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