 4.49 (5.33 incl tax)
• Germany: 4.39 (12.58)
• France: 4.09 (11.9)
• UK: 4.13 (12.7)
• China: 4.26 (4.26)
• The current price cap does not work, as it does not reflect the true economics in the industry. For imported crude, the oligarch are probably adversely affected by the price control. For domestic crudes, they are making obscene profit, because the overall price has rised but cost (of extraction to refinery to retail) does not change. It is all very muddled and impossible for SDRC to determine a fair market price
• The cost for domstically produced crude: the state only charges charge RMB30/ton of mining loyalty fee (the US charges about 1/6 crude price as loysalty for mining, which is US$73 per ton, assuming crude price is $60/barrel. 1 ton=7.3 barrel). So the oligarchs are actually making obscene profit at mining, hence there is no incentive to improve efficiency. (note: the cost of exploration and mining is supposed to be higher for China, due to management expertise, technology and to a lesser degree, geological factors
• Current price control is only at the retail level. The oligarchs are free to set wholesale prices. By setting a high wholesale price, or delaying/refusing supply to independent retail stations. Independent Retail Gas Stations are crushed
• Sheng also pointed out a fatal mistake by SDRC in 1999 (#38 document), where smaller refineries were shut down in the name of "improving scale and efficiency". This essentially eliminated competition for the oligarchs. Sheng also blamed "#38" for failing to require the oligarchs in providing "Universal Service Obligation", (and "uninterrupted service") which is a common obligation for oligarchs (e.g. in telecom industry), essentially giving up any check and balance for these oligarchs

However, SDRC is still resisting, citing various lame excuses, such as various complications (lack of competition and fear of smuggling) created by themselves in earlier years. There are a few problems to be solved, and SDRC need to untangle the complications it created ASAP

• Some Chinese media tend to include road tax into the cost of operating a car, but that is nonsense, because a fixed car tax will not discourage oil usage, instead, it is more likely to encourage wasting
• Yes, lifting price cap alone does not solve the problem. Because there is no real competition. The oligarchs will continue (and be encouraged) to operate under sub-optimal efficiency. Competition is needed to ensure a fair price
• As long as the value chain (from extraction to refining to retail) is integrated, it is hard even for the oligarchs themselves to improve efficiency, because there is no accoutability for the sub-divisions inside the oligarchs. Therefore, lifting price control can help to discourage waste, but will not help to improve efficiency
• One probable reason that CNPC, Sinopec and CNOOC have been so eager in securing crude (instead of) refinery assets is they could ask for state subsidy in terms of cheap capital and the profit is less affectedd by domestic price control. This obviously does not align with China's interests (or Chinese people's), as acquisition might be overpriced, and the more urgent needs for refinery investment are not met

To address the aforementioned problems, China needs to form a clear objective for its energy policy. Among the key objectives are, (1) encourage efficiency use of oil (vs other energy sources), and (2) improve efficiency of the oil industry (by competition). This can be achieved by deregulating the oil industry and removing price control at the same time:

• Deregulate oil industry by decoupling the oil exploration/extration, refinery, retail value chain
• In transition period, the price control can be impose at the crude oil level (using international market price - not to be large than a few %), instead of at retail gasoline level. This is easy to implement, e.g., by introducing an independent company to arbitrage via importing/exporting
• Once the crude price is secured, one can rely on competition to ensure the wholesale and retail prices are "fair". To do this, one needs to make sure there is sufficient compeition at the refinery and retail levels.
• To ensure competition at retail level, crude producers and refineries are not allowed to own retail. (Spin off baby-CNPCs, baby-Sinopecs per province, and encourage cross-province competition) This would then help to improve efficiency at the retail level and ensure fair market price through competition. The retailers should be allowed to also import gasoline from world market, though in reality it might not be practiced if there is suffcient cometition at the refinery level
• Even though crude producers and importers may still own refineries (some synergy), independent refineries can compete effectively because curde price is connected with the oil market (and they should be allowed to purchase at world market to ensure this)
• Now it will be hard for the oil oligarchs to muddle the price matters, as crude price becomes very transparent
• Further decoupling oil refinery and gasoline retail can be considered. Even if the companies may still be linked, for synergy reasons. But they should have independent financial and accountability. This would help to ensure a fair market price for gasoline wholesale
• Finally, introduce more competition into each sector. (This will be a slow process)
• Lift price control, meanwhile introduce mechanism to ensure pricing interface with international market. e.g. create an independent import/export company to ensure the domestic and international crude prices do not diverge.
• (As suggested by Sheng) Impose loyalty fee (based on % crude extracted) for mining, and introduce more oil producers, so that the loyalty fee (the percentage) will be determined based on auction. One bonus of this loyalty is that the crude collected can be used to build up China's strategic oil reserve.