Capacity surge shrinks refining margins

India’s status as a refining hub is being increasingly challenged by excess international capacity; therefore sourcing strategies need to be extremely agile to opportunistic crude oil to ensure GRMs are not hit. Sandeep Menezes looks at the international challenges facing private Indian refiners and therefore hurting their GRMs at the same time making their economic viability or may be even survival of export business suspect.

Many of India’s private petroleum companies which witnessed windfall gains in Gross Refining Margins (GRMs) over last few quarters must have realized that the time of high GRMs has passed. This drop in GRMs has been largely due to huge refining capacity expansion witnessed across Middle-East, China and other nations. GRMs are the earnings from processing every barrel of crude oil.

The authorities in various nations continue to expand their current refining capacity, which is already operating at very low or no returns, just in order to maintain employment and lessen their dependence on imported fuels. As a result, a lot more refining capacity has been lately added worldwide than what has been retired. This has put a downward pressure on the profitability of refining industry at a time when soaring crude oil prices and environmental costs are already weighing on GRMs.

GRMs Under Stress:

With the slowing down of the major economies like China and India, also economic growth across the EU and US have remained near stagnant in recent months. This has led to a scenario wherein the demand for petroleum products has remained lower than the refining capacity expansion witnessed worldwide especially across Asia-Pacific region.

Despite industry’s current excess supply, oil companies continue to add capacity, primarily in developing countries. In oil-rich countries, oil companies want to promote the socioeconomic development of their homeland. Building refining capacity adds value (and margin) to the crude oil produced in those countries. This is also emerging as a major hurdle to private petroleum companies since their crude suppliers are themselves building their own refining capacities.

True, the world is seeing a major increase in refinery capacity addition, especially in China, Saudi Arabia, Kuwait, UAE, South America and in Russia. At the same time, increase in global refining capacity is shutting down inefficient units that are high on the cost curve. The trend in the refining industry is to be closer to the end customers explained Samik Mukherjee – MD & Country Head, Technip India.

Ashu Sagar, Secretary General, Association of Oil & Gas Operators (AOGO) stated that “margins in any free market are demand – supply issue, and private refinery designs are robust enough to compete. New capacities coming on-line or going off-line are part of the game. We should also remember that the energy demand worldwide is growing, so the size of pie is also getting larger.”

Domestic Refining Capacity:

The refining industry is an important part of India’s economy, and the private sector owns about 38 per cent of total capacity. At the end of 2013, India had 4.35 million bpd (or around 218 million tpa) of refining capacity, making it the second-largest refiner in Asia after China. The two largest refineries by crude capacity, located in the Jamnagar complex in Gujarat, are world-class export facilities and are owned by Reliance Industries. The Jamnagar refineries account for 29 per cent of India’s current capacity. These refineries are close to crude oil-producing regions in the Middle East, which allows them to take advantage of lower transportation costs.
The Strategic Plan 2011-17 of Ministry of Petroleum & Natural Gas targets augmentation of refining capacity to about 260 million tpa by 2017, both to meet the growing domestic demand as well as maintain the high level of exports of petroleum products.

Demand Scenario:

Petroleum demand across the developed world declined with the sluggish economies, it continues to remain weak as more hybrids and electric vehicles enter the market and bio-fuels become more competitive. Under these circumstances, the developing world is slowly becoming the center of gravity for the refining industry. Petroleum prices, which were long reliant on demand in developed nations, now fluctuate with the developing world’s rising thirst for crude oil and fuels. However, demand growth from the developing nations, especially India and China has reduced over the last few years due to slowing economic growth in these nations.

The public sector refiners largely cater to the domestic market hence they would not be impacted by the changing global scenario. The private companies like Reliance and Essar don’t find it economical to sell within India. The only reason these private companies export is that there is pricing gap between Indian and international prices. If there is no gap in prices, they can supply domestically instead of focusing on exports.

Refining Capacities in Neighborhood:

According to a recent OPEC report, starting in March 2013, the Asian market came under pressure due to increasing supplies within the region, mainly from India, South Korea and China, and heavy losses were recorded across all parts of the barrel. These developments caused refinery margins in Singapore to show a sharp loss of more than $2 in 2Q13, with the downward trend continuing on the back of weaker fundamentals, as demand remained lacklustre amid a rise in supply. Meanwhile, the middle of the barrel was relatively healthy and stable in a balanced market, though the sharp loss at the top and bottom of the barrel caused refinery margins in Singapore to continue weakening, falling to 77¢ in 4Q13, thus averaging around $2.3/b for 2013, a loss of $1 versus the previous year.

Supply side pressure came not only from new capacity coming online in Asian countries, but also due to increasing inflows into the region. In Asia, Chinese and Indian refinery runs continued rising to average around 90 per cent during 2013. In Singapore and Japan, refinery runs increased 300 basis points (100 basis points = 1 percentage point) during 2013 to reach an average throughput of 94 per cent and 79 per cent of capacity in 2013, respectively, the OPEC report showed.

Looking Ahead:

As per Independent Statistics & Analysis of US Energy Information Administration, India projects an increase of the its refining capacity to 6.3 million bpd by 2017 based on its current five-year plan to meet rising domestic demand and export markets, although this projection hinges on all proposed projects becoming operational. Some refinery projects have faced delays in the past few years, and there is now greater competition within Asia from countries such as China that have built large refineries able to process more complex crude oil types.

Ashu Sagar felt that since the additional capacities are with major suppliers and consumers, the areas to watch would be the transfer prices used in these economies, and that can be fairly opaque. The tilts so introduced in the playing field, in turn can have more significant effects.

Samik Mukherjee stated that although the situation may appear difficult for Indian private refiners, there are a few factors that Indian private refiners are using to keep their margins intact:

-Reducing cost of oil import by having long term contracts; sourcing opportunistic crudes.
-Cost competitiveness in plant operation, energy, maintenance etc.
-Integrating Petrochemical units with existing and new refineries.
-Targeting markets for exports where inefficient units have shutdown.

The above steps will ensure that private sector refineries in India are well equipped to face the upcoming increase in global refining capacity.

Conclusion:

As the refining industry tries to cope with oversupply, shifting cyclicality and low average margins, operational excellence and a continuous improvement mindset and capability will separate the leaders from the rest of the pack. Companies that successfully lower costs and energetically pursue continuous improvement can benefit with significantly higher returns on capital employed. But over the long term, it will be a tough challenge to compete with crude producing nations who are building their own refining capacities since they will enjoy costs benefits vis-à-vis private Indian refiners.

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