The Crude Report - Shifting flows: the impact of the Russia-Ukraine war on China's crude market

Argus China Petroleum editor Tom Reed joins James Gooder on this week's Crude Report podcast to discuss the various impacts on China's crude buying habits of the disruption caused by the Russia-Ukraine conflict.

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Transcript

James: Hello, and welcome to another edition of the "Crude Report." This is a podcast from Argus Media, covering all the important topics in the world of crude oil trading, and it's very good to have you with us again. My name is James Gooder. I'm VP for crude at Argus based in London and I'm very pleased to welcome back our leading China watcher, editor of the Argus China Petroleum Report, Tom Reed. Good timing as well, because what we want to talk about today is the impact of the Russia-Ukraine conflict on trade flows into China specifically. And of course, China is one of the world's biggest consumers of oil, and with all the disruption, it's going to be very interesting to see how trade flows have shifted in the wake of these changes. And also, we're talking today on the 1st of June, when we're hearing news of an EU oil embargo, which may have further impacts on the markets.

The EU has finally joined the US, which, of course, is less exposed to Russian energy, with an embargo on Russian oil imports with some caveats. And that, combined with some very tight global product balances has helped to push ICE Brent over $120/bl, its highest since the previous record-breaking spike in the middle of 2008. This EU deal, as I say, has some important carve-outs, particularly for pipeline crude into those landlocked markets in Europe that ships can't get to. But this is still going to displace a chunk of crude from Europe, which was previously Russia's main export market. So how is this affecting China? Do Western sanctions, Western embargoes allow all that oil just to go to China instead?

Tom: Well, that's a reasonable assumption to make. And I think it's something that people have really expected to see happen and it is happening, but it hasn't done so to the degree that you might expect, given the political proximity of Russia and China, Xi Jinping and Vladimir Putin. So currently, crude imports are up a bit. Product imports have actually fallen slightly since the start of the war. But I think we are about to see an expansion of Russia's market share in China. And that is going to come at the loss of market share from competing producers. Just by way of context obviously, China's attitude towards the war in Ukraine has been pretty ambivalent. They didn't want a war. China was a major investor in Ukraine before the war as part of their Belt and Road Initiative. A lot of that investment is just going to be written off, clearly.

China has been a major buyer of Ukrainian agricultural exports like wheat. So the carnage in East Ukraine, the blockade of the Black Sea ports is a real worry for them. And it's also, I think, worth noting that China has always maintained that Ukraine is a sovereign entity, unlike Russia's position. And just before the invasion, China's Foreign Ministry actually said that explicitly at the Munich Security Conference. But on the other hand, President Xi Jinping has declined to intervene, to try and persuade Putin to back down. And he's also refused to have a call with Ukraine's President, Volodymyr Zelensky. And Chinese domestic media, and I think this is quite important, tend to be pretty aggressively pro-Russian. And that's been quite an important factor, because it's meant that there's very little, if any, moral dimension to the notion of buying crude from Russia.

James: Interesting, yes. And I think the way the war is perceived is very different, depending on where you are, isn't it?

Tom: Mm-hmm.

James: But you say imports from Russia into China have risen since the war began, since the invasion?

Tom: Yeah, crude imports. Yep. They have gone up a bit. China imports a little bit of products as well but naphtha volumes are pretty small and they have fallen if anything. Crude is the main thing. Imports have been rising from a relatively low point, 1.4 million barrels a day in February, and they rose to 1.6 million barrels in April. But the context is important here, because really, that just took them back to the average level of Russian imports in 2021. Russia is China's second-largest source of crude. It's either Russia or it's Saudi Arabia, you know, they kind of vie for the top spot.

In terms of quality and buyer though, there's quite a big difference between what China takes from Saudi Arabia, which is medium sour, mainly goes to Sinopec and what it takes from Russia, which is 75%, light sweet ESPO Blend, and that tends to go to PetroChina by pipeline, or to the independents of Shandong by ship around the coast from Kozmino.

James: I see. But you're talking here about April deliveries to China. Now, these tend to trade quite far in advance. So they would have traded before the war began. Though, of course, there was a sense that something was on the way.

Tom: Yes. Well, they tried to refuse to believe it, yeah. No, you're quite right. So China was halfway through trading April-arriving ESPO crude when the invasion kicked off 24th February. Russian crude ESPO Blend premiums spiked, initially, as people kind of wondered what the implication of that was going to be and then the premiums collapsed. I'm talking premiums to ICE Brent futures. Then the ESPO premium collapsed as a lot of buyers in northeast Asia other than China, so Japan, South Korea began to embargo Russian imports. And these continued to flow to China. The market has become far more opaque as a result of the war, although there aren't any sanctions yet for companies buying Russian crude in Asia. But we have sufficient visibility of what's going on in that market to be reasonably confident in our assessment of the current price of ESPO Blend that $3.20/bl discount to ICE Brent, for cargoes arriving in July.

James: That's interesting. I mean, we've seen much bigger discounts for other kinds of Russian crude into Europe, of course, but I guess even that makes ESPO far cheaper than any of the alternatives of that quality delivered into China.

Tom: Yeah. No, it does. And you know the news today about the EU sanctions, that just pushed the premiums for crude on the delivered market in China up even further. ESPO Blend's a really nice crude with good distillation yields. It's sweet. It produces good naphtha for gasoline, comes out of Russia in the Sea of Japan. The bulk of it is always headed to China. Chinese refiners love ESPO Blend, and in the past, they valued it at a slight premium to another very good quality crude, Tupi from Brazil. But Tupi, unlike ESPO, is a global market. Tupi and the other Brazilian medium sweet pre-salt grades which come from offshore Brazil, they can go to the US. They can go to Europe. They can go to South Korea, and that means their prices are globalised. And in the current context that makes them very expensive. Tupi has been, you know, kind of trading nearly $7/bl above ESPO Blend. So we have seen demand for Brazilian crude fall and be replaced in China with demand for this far cheaper ESPO Blend.

James: Right. Got it. But trading has tended to be a low-margin, high-volume business. That's how firms make their money. But now trading companies seem to be able to make enough money on Urals, given the massive discounts of that crude typically exported west, that they are now shipping it as far afield as China, is that something that you see?

Tom: Yeah. So [ship-tracking service] Vortexa puts Urals deliveries to China in May at 260,000 barrels a day. That's the highest since the market went totally crazy in early 2020 as a result of the pandemic. And that is because these Russian grades, ESPO Blend, like Urals, they are trading at even deeper discounts to benchmark prices at loading ports than they are on a delivered basis in China. That's been a really important factor in ensuring that Russian exports continue to flow to China. Because as you say, you know, for companies prepared to do it, there are these very, very large and attractive trading margins to be made. FOB discounts for Urals in the Gulf of Finland, you know, where it comes out are so wide now that trading firms are actually sending Urals straight to China on Aframaxes. In the past, these little Aframaxes were far too expensive. And when the arbitrage to China was open, you'd see companies combining these 720,000-barrel Aframaxes into 2 million-barrel VLCCs to send these because that was obviously far more... you get these economies of scale. Now, even though it costs, and we see fixtures at this level, which is why I mention it, maybe $12.50/bl to send Urals on an Aframax to China, traders are still making $6/bl, $7/bl profit on that arbitrage.

James: Interesting. But, I mean, of course they're still competing with India where Urals has become extremely popular since all of this started. But do you think we're going to see exponential growth now in Chinese demand for these embargoed Russian grades both from east and west?

Tom: Well, I think there are a couple of really important caveats to bear in mind. And the first is that thanks to its lockdown policy, Chinese oil demand is weak. It's currently around 600,000 barrels a day lower than it was a year earlier. The shutdown of Shanghai, the semi shutdown of Beijing have really caused crude stocks in China to balloon. So there is less demand for imports on an outright basis and weak demand is one of the reasons why you see refiners buying Russian crude. It is simply that they cannot compete with refiners in Europe currently because margins in Europe or the US, Singapore, are sky-high. And so, you know, the Chinese refiners just cannot compete with those margins. So they've got to pay less.

James: Yeah, of course. And the other factor, of course, to come back to where we began: EU sanctions, an EU embargo, and also now it looks likely to include a ban on insurance, both in EU and UK for vessels carrying Russian crude. What is the impact of this?

Tom: Well, I think this has the potential to be very, very disruptive. You're right. It's interesting. It's the joint EU-UK initiative because that, of course, sucks in the big Lloyd's of London insurance market. And I guess anyone selling crude to China on the delivered basis is likely to have to organise shipping from Europe, talking about Urals, where P&I Club members, that's the insurers' umbrella club, now won't be insuring Russian oil. In the past, you know, we've seen ships flag to a whole load of different countries, but ultimately, a lot of them get insurance through companies connected to Lloyd's. So this, I think, is going to make it far harder to ship Urals east. They'll probably have a small impact on the ESPO market, which is far more local and Asian, but I think it is worth also noting that China has these vast, deep shipping fleets of its own, you know, China Merchant and COSCO, which can get insurance via the Chinese market. So that, I think is one potential outcome.

The other, of course, and a far riskier one is that you just end up seeing as we did with Iran, a lot of that shipping go underground to poorer quality vessels, which maybe aren't insured, maybe don't carry transponders and the risk of shipping does get a lot higher.

James: Well, thanks so much, Tom, for that very interesting overview. I'm sure everyone listening can tell that we've got good intelligence on what's happening in China, even though the oil market there and everywhere else seems to be remaking itself on a daily or weekly basis. So if anyone wants to learn more about what's happening in China, and you don't already receive it, do get in touch with us to get access to the Argus China Petroleum report. And of course, if you want to hear about what's happening in the crude market, even more often than that, then ask us about the daily Argus Crude service.

Thanks again for listening. Thanks very much to Tom for joining us, and tune in next time for another Argus Crude Report.

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