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Cablegate: China/Energy: Refining How Oil Is Priced

VZCZCXRO7036
PP RUEHCN RUEHGH RUEHVC
DE RUEHBJ #1734/01 0740307
ZNR UUUUU ZZH
P 150307Z MAR 07
FM AMEMBASSY BEIJING
TO RUEHC/SECSTATE WASHDC PRIORITY 5690
RHMFIUU/DEPT OF ENERGY WASHINGTON DC PRIORITY
INFO RUEHOO/CHINA POSTS COLLECTIVE PRIORITY
RUEATRS/DEPT OF TREASURY WASHDC PRIORITY
RUCPDOC/DEPT OF COMMERCE WASHDC PRIORITY
RHEHNSC/NSC WASHDC PRIORITY

UNCLAS SECTION 01 OF 04 BEIJING 001734

SIPDIS

SIPDIS
SENSITIVE

STATE FOR EAP/CM PSECOR, GWARD AND EB/ESC SIMONS, HAYMOND, WECKER
DOE OIC FOR PUMPHREY, OEA FOR CUTLER, NAKANO
TREASURY FOR OASIA DOHNER, CUSHMAN
USDOC FOR 4420/ITA/MAC/CEA/MCQUEEN
USTR FOR BHATIA/STRATFORD/WINTER/ALTBACH/MCCARTIN

E.O. 12958: N/A
TAGS: ECON ENRG EINV EPET EFIN CH
SUBJECT: CHINA/ENERGY: REFINING HOW OIL IS PRICED

BEIJING 00001734 001.2 OF 004


SUMMARY
-------

1. (SBU) China presently has in place an interim oil pricing
mechanism that will eventually lead to the integration of domestic
prices with global prices, according to National Development and
Reform Commission (NDRC) Vice Chairman Bi Jingquan, as quoted by
media on March 11. Bi's comment caps years of efforts on China's
part to keep rising global oil prices and increasing market
volatility from harming consumers, rural residents, and oil
refiners. A previous oil pricing policy was suspended in 2004 amid
a combination of Beijing's concern with the inflationary effect of
high oil prices and worries that the policy's mechanics were flawed.
The NDRC has subsequently relied on administrative pricing, but
this has come at a cost: refinery profitability has vanished over
extended periods, leading to a need for subsidies to the oil
companies, while consumers and the media have grown increasingly
vocal about insufficient price decreases as global oil prices have
come down from recent highs. Several of our contacts are familiar
with details of the new pricing mechanism to be put in place, and
they say the system will guarantee domestic oil refiners a profit
while shielding gasoline and diesel consumers from major
fluctuations in international oil prices. They view the new
mechanism as incorporating elements of market-based pricing but
assess the NDRC's approach as still highly controlled overall, with
the new system potentially vulnerable to speculation. End Summary.


NEW PRICING MECHANISM IN PROCESS
--------------------------------

2. (SBU) NDRC Vice Chairman Bi Jingquan was quoted by media on March
11 as saying that China presently has in place an interim oil
pricing mechanism that will eventually lead to the integration of
domestic prices with global prices. Bi's comments cap years of
efforts on China's part to keep global oil price volatility and
price hikes from harming consumers, rural residents, and oil
refiners. The new pricing mechanism will reportedly derive the
domestic Chinese price of oil from a market basket of Brent, Dubai
Fateh, and Indonesian Minas prices. (Note: Brent is considered a
world oil price benchmark. Dubai Fateh is the established Middle
Eastern price for Asia-destined crude oil. Minas is one of seven
oil prices that constitute the OPEC market basket price and is a
representative Asian price. End Note.) Such an approach coincides
with the NDRC's January reduction of the price of refined oil
products by 3-5 percent, suggesting that it may be a part of the
"interim" approach that Vice Minister Bi asserts is already in
place.

3. (SBU) Dr. Zhao Jianping, a Beijing-based World Bank energy
analyst, told us that Beijing has finalized the specific pricing
formula to be used. The NDRC will most likely initiate the new
mechanism when it assesses international oil prices have settled in
the USD 55/barrel range. Dr. Wang Zhenzhong, Deputy Director of the
Institute of Economics at the Chinese Academy of Social Sciences
(CASS), stated that Beijing has not yet enacted the oil pricing
mechanism because NDRC officials are still watching international
oil prices and assessing whether major prices fluctuations are on
the horizon. There is ongoing criticism of the current pricing
policy in newspapers such as the China Daily and the Beijing
Economic Daily.

OLD SYSTEM AND MARKET: LIKE OIL AND WATER
-----------------------------------------

4. (SBU) Beijing's previous pricing mechanism for domestic oil was
in use from 2000 to 2004 and relied on a market basket of New York,
Rotterdam, and Singapore bourse quotations. The NDRC then used a
proprietary formula to make adjustments monthly based on market
movements, but fears about possible inflation and slower economic
growth from rapidly rising global prices led to suspension of the
mechanism, according to our contacts. World Bank's Zhao said that
the pricing formula also had mechanical problems that concerned the
NDRC. For example, the one-month time lag fueled market
speculation, which was evident in hoarding and resulted in periodic
gasoline and diesel shortages. Zhao also noted that the previous
pricing system linked the domestic crude price to international
refined product (rather than crude product) prices, thus
incorporating other countries' refining taxes and administrative
fees into China's unrefined oil price.

ADMINSTRATIVE PRICE CONTROLS

BEIJING 00001734 002.2 OF 004


----------------------------

5. (SBU) After suspending the previous system, the NDRC turned to
administrative pricing. This also led to hoarding and speculation
by China's oil companies, according to K.F. Yan, a researcher at
Cambridge Energy Research Associates (CERA). For example, domestic
oil companies recognized that in order to protect farmers, the NDRC
was unwilling to raise refined product prices until after the spring
planting season was completed. According to Yan, oil companies
responded by withholding gasoline and diesel from the market until
after the price increases had been implemented.

6. (SBU) The NDRC thus shielded domestic consumers and farmers from
increased international oil prices, but at the expense of Chinese
refiners. Sinopec and China National Petroleum Company (CNPC),
which together control some 80 to 90 percent of refinery capacity,
lost several billion dollars in 2005 and 2006 selling refined oil
products in the domestic market: the below-market oil price forced
the companies to import oil at international market rates but to
sell their refined products at a loss using the administratively set
prices. Senior NDRC officials told us the oil companies' losses
were as high as USD 20-25 per barrel at the peak of international
oil prices in 2006. As a result, the Central Government ended up
compensating Sinopec, China's largest refiner, with subsidies of USD
1.2 billion dollars in 2005 and USD 650 million dollars in 2006.
(Note: The current exchange rate, 7.75 Chinese yuan per one United
States dollar, is used to convert currency figures throughout this
report. End Note.)

CONSUMERS GRUMBLE WHILE EXPERTS QUESTION THE SYSTEM
--------------------------------------------- ------

7. (SBU) CASS' Dr. Wang told us that Chinese consumers are
increasingly unhappy with domestic gasoline and diesel pricing,
having realized that domestic gasoline and diesel prices do not fall
in concert with international trends. He stated that Chinese
consumers do not understand why they paid less than USD 2.00/gallon
of gasoline when oil prices approached USD 70/barrel in 2005, but
now pay USD 2.40/gallon with oil at USD 55-60/barrel. (Note: We
have converted Dr. Yang's figures to USD and gallons for clarity.
End Note.) Chinese consumers' unhappiness with prices at the pump
is leading them to oppose the oil refinery subsidization payments to
the oil companies, he said. (Note: Consumer concerns have been
reflected and even supported in state-controlled media. End Note.)


8. (SBU) Elaborating on Wang's comments, we note that the NDRC has
raised China's domestic gasoline prices by 40 percent over the past
two years. China's average retail gasoline price, presently USD
2.40/gallon, has in recent months trended lower than the U.S.
equivalent, which stands at USD 2.51/gallon, according to March 5
Department of Energy Statistics. China's diesel prices also have
increased by 40 percent during the past two years. Chinese
consumers are paying approximately 2.00 dollars per gallon for
diesel, some 62 cents per gallon less than United States consumers.
China's administratively set pricing scheme has thus ensured Chinese
consumers did not experience either the volatility or magnitude of
price increases that have affected United States consumers during
the course of 2005 and 2006.

9. (SBU) Discontent about administrative price controls has found
its way into government circles as well. Zhou Dadi, former Director
General of the NDRC's Energy Research Institute (NDRC/ERI), recently
told a China energy investment forum attended by Econoff that it is
inappropriate for the Chinese Government to set oil prices and then
subsidize China's oil companies. He stated that the Central
Government is being too generous to Chinese oil companies at a time
when they are earning large profits. CERA's Yan stated that
opposition to the subsidies has led some officials to call for an
investigation into the legality of the subsidies.

NEW PRICING SYSTEM A RESPONSE TO CRITICISM
------------------------------------------

10. (SBU) The World Bank's Zhao told us that the Central Government
began working on the new pricing mechanism in late-2005 in response
to the mounting, and often contradictory, criticism from the public,
policy circles, and oil companies. Numerous contacts understand the
new system will: (1) reflect oil companies' concerns about
profitability; (2) link China's oil price to three international
crude oil prices: Brent, Dubai Fateh, and Indonesian Minas; and (3)
involve more frequent price adjustments, perhaps as often as every

BEIJING 00001734 003 OF 004


2-3 days. It is still unclear, however, just how the NDRC will set
the refining profit for the oil companies.

11. (SBU) One international oil executive we met with pointed to two
ways to set refining profits -- either establish an automatic profit
rate that includes refining margins or rely on a fixed price but
ensure that this price moves with market conditions. The
international oil executive said that the NDRC should draw upon its
experiences in implementing a pricing mechanism in the power sector
during the 1980's when choosing which approach to take. During this
period, the Chinese Government set a guaranteed profit margin for
power producers. This failed to encourage competition resulting in
very inefficient production. The executive stated that if the NDRC
heeded this lesson, it would set a fixed price for refined products
to ensure more competition and more efficient production. Our
contacts and other observers, however, generally believe that the
NDRC will move towards an automatic profit rate.

TWO KEY CONSTITUENCIES
----------------------

12. (SBU) The World Bank's Zhao said that the Chinese Government is
sensitive about cushioning the impact that any pricing system has on
taxi drivers and the rural population. CASS's Wang noted that the
Central Government has a longstanding policy of providing fuel
subsidies to farmers. The government provided farmers fuel
subsidies in 2006 when the NDRC increased fuel prices by 17 percent.
Wang believes the Central Government will allocate a special
subsidy for farmers when the new fuel price mechanism is in place.
He expects that taxi drivers, however, will only receive a small
subsidy, perhaps around RMB 100 (approximately USD 13) annually, an
amount that will make little difference given the large volume of
fuel they consume.

PROTECTING THE GROWING MIDDLE CLASS
-----------------------------------

13. (SBU) Both Wang and Zhao also expect the Central Government to
cushion the middle class (i.e., those consumers who have the means
to spend enough on fuel to be impacted directly by price changes)
from future price shocks through a price stability mechanism. It
is Wang's understanding that China's oil companies have agreed with
the NDRC that pump prices correlating with USD 50-60/barrel oil make
for an acceptable pricing range. The World Bank's Zhao said that he
expects the NDRC, in order to shield consumers from rapid price
increases at the pump, will reduce oil companies' refining profits
if oil moves into the USD 60-65 range. If prices move above USD 65,
the NDRC will return to direct refinery subsidization.

SPECULATION MAY REMAIN A CHALLENGE
----------------------------------

14. (SBU) CASS's Wang said that despite the new pricing mechanism,
the perception remains that China's energy pricing system is opaque.
This could feed into a new form of market speculation, more
frequent pricing adjustments notwithstanding. Thomas Wong, Director
of Oil and Gas Research at UBS, stated that there are two extremes
in pricing: state-set prices and the free market. A market-based
pricing system that exists somewhere in between is always vulnerable
to speculators. Speculation on how China will value oil at any
given time could lead to increased prices in the international
futures markets. Depending on where and from whom China is
purchasing oil, increased futures prices could make China's overseas
purchases more expensive.

POSSIBLE FUEL TAX
-----------------

15. (SBU) There is ongoing debate about introducing a 4.5 percent
fuel tax that would accompany the new oil pricing mechanism. The
tax would reportedly fund energy efficiency and conservation
initiatives along with basic road maintenance needs, replacing an
existing road maintenance fee that car owners pay annually. Such an
arrangement is already in place on an experimental basis in Hainan
Province. The international energy executive we spoke with stated
that a fuel tax is inevitable, but believes it will be sidelined
while the NDRC assesses how well the new oil pricing mechanism
works. UBS's Wong agreed, arguing that the fuel tax is a
medium-term goal, rather than an immediate one for the Chinese
Government. The World Bank's Zhao said a fuel tax could be
implemented by 2008. A recent World Bank report described a fuel
tax as "the instrument of choice to limit car use, vehicle

BEIJING 00001734 004.2 OF 004


pollution, and energy intensity in the economy."

COMMENT: A BALANCING ACT
------------------------

16. (SBU) Consumer and rural frustration, hoarding, speculation, and
a loss of refining profitability have been among the distortions
wrought by China's efforts to date to manage domestic oil prices as
their international equivalents have trended upward. What we know
of ongoing efforts to reform the system suggests similar headaches
may lie ahead, despite some moderate steps towards a mechanism that
incorporates more "correct" market information (using unrefined
rather than refined prices) and adjusts according to that data more
frequently. Rather than aiming for true market based pricing,
policy makers appear to be cobbling together a system that protects
consumers from price shocks while assuring refiners' profits -- but
only as long as global prices stay below USD 65/barrel.

RANDT

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