By Chen Aizhu

SINGAPORE, (Reuters) - Up to 10% of China's oil refining capacity faces closure in the next ten years as an earlier-than-expected peak in Chinese fuel demand crushes margins and Beijing's drive to wring out inefficiency begins to squeeze older and smaller plants.

Tighter U.S. sanctions enforcement under the incoming Trump administration could send more plants into the red and accelerate shutdowns by halting access to cheap crude from the likes of Iran, industry players and analysts say.

The world's second-largest refining industry has long been plagued by excess capacity after expanding to capitalise on three decades of rapid demand growth.

Authorities, including officials in the independent refinery hub of Shandong province, have lacked political will to shut inefficient plants that employ tens of thousands of workers, analysts said.

However, rapid electrification of China's vehicles and flagging economic growth are making the weakest operators unviable, forcing a moment of reckoning.

The shakeout is likely to cap crude imports into China, the world's largest buyer, accounting for 11% of global demand. Chinese crude imports declined 1.9% in 2024, the only drop in the last two decades outside the COVID years, with weaker demand weighing on global oil prices.

Refinery output last year recorded a rare fall as well.

Poor operating rates are the clearest sign of the industry's pain. Consultancy Wood Mackenzie estimates Chinese refineries ran at only 75.5% of their capacity in 2024, the second-lowest utilisation rate since 2019 and significantly below U.S. refiners' rate of above 90%.

Worst off are independent fuel producers known as teapots, mostly located in east China's Shandong, which make up a quarter of the industry. They operated at just 54% of capacity last year, according to a Chinese consultancy, the lowest since 2017 outside the COVID years.

Weaker players were effectively put on notice by Beijing in 2023 when it vowed to weed out the smallest plants under a national refining capacity cap of 20 million barrels per day by 2025, only slightly above 19 million bpd currently.

The smaller plants have become dispensable following the start-up of four large privately-controlled refiners since 2019 which together make up 10% of China's refining capacity, industry players said.

Adding to their challenges, Beijing began chasing independent refiners in 2021 for unpaid tax.

Smaller operators, especially those that do not qualify for Beijing's crude oil quotas and survive instead on processing imported fuel oil, face a further crunch as new tariff and tax policies are set to drive up their costs in 2025, industry executives said.

Those plants account for combined processing capacity exceeding 400,000 bpd, two of the executives added.

Several senior managers at independent refineries and an analyst estimated that between 15 and 20 independent plants, accounting for roughly half of the 4.2 million to 5 million bpd of teapot capacity, could withstand the stress for a decade or more.

"Those of scale and integrated with chemicals production, having land space for expansion and infrastructure like pipelines and terminals in place, could sustain in the longer term," said Wang Zhao, a senior researcher at Sublime China Information, referring to teapots in Shandong.

Wood Mackenzie predicts closures of 1.1 million bpd in capacity between 2023 and 2028, or 5.5% of the stated national cap, and a further 1.2 million bpd by 2050.

CRITICAL 2025

Already, three Shandong-based refineries under state-run Sinochem Group faced bankruptcy last year due to hefty unpaid taxes and were shut indefinitely.

Even if Sinochem managed to reopen them, the plants would operate at a cost disadvantage as Sinochem shuns discounted oil from Iran, Venezuela or Russia due to sanctions concerns, according to Mia Geng, energy consultant FGE's China analyst.

To cope with deteriorating margins, many teapots have shifted almost completely to discounted oil, especially from Iran, Reuters has reported.

However, the prospect that the U.S. under incoming President Donald Trump could harden sanctions enforcement on Iranian oil, which accounts for over 10% of Chinese imports, could further raise costs for teapots.

A sudden ban on U.S.-sanctioned tankers by China's Shandong Port group is already rocking the shipping market and lifting oil prices.

Plants in Shandong face a particularly tough year in 2025 as the $20 billion Yulong Petrochemical plant there is due to start up its second 200,000-bpd crude unit in coming months, worsening the fuel surplus, said Shandong-based traders.

GOVERNMENT HAND

Local governments have already forced some industry streamlining.

To make way for the Yulong plant, a cornerstone project for Shandong, provincial authorities by late 2022 closed 10 small plants totalling about 540,000 bpd.

In addition, in a nationwide probe in 2021/2022, Beijing stripped five refineries of their import quotas, which contributed to the first annual decline in China's crude oil imports in two decades in 2022.

Meanwhile, state-owned refiners are shifting to higher-end chemicals investment. PetroChina is set to shut a 410,000-bpd refinery in Dalian this year and replace it with a smaller new plant focusing on petrochemicals.

Similarly, refining giant Sinopec Corp will eventually be compelled to close older fuel-centric plants in eastern provinces where electric vehicle penetration is higher, said FGE's Geng and a Sinopec trader who declined to be named.

Sinopec had no immediate comment when asked about the prospect of closures.

A senior crude oil procurement manager who has worked at a Shandong teapot for 16 years said he has been looking for a new job as his plant, one of those stripped of a crude oil quota, is running at 20% capacity and has been losing money for nearly 18 months.

"We're on the verge of closing down, after an extremely tough 2023 and 2024," said the person, declining to be identified by name or where he works.

"But it is not easy to find a job in the same industry."