OREANDA-NEWS.  July 09, 2014. China's small independent refineries continue to produce lower grade fuels despite a government-mandated shift to tighter specification gasoil and gasoline as they continue to see demand for lower-spec grades and also lack the financial resources to upgrade their plants.

Some of these refineries, commonly known as "teapot refineries" in the country, are still producing National Phase II gasoil, which caps sulfur content at 500 ppm, against the national mandate of Phase III gasoil, where sulfur is capped at 350 ppm.

Teapot refineries typically have less than 5 million mt/year (100,000 b/d) of processing capacity and limited secondary units.

The gasoline they produce mostly complies with Phase III standards where the maximum sulfur content is capped at 150 ppm even though the country moved to Phase IV -- which limits sulfur at 50 ppm -- in early 2014.

Starting next year, the central government will fully implement Phase IV specification standard for gasoil, while Phase V standards for both fuels are scheduled to be introduced in 2018.

According to data from Beijing-based information provider JYD Commodities Hub, just over half of the 36 teapot refineries it tracks in Shandong province -- where most of the teapot refineries are located -- have the capability to produce Phase IV gasoline and Phase III gasoil.

Refineries that have not progressed to producing higher quality fuels are restricted mainly because they do not have hydrogenation units, which are expensive to build.

"Some small-scale refineries have not put up new hydrogenation units yet ... perhaps because these units are quite expensive to build, and [the teapot] refineries usually lack the financial resources," said a source with the 4.8 million mt/year Huifeng Petrochemical.

Huifeng is now able to produce Phase IV gasoline and Phase III gasoil after adding some hydrogenation units over the past years.

China's state refiners, led by Sinopec or China Petroleum & Chemical Corp., and PetroChina, have been aggressively upgrading their refineries since 2012 to produce fuels compliant with Phase IV standards. Some of those state-owned refineries have also started producing Phase V compliant gasoline, which caps sulfur at 10 ppm.

As teapot refineries do not have oil product export licenses, their only outlet is the domestic market, where despite a nation-wide move to tighter spec fuels, these refiners have found pockets of demand for their lower quality output.

"The new standards introduced by the government since late last year does not mean the end for Phase III gasoline and Phase II gasoil, as long as there is demand for it," said a source with the 5 million mt/year Lijin Petrochemical refinery.

Gasoline is the main fuel for passenger vehicles, while gasoil is used in heavy trucks, and the industrial and agricultural sectors.

Demand for 500 ppm sulfur gasoil now mostly comes from the construction and mining sectors, particularly in the rural parts of the country, refinery sources said.

Teapot refiner Tianhong New Energy, which has a refining capacity of 1.5 million mt/year, says it sells its 500 ppm sulfur gasoline and off-spec gasoil -- that does not even meet Phase II gasoil specifications -- to industrial users and the fishing sector.

"Those buyers are sensitive to price and tend to use cheaper fuel if possible," said a refinery source.

The wholesale price of Phase II gasoil is typically about Yuan 100/mt (USD16/mt) lower than 350 ppm sulfur gasoil in Shandong market.

China last year said that it would raise the price of cleaner transport fuels to incentivize refiners to upgrade as it tried to control pollution in the country.

The National Development and Reform Commission in September 2013 said it would raise the price of Phase IV gasoline and gasoil by Yuan 290/mt and Yuan 370/mt respectively, up from Phase III fuels. Meanwhile, prices of Phase V gasoline and gasoil will be even higher.

"There is a lot of demand for Phase II gasoil," a source with the 3.5 million mt/year Jingbo Petrochemical said.

For refineries, it does not hurt their profit if they sell Phase II gasoil rather than Phase III, as the profit margin for both are almost the same even though the latter needs further treatment, refinery sources said.

The price of Phase III gasoil is about Yuan 100/mt higher than Phase II, but the production cost of Phase III is also about Yuan 60-80/mt higher, sources said.

Demand for Phase III gasoil is not as strong as for Phase II as buyers tend to use low grade fuels that cost less, they said.

In addition, demand for the lower-spec fuels is rising from another source -- teapot refineries that are only building hydrogenation units.

Dongying Huasheng, a company in Shandong that does not have a crude distillation unit, plans to commission a 300,000 mt/year gasoil hydrogenation unit in the coming weeks that will enable it to produce Phase III gasoil.

"We will need to purchase off-spec gasoil that is produced out of CDUs as feedstock for our new unit. We aim to produce around 15,000 mt to 20,000 mt of Phase III gasoil every month," a company source said.