THE prospects for the reform of fuel pricing in China continue to improve as the government steels its resolve to introduce a market-oriented mechanism that's more transparent and predictable for refining margins at state giants such as Sinopec Corp.

Under the current pricing system, which has been in place since late 2008, the government can adjust fuel prices when the moving average of a basket of international crudes changes more than 4 percent over 22 working days.

However, the National Development and Reform Commission, which sets energy prices in China, also takes into account other factors, such as inflation, which have delayed overdue price adjustments in the past.

As a result, mounting losses in the refining sector and the shutdown of independent refineries across China have led to diesel shortages, analysts said, as the price of refined products falls further behind processing costs.

"With pricing-induced diesel shortages across China, the current mechanism is clearly doing more harm than good," Neil Beveridge, Hong Kong-based senior analyst at Sanford C Bernstein, said in a recent note.

China will increase the frequency of price adjustments as part of efforts to revamp the current pricing system, the NDRC said early last month, when announcing a cut in retail fuel prices.

Though the commission didn't elaborate on its plans or suggest any timetable, analysts and industry sources said they believe the pricing formula could be reduced to 10 working days or two weeks from 22 days now.

Beveridge said it "looks increasingly probable" that a new round of reforms will be announced before the Lunar New Year holiday, which starts on January 23.

The changes could also involve plans to give Sinopec and PetroChina Co, the nation's two dominant state refiners, the freedom to adjust prices up to the maximum level allowed under a government-set pricing formula, according to the China Securities Journal and industry sources.

That suggests less political interference in the pricing system.

But some analysts said they don't expect that to happen immediately.

"If PetroChina and Sinopec get that pricing power now, the monopoly in the market could only get worse," said Li Yadan, an analyst at JYD, a leading Chinese petrochemical electronic trading platform and commodity information service.

Even state refiners are regarding the issue of pricing power as a hot potato.

Speaking to reporters on the sidelines of a shareholders' meeting last month, PetroChina President Zhou Jiping said now is not the appropriate time to let individual energy companies set fuel prices, given the country's high inflation.

"It's still better to let the government control the prices," he added.

Zhou's remarks suggested that oil companies don't want to be the butt of public outrage if prices rise. Better to leave decisions with unpopular repercussions to the government and just complain loudly about refining losses, industry observers said.

Refining loss

PetroChina's refining loss could be more than 50 billion yuan (US$7.85 billion) this year if fuel prices remain at current levels, Zhou said then.

"While the decision on who gets to adjust fuel prices (companies or the NDRC) is still under debate, we believe the new mechanism should provide far greater transparency on future refining margins," Beveridge said, adding that such a change could trigger a re-rating for Sinopec, the largest refiner in Asia.

"Although refining margins are currently close to zero, we expect to see margins improve to US$5 per barrel, post-reform," he said.

Sinopec was incurring losses of over US$20 a barrel when oil prices reached over US$100 barrel prior to the last round of reforms in late 2008. After that, Sinopec's refining margins stabilized in a narrow range of US$9.50-US$4.40 a barrel, while oil prices seesawed between US$45 and US$85 in the period of early 2009 to the end of 2010, according to Beveridge.

Oil prices have increased sharply this year, rising from around US$90 to well over US$100 in the second and third quarters. As a result, Sinopec's refining margins have dropped from US$3.70 in the first quarter to minus 60 US cents in the second quarter. "We expect any further reforms will need to raise prices to lift refining margins to between US$4 and US$5 a barrel when world crude prices are US$100 to US$120," Beveridge said.

He noted that Sinopec needs a minimum refining margin of US$4 to break even at the operating level in the refining segment, given depreciation costs and operating expenses.

Another key point in the proposed revamped mechanism would be the addition of more benchmark crudes as the basis for China's fuel prices. Today, China sets retail fuel prices by tracking a basket of three crudes - Dubai, Brent and Cinta.

Analysts, including Li Heng at TX Investment Consulting Co, said it will be necessary and feasible to add West Texas Intermediate, the United States benchmark, to the basket because there is such a spread between WTI and Brent, the European benchmark for North Sea oil.

The premium of Brent to WTI reached a record US$27.88 a barrel on October 14, though the spread narrowed to around US$10 more recently.

"In the absence of WTI, (Chinese) consumers will be forced to accept higher prices," TX's Li said.

Less representative

But others see WTI as a less representative benchmark because it's not deliverable against the Brent contract.

"In recent years, WTI has been increasingly less referenced because it reflects domestic supply and demand fundamentals only in the US," said David Hanna, senior director for Asia editorial business development at energy-pricing service Platts.

In August, the NDRC introduced a freer pricing scheme for jet kerosene, under which domestic jet fuel prices would be adjusted monthly, based on the average landed price of Singapore jet kerosene, adjusted for insurance costs, port fees and exchange rates.

Analysts saw the change as a small but symbolic move.

"We are encouraged by evidence that the government has a genuine interest in moving toward free-market pricing," UBS analysts wrote in a July report. "If oil prices remain subdued, we believe that could set the tone for additional reform measures."

JYD's Li said the reform in kerosene pricing has been a "big success" so far, but that doesn't necessarily mean reform in gasoline and diesel pricing will be exactly the same.

Kerosene accounts for only about 5 to 6 percent of refinery production in China.