China is moving gingerly towards liberalizing oil products market as the deadline for the sector's opening-up under WTO commitments approaches.

Beijing is now working on deregulating prices and eliminating entry barriers imposed on the domestic players.

But the deregulation is unlikely to shake the market overnight, which is still dominated by the duopoly of State-owned Sinopec and PetroChina. And a fully competitive market will only take shape in a gradual process, traders and analysts said.

The government is mulling over reforms to the current pricing mechanism for refined products such as gasoline and diesel to better reflect market conditions, sources said.

Different proposals are under study: regulating factory price and CIF (Cost Insurance and Freight) prices, but freeing wholesale and retail prices; regulating retail prices while liberalizing wholesale prices; and liberalizing retail and wholesale prices completely.

The government is also likely to introduce price hearings - a system that has been used in other monopolized industries like aviation and railway sectors to ensure fair prices - in two years, the sources said.

In the longer term, the government also plans to establish an oil futures market to accurately reflect domestic demand and supply; and oil prices.

The National Reform and Development Commission is now soliciting opinions from companies and experts over the price reform.

If finalized, it will be the third time that China has revised its pricing system in five years, gradually giving up government control over prices to market forces.

In 1998, the government started setting benchmark retail prices for diesel and gasoline monthly, based on the average rates of the previous month on the Singapore market.

The over-transparent pricing mechanism had resulted in massive speculation as dealers could easily calculate the prices and manipulate the market. It also led to frequent price fluctuations.

In 2001, the government scrapped the monthly pricing formula; it adjusted the benchmark prices only when the average price on the Singapore, Rotterdam and New York markets changes by "a certain margin" which is kept secret.

The government also takes into account the condition of the domestic market when adjusting the benchmark price.

Meanwhile, it gave Sinopec and PetroChina more freedom to decide retail prices by allowing them to fluctuate 8 per cent up or down from the government-set benchmark. The previous range was 5 per cent.

The problem, however, has now shifted from over-transparency to little transparency, said oil traders and companies.

"The government adjusts the prices only when it feels necessary for manoeuvering economic performance," said a manager from a major state-owned oil trader. "It does not reflect the market situation."

International oil prices fluctuated frequently from March to May, pushed up by the Iraq war and hit by SARS (severe acute respiratory syndrome) outbreak. But domestic prices stood still during the time.

A Sinopec official estimated that the domestic oil sector lost at least 20 billion yuan (US$2.4 billion) in revenue because domestic prices did not fully reflect the international price rises.

Analysts said the pricing reform is also inevitable to accommodate the market trend of opening up.

China is going to allow foreign companies to operate retail business from 2005, and wholesale business from 2007, according to its WTO commitment.

Meanwhile, China has allowed companies other than the four State-designated traders to import crude oil and refined oil products.

Imports of crude by qualified non-State firms are allowed to increase by 15 per cent a year for the next 10 years.

Their refined-oil imports will also be allowed to rise by 15 per cent annually until 2004 when the quota will be discussed again.

"With the opening-up of the market and more imports coming in, the government will lose control over prices," said Shan Hongqing, an expert with a consultant institution under Sinopec.

"Price deregulation is the inevitable trend," she added.

Market entry

Apart from pricing reforms, the government is studying the abolishment of current restrictions on private companies entering the oil-product sector before it is fully exposed to foreign giants in December 2006.

The move aims to give qualified private firms a level playing field, and provide a testing ground to prepare Sinopec and PetroChina to meet the impending foreign competition, experts said.

According to current regulations, only the Big Two are allowed to build new gasoline stations. They are also the only companies to run wholesale distribution business.

The government had imposed the restrictions so that the two companies could get a better grip on the market and sustain prices to underpin the revenues at their lumbering refineries, which are especially important to the national economy as they absorb millions of workers and contribute billions in tax revenues.

With government support, and their massive acquisition of private and local-government-owned filling stations, the Big Two have increased their share in the retail market to over 50 per cent from less than 40 per cent. They also control over 90 per cent of the wholesale market.

But there are signs that the government is trying to relax the restriction.

Last month, Shanghai-listed Hubei Tianfa Group, a refined-oil-products trader, announced that it had obtained a wholesale licence for its products.

It is the first wholesale licence granted by the government in four years after thousands of such licences were recalled and the business consolidated into PetroChina and Sinopec in 1999.

"It is a signal that the government will gradually loosen its control," said Shan. "More licences are expected in the near future."

But the participation of private firms will not particularly rock the sector, since PetroChina and Sinopec still control oil supply at the wholesale level; and most storage facilities, traders and experts said.

"The two giants have a strong say in the market," said an official with Sinochem, a major State-owned oil trader. "It is unlikely for the two giants to support others and shoot themselves in the foot."

As for the retail network, the Sinopec official said petrol stations are dependent on where storage facilities are located, and the "Big Two" have almost all the best places.

Another source with China National United Oil Corp, a State-owned oil trader, said: "The government would like to see competition in the market, but not too much competition. The development of Tianfa may be restricted to Central China, rather than expanding nationwide."

Lifting quotas

Traders said the market scenario is also unlikely to change overnight, even though China is going to drop the quota system for State trade of refined oil products starting from next year.

The quota system used to require oil users to apply for import quotas from the government and import the oil via the four State-designated traders, Sinochem, China United Oil, Unipec and Zhuhai Zhengrong.

To replace the quota system, the government is expected to introduce a system of registering importers and exporters, setting up strict qualifications which only a few players can meet, analysts said.

They said the government does not want to see the market spin out of the control, because a flood of imports would hurt the interests of the State-owned refineries.

"There will be no big change in the market next year," said the Sinochem official. "Dismantling the quota system will only facilitate the import procedure. But not everyone will be allowed to import."

Although non-State trade quotas are allocated to companies other than the Big Four, the quota volume is too small to have a significant impact on the market.

The non-State trade quota was 4.6 million tons in 2001, with the volume rising by 15 per cent annually.

Even though private firms are allowed to import, they cannot handle imports without storage depots along the coastline, where Sinopec and PetroChina control most of the tanks and storage facilities.

"The best route is always the only choice. How can you compete when the best routes are mine?" asked the Sinopec official.

Shan said a truly competitive market would only take shape after 2007 when the market is completely opened up.

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