ANALYSIS: China Tax Rules to Raise Bunker Fuel Costs; Cut Teapot Margins

The Chinese government's move to tighten tax rules to prevent domestic blenders and "teapot" refiners from avoiding a Yuan 812/mt ($129.20/mt) consumption tax on their purchases of domestic or imported fuel oil is likely to raise costs and erode margins, industry sources said this week.

The State Administration of Taxation earlier this month announced a series of measures aimed at clamping down on refiners, traders and other operators who evade taxes by declaring taxable oil products under other names.

According to a notice by the tax authority dated November 15, starting January 1, 2013, producers will have to submit a "quality inspection certificate" to the taxation bureau if they are seeking consumption tax exemption. That will make it difficult for sellers or importers to declare fuel oil as asphalt, for example, which is exempt from consumption tax.

The notice also adds a specific detail to the current list of taxable oil products -- gasoline, diesel, naphtha, lubricants, jet/kerosene and solvents -- saying those obtained from the processing of crude oil and meeting national and industrial standards will attract consumption tax. Separately, MTBE and aromatics, commonly used in gasoline blending and which have no national standards, have been added to the consumption tax list of products effective January 1. China's consumption tax is imposed on entities and individuals engaged in the production, processing or importing of taxable consumer goods.

BLOW FOR FUEL OIL BLENDERS

Fuel oil blenders in China typically buy residual oil for blending purposes, but some get the sellers to declare it as asphalt, to avoid paying the Yuan 812/mt consumption tax levied on residual fuel oil.

"When the new rules come into force, the cost of domestically blended 180 CST bunker will increase by Yuan 300-400/mt, and possibly dampen fuel oil demand," a trader said. That calculation is based on a typical ratio of 0.3-0.4 mt of residual oil used to produce 1 mt of 180 CST bunker fuel.

The Yuan 812/mt consumption tax, once added to the value of the fuel, would also lead to a corresponding Yuan 138/mt rise in the value-added tax or VAT payable on it, which is levied at a rate of 17% of the product value. That implies a total of Yuan 950/mt in additional costs on residual fuel, or Yuan 285-380/mt of incremental cost in the production of blended fuel oil.

The shipping sector consumes about 80-90% of domestically blended 180 CST fuel oil in China now, with other end-users such as factories and power plants having largely switched to other fuels such as natural gas and coal in recent years, and also spurred by the government jacking up fuel consumption tax to Yuan 812/mt from Yuan 101.50/mt effective January 1, 2009.

While the shipping sector is expected to absorb the higher bunker fuel costs given the lack of viable alternatives, the more price-sensitive end-users who can substitute, such as industries using it as boiler feedstock, might stop buying the domestically blended product altogether, traders said. Other users might choose to buy fuel oil in smaller lots to limit their payments, they added.

Already, Chinese fuel oil demand has been weakening gradually this year, in line with the country's slowing economic growth, sources noted.

"We are selling less domestically blended bunker fuel this year compared with last year, but it's difficult to say how much less until we see the final number for the year," said a trader at Chimbusco Guangzhou.

IMPORTS MIGHT LOOK GOOD

Costlier domestically blended fuel oil would also likely narrow the price spread with Singapore-origin cracked fuel oil, opening up more import arbitrage opportunities, sources said.

The cost of Singapore-origin 180 CST fuel oil imported into southern China's Huangpu port was around Yuan 5,700/mt inclusive of all taxes, based on Platts assessments November 23, while the spot price of domestically blended fuel oil with similar specifications was around Yuan 4,830/mt in Huangpu. The Yuan 870/mt spread would crunch by Yuan 300-400/mt with the imposition of stricter tax rules next year.

The arbitrage window for Singapore fuel oil to move into China has remained mostly closed since the 2009 hike in consumption tax. The tax dealt a second blow to China's appetite for imported fuel oil, which peaked at 7.62 million mt in 2004, but had begun to slump from around 2006 because of natural gas substitution.

Currently, the bulk of cracked fuel oil imported into Chinese ports from Singapore is stored as "bonded" or tax-free product, and supplied as bunker fuel to ships plying international routes. That material is exempt from the 1% import tax, the Yuan 812/mt consumption tax and the 17% VAT.

Separately, China's "teapot" refiners -- small independent plants concentrated in the provinces of Shandong and Guangdong with typically less than 5 million mt/year (100,000 b/d) capacity -- would also see their feedstock costs rise, as they would be unable to declare their crude imports as asphalt and avoid paying consumption tax, sources said.

VENEZUELAN CRUDE COULD LOSE FAVOR

Some of the teapot refiners have been declaring their imports of crudes such as the heavy Venezuelan grade Merey as fuel oil or asphalt, they added. While declaring it as fuel oil enables them to skirt the problem that they do not have crude import licenses or quotas from the government, calling the cargo asphalt frees it from consumption tax, said a source in Shandong.

"The crude would have to be declared as fuel oil and pay the consumption tax next year, as it looks like it will be impossible to prove the cargoes as asphalt," the source added.

The additional Yuan 950/mt taxes would put the price of an imported Merey cargo on a par with or even higher than imported straight-run fuel oil. On November 23, the spot price of Merey was around Yuan 5,500/mt in the Shandong market, while the alternative feedstock for teapot refineries, imported Russian straight-run fuel oil M100, fetched around Yuan 6,300/mt, translating to a spread of Yuan 800/mt.

The teapot refineries, which have little or no secondary processing capacity, typically crack imported crudes and fuel oil to produce mostly gasoil and gasoline for sale in the domestic market and already operate on razor-thin or at times negative margins.

These refiners consumed 815,000 mt of Merey crude and 286,000 mt of M100 in October, accounting for 24% and 8% of their total feedstock respectively last month, according data from Beijing-based energy information provider JYD Commodities Hub.