Reform of China jet fuel pricing may not ease airline costs

They said reforms to break up the state monopoly are on the drawing board but they may not add a significant amount of competition to the system.

It is still unclear how many new players will actually enter the market, and many observers doubt that foreign firms will be among them anytime soon - even though the oil sector wholesale market is supposed to be opened up by the end of 2006.

Moreover, a truly open market would push prices up faster, burdening carriers with even higher fuel costs, analysts said.

Currently, the state-run China Aviation Oil Holding Co (CAOHC) holds a near-monopoly on China's jet fuel market and prices are set by the government planning agency, the National Development and Reform Commission, based on international crude prices.

But there is a time lag in reacting to international price movements, and in this current market of quick increases in the price of crude oil, refiners have been losing money. It has also meant that supply often falls short of demand as refiners hold back oil products from the market.

Since CAO's Singapore unit became embroiled in an embarrassing derivatives trading scandal last year, the aviation regulator -- the General Administration of Civil Aviation of China -- has repeatedly said it is in the process of reforming its jet fuel marketing system.

But airlines contend that the government is moving too slowly.

Even though domestic jet fuel prices are currently lower than international levels, China's carriers are struggling to post profits and are blaming the government and the slow pace of reform for their poor performance.

China Southern posted a net loss of over 800 mln yuan in the first half and China Eastern, though it said it expects to be profitable this year, reported a net loss of 471 mln yuan for the first half.

This weekend China Eastern's president called for reform of the system, saying that it was essential to cutting fuel costs.

China Southern also told XFN-Asia that the airline also hoped the state monopoly would be dismantled soon.
"We certainly hope that the jet fuel monopoly is broken and the business becomes a competitive one," said Su Liang, spokesman for China Southern.

"For each airport, there should be at least three independent jet fuel dealers," he said.

But analysts said the monopoly is not the problem. They added it is the pricing system which disrupts the market whenever there is a large hike on international markets.

They also said the airlines themselves were partly to blame for their energy costs, which account for 40 pct of total costs.

"The companies did not hedge jet fuel exposure. They have no protection measures," said Elisa Liu, aviation analyst with Fitch Ratings.

As a result, Chinese carriers are more sensitive to changes in prices and the end of the state monopoly will not change the situation.

Analysts said only CAOHC has the infrastructure to supply jet fuel to airports. The end of the monopoly will mean huge investments from other oil companies to build up infrastructure.

"If you duplicate hard assets, this will not lower the price of fuel," said Chris Sanders, aviation analyst for DBS Vickers in Singapore.

"Airlines are blaming CAOHC for the high cost of energy but they are pointing their finger at the wrong person," he said.

Fitch's Liu also said letting new players into the market will not lower the cost of fuel.

"It will just give carriers more flexibility on how and where they get their supplies," she said.

Sanders of DBS Vickers said that the key is for the government to move closer to market prices.

"They will eventually link kerosene prices to crude oil. They can't subsidize the system forever. Jet fuel is being kept artificially low and that is causing shortages," he said.

While historically jet fuel prices tend to be around 30 pct higher in China than on the international market, recently they have been lower as the National Development and Reform Commission has proved reluctant to pass on the increases.

"That will put pressure on the price of tickets, which are capped," Sanders said. "It is best to let the market decide prices."

A draft reform is in the works that will allow jet fuel prices to be determined according to aircraft movements and jet fuel consumption at each airport.

"There is mounting pressure to reform the system," Sanders said.

But the final form of the industry restructuring is unclear.

"I don't see foreign players entering the market anytime soon," Liu from Fitch said.

"As a first phase of reform CAOHC will be restructured and will include PetroChina and Sinopec as shareholders," she said.

CAOHC said previously it will take 51 pct of a new joint venture to be set up. It said state-run oil company China National Petroleum Corp (CNPC) will own 21 pct and fellow state-run firm China Petroleum and Chemical Corp (Sinopec) will hold the remaining 29 pct.

The joint venture is being created to fend off competition when the government opens up the wholesale segment from the end of next year.

But even though China is supposed to open the wholesale sector to foreign competitors as part of World Trade Organization requirements, many analysts anticipate new restrictions that will not make it possible for swift entry into the jet fuel segment.

"China has been reforming the sector for some time now but with little success so far," said Su from China Southern Airlines.

"The reform is very complicated because it involves many aspects of the economy," he added.