China Refineries Expand to Escape Crackdown

China's effort to shut down dozens of small, privately owned oil refineries is instead making them grow bigger, threatening Beijing's plans to regulate an industry that the International Energy Agency says is already overheating.

Government policies in the resources sector in recent years have caused the closure of hundreds of small Chinese coal mines and cement and steel factories, but a similar push in oil refining is playing out differently.

Faced with a potential government crackdown next year on refineries processing fewer than 40,000 barrels of oil a day, some independent refiners—called teapots because of their small size—are responding by raising capacity, and their efforts to resist closure are being backed by regional governments, reflecting how China's top-down policies can run into resistance at a local level.

Continued increases in China's capacity would be bad news for refiners globally, especially in the industrialized world, where plants are being shut or run at substantial losses due to overcapacity and weak demand.

In its latest medium-term outlook, the IEA, a Paris-based global energy watchdog, said China could become a petroleum-product exporting powerhouse given current expansion plans.

The IEA last week forecast that global oil demand would rise to 95.7 million barrels a day by 2017, but refining-sector expansion plans will likely take global refining capacity to 100.5 million barrels daily.

China will account for more than 40% of global refining capacity growth in the next five years. However, the viability of the country's refining sector is under question because of recently sluggish demand and a weaker economic growth outlook, which has prompted some state-run oil firms to scale back expansion plans, the IEA said.

Analysts say while Beijing can slow the pace of expansion by its state-owned oil companies, a surge in capacity addition by private refiners could undermine its balancing act.

Nearly half of the some 155 independent refineries spread across China have yet to be even legally identified by Beijing, according to a new study published by Argus Media.

Teapot refineries, which already make up more than a quarter of China's total refining capacity, may expand by 37% to 5.23 million barrels a day by 2015, according to the Argus study.

If so, together, the teapots will rival the entire oil refining capacity of big energy-consuming nations like India and Japan.

Beijing faces tough choices in dealing with the teapots. Often, they are key to preventing fuel shortages when demand swings up, but their growing scale and significance threatens to loosen Beijing's control over the industry and weaken the sector domination of two powerful state-run groups, China Petrochemical Corp., known as Sinopec Group, and China National Petroleum Corp.

Teapots have traditionally produced low-grade fuels, but with expansions and upgrades many can now produce on-specification products like high-quality diesel, potentially putting them in direct competition with the big refiners.

Unlike their state-run rivals, who are mandated to produce fuel to meet domestic demand often at a loss because of government-set fuel prices, teapots are largely swing players—they raise production when refining margins are good and reduce output when they are weak.

"Teapots have become a credible force in China's refining sector and it's a challenge for the government to handle," said Kang Wu, a senior adviser at Facts Global Energy.

Beijing still maintains tight control over the teapots' operation by controlling their supply of crude oil, which often leaves them reliant on processing imported fuel oil.

Analysts say the government could continue to raise the minimum threshold for refining capacity in hopes of closing more of them, although that could prompt another wave of expansion.

One way China's National Development and Reform Commission is managing the growing prowess of independent refiners is by pushing them to integrate with state-run giants, with whom they have a complex relationship, says Tian Miao, an energy analyst at North Square Blue Oak, a London-based institutional broker.

While teapots are a market share threat for Sinopec, the country's biggest refiner, for companies like CNOOC Ltd. 0883.HK +0.37%and Sinochem Group, they offer a quick-fire way to expand in the refining business. Joining with big state companies gives teapots access to much-needed crude oil.

Some analysts' estimates suggest state-run oil firms now own or have joint ventures with 20% of total teapot refining capacity.

"The government is kind of forcing [teapots] to sell to state-run companies," Ms. Miao said. "Teapots that expand won't be shut down, but they'll still be consolidated by the majors."