The unprecedented drop in international oil prices has sent shockwaves through the energy industry, with many wondering why giant Chinese oil companies like China National Petroleum Corporation (CNPC) and China Petroleum & Chemical Corporation (Sinopec) report dire financial straits amid these circumstancesAfter all, the sharp decline in oil prices would typically suggest a decrease in operational costs and an opportunity for higher profits—so why are these massive entities facing crippling losses instead?

The first quarter of this year has seen CNPC racking up losses of approximately 16.2 billion yuan, while Sinopec reported even greater losses of about 19.78 billion yuanThese figures reflect the worst quarterly losses since these companies went public, raising eyebrows and prompting detailed scrutiny into the underlying factors of this financial disasterUnderstanding this predicament requires venturing into three principal causes: high inventory costs, sluggish sales, and the challenge of maintaining domestic oil production in China.

Let’s begin with the first key factor: high inventory costs

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Both CNPC and Sinopec operate across the entire oil supply chain—they extract, refine, and sell oilThe cycle from the procurement of crude oil to refining and eventual sale can take anywhere from two to three monthsTo maintain a consistent business flow, these companies are compelled to keep substantial amounts of crude oil in stock, meaning that the fuel being sold in February and March was often derived from oil purchased at prices soaring above $60 per barrel during 2019.

As the world faced a dramatic escalation in COVID-19 cases coinciding with an oil price war led by Saudi Arabia, international prices plunged dramaticallyThe prices cascaded from being above 60 dollars to below 50 dollars, and even slipped below 20 dollars in very short orderThis stark discrepancy meant that while refined products were selling at these much lower prices, the underlying crude oil had been acquired at the considerably higher pre-crash rates

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The result was catastrophic losses for CNPC and Sinopec.

Although there is a 40-dollar floor price that offers some protection, it must be noted that the financial benefits from this price discrepancy do not get funneled into the coffers of these companies—the profits are instead directed to the state treasuryThus, this regulatory environment adds to the financial strain borne by China’s two leading oil firms.

The second factor contributing to these losses is the sluggish sales environmentDuring the first quarter of this year, refined oil sales in China plummeted by more than 20%, with CNPC reporting a staggering 14.4% decline in revenue compared to the previous yearMeanwhile, Sinopec's revenue dropped even more sharply by about 22.6%. These figures paint a clear picture: demand is sluggish and even dwindling, severely impacting the operating margins of the nation’s energy suppliers.

The persistent decline in sales also complicates the companies' efforts to offload existing stock, prolonging the time required to achieve the much-needed reduction in inventory levels

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This situation compounds the challenges posed by their high inventory costs because they are still reliant on the procurement of crude oil, which has been consistently falling in priceThe gap between the rates at which oil was purchased and the current market prices grows wider the longer the sales slump lasts, escalating their overall financial losses.

However, there is cautious optimism on the horizon as the domestic response to the pandemic has shown signs of stabilizationAs of now, diesel sales have reportedly normalized to figures similar to those from a year ago, and gasoline sales have climbed to approximately 90% of last year’s levelsChemical product sales have also made strides, reaching 86% of last year's figuresThis recovery in demand signals that companies may be able to gradually chew away at their high-priced inventory.

The third key reason for the financial woes of CNPC and Sinopec lies in the mechanics of maintaining domestic oil production levels amidst these price challenges

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Despite China’s position as one of the top oil-producing nations, with output that ranks among the world’s largest, the production costs for Chinese oil field developments hover between 50 to 60 dollars per barrelTherefore, in a pre-pandemic era when international oil prices exceeded 60 dollars, Chinese oil production could maintain profitability.

Now that international prices have sunk below 20 dollars, the cost structure means Chinese producers face significant financial lossesNonetheless, it remains critically important for the country to preserve its domestic extraction capabilitiesIf these oil extraction operations were to collapse, China’s dependence on foreign oil would only increase, raising significant concerns around energy security and self-sufficiency in the long term.

This scenario serves to illustrate the broader economic wisdom behind maintaining a viable domestic oil industry; as observed with the implosion of many American shale oil producers during this downturn, the survival of this sector is essential