Base oil arb benefits then hinders Chinese buyers

Northeast Asian base oil prices will likely hold firm in early 2021 as tight availability throughout the region coincides with a seasonal rise in demand.

Prices were unusually volatile in 2020, before ending the year at higher levels. Prices slumped in the first five months of the year. Prices for Group I bright stock and Group II heavy grades then began a gradual revival from mid-year, before surging in the fourth quarter and ending the year at much higher levels than at the start of 2020.

Base oil prices began the year firmer than usual, even as Chinese buyers opted to hold off replenishing their stocks until after the lunar new year holidays in late January. But supply at the start of the year was tighter than usual because of a combination of run cuts and moves by producers to divert supplies to other outlets like the marine fuel market.

China went into lockdown from late January following the Covid-19 outbreak. The move triggered a slowdown in Chinese demand in February as factories closed or operated at lower run rates. Workers struggled to return to factories and refineries after the lunar new year holidays. Travel restrictions created logistical complications for blenders that did seek supplies.

Run cuts curb supply surge

The prospect of a surge in surplus supply failed to materialise. Domestic refiners in China slashed their run rates in response to the slowdown in demand. Buyers cut their requirements from overseas markets. The move triggered a sharp fall in China's base oil imports in the first quarter of the year.

Many blenders, distributors and refiners had low stocks anyway because of plans to replenish inventories after the lunar new year holidays.

Chinese buying interest revived in March as the country's lockdown measures were gradually withdrawn. The move triggered a steady recovery in economic, transport and industrial activity.

But buyers continued to hold off seeking more supplies to replenish their stocks. Their preference to wait followed the slump in crude prices in early March. A widening gap between prices for domestic light-grade supplies and imported base oils also incentivised buyers to secure more supplies from domestic producers.

Expectations of rising domestic supplies and a seasonal slowdown in demand for light neutrals added to pressure on the grade. Several new base oil plants also began operations in China during the second quarter of the year.

Demand revives in 2Q

A recovery in Chinese demand then gathered pace from the start of the second quarter of the year. The trend coincided with a slump in regional cargo base oil prices. Cargo prices fell as country lockdown measures throughout Asia-Pacific triggered a slump in demand.

Domestic prices in China fell in response to lower cargo prices. But the size of the fall in domestic prices was smaller than the drop in cargo prices.

The result was an unusually wide gap between domestic Group I and Group II prices in China and fob Asia cargo prices.

Buyers tap open arb

The gap between fob Asia N500 prices and domestic Chinese N500 prices widened to more than $220/t by early May. The spread was up from typical levels of less than $60/t in 2019. The gap between fob Asia SN 500 prices and domestic Chinese SN 500 prices widened to more than $190/t by early May. The gap is usually less than $100/t.

The arbitrage even opened for fob Asia light-grade supplies, despite the greater pressure on these prices in China's domestic market.

Rebounding Chinese lube consumption and a wide-open arbitrage triggered a surge in demand for overseas supplies.

Producers move surplus to China

South Korean producers especially tapped this opportunity to move large volumes to China and clear their own oversupply. South Korean base oil exports to China surged from May and rose in June to a record high. Exports of 305,940t to China in the second quarter surged by more than 75pc from 171,900t in the first quarter of the year.

Chinese demand for South Korean base oils got a further boost from persistently low supplies from Taiwan throughout most of the first three quarters of the year. Group II exports from Taiwan to China fell by more than 110,000t, or 36pc, in the first eight months of the year.

The slowdown reflected delayed shipments and run cuts earlier in the year. Supply then remained tight because of stockbuilding ahead of and during the shutdown of Formosa Petrochemical's Group II unit from the start of the third quarter for maintenance.

The slowdown in supplies from Taiwan helped to support domestic heavy-grade prices in China at firm levels during the first three quarters of the year, even after the slump in crude prices.

Closed arb deters supplies

Steady domestic prices in China contrasted with rising fob Asia cargo prices from the third quarter on. Prices held steady despite a seasonal pick-up in demand in September and increasingly tight availability of supplies throughout the rest of Asia-Pacific.

The trend narrowed the gap between domestic Chinese and fob Asia prices and made the arbitrage increasingly hard to work, especially for light grades. Regional producers responded by diverting more supplies to other markets instead at the start of the fourth quarter. Chinese base oil imports fell in response. The drop in shipments left supply increasingly tight for products like Group I bright stock and Group II heavy grades.

The Chinese market remains structurally short of those products. Fob Asia cargo prices for these supplies rose steadily from mid-year. More competitive bids from buyers in other markets like India, the Mideast Gulf and southeast Asia attracted a growing volume of supplies to these markets from the end of the third quarter.

Chinese importers and distributors responded by raising their own prices in the fourth quarter to redirect more supplies back to the Chinese market. The higher bids pushed prices by the end of the year to a steep premium to prices at the beginning of 2020. Even with these higher prices, importers struggled to secure supplies.

By Iain Pocock