In the Pipeline: Risks of expanding capacity

The outlook for the global refining industry does not look good but this is not the first time in history that it has been so. The profits in the refining business have always been squeezed by the high profits in the upstream (exploration and production) business and marketing.

A few years ago, analysts attributed the rise in oil prices to the less-than-adequate refining industry in terms of capacity and quality that prompted the initiation of many expansion projects worldwide.

But demand has collapsed since the second half of 2008 and although the recovery is on its way, nobody expects the level of demand in the long run to return to the previous high forecasts.

Oil demand in 2030 was often forecast at 120 million barrels a day (bpd) but current forecasts of 106 million may be optimistic.

Therefore, the refining industry suddenly finds itself with surplus capacity such that eminent closures are unavoidable.

JBC Energy estimates that 3.4 million bpd of European capacity must close and Tim Wright in an editorial in the November issue of Hydrocarbon Processing Magazine says that "the US consulting group Ensys said that 10 million bpd of cuts would be required to bring global utilisation rates up to 85 per cent by 2020".

Other consultants predict even higher closures and Opec says a reduction of 9 million bpd is needed to bring utilisation rates to 85 per cent, the rates where refiners could be comfortable with their margins.

Fluctuating margins

The Global Indicator Margin), a sort of average refining profitability margin, as calculated by BP, increased from $2.20 per barrel in 2002 to the lucrative $9.90 in 2007 but then fell drastically to $1.49 in the fourth quarter of 2009.

There has been some recovery in 2010 due to increased demand but the margin is so far not as half as it was in 2007. Of course some regions are better than others — depending on the scale of complexity in the refining configuration and utilisation rates but the margin in Singapore is reported to be "barely positive".

In order to keep utilisation rates high, about one million bpd of refining capacity were closed in 2009 and more is to come. Total is planning to reduce refining capacity by 500,000 by 2011 and many European refineries are being offered for sale while buyers are reluctant. Japan is no exception and 1 million bpd is expected to be closed.

Coupled with all this is the rising cost of refinery construction due to the promised global economic recovery and the renewed pressure on construction materials and engineering and manufacturing costs.

The dilemma of lower margins, refinery closures in OECD countries and rising construction costs can be explained by the continuing downstream projects in China, India and the Middle East to satisfy higher refined products' demand locally and government policies of supporting the industry — despite the weak margins.

These regions also expect further refinery closures in industrial countries due to environmental policies and carbon dioxide emission limitations on refineries such that there is a need to "offset by new capacity that continues to come online in the developing world," Cambridge Energy Research Associates (CERA) said. In the long term refining capacity will also be affected by rising non-crude oil streams such as natural gas liquids, gas-to-liquids volumes and bio-fuels such as ethanol and bio-diesel. The expected increase in these volumes will undoubtedly affect crude oil refining capacity.

Increased distillation

Opec estimates based on current observations that by 2015 crude distillation capacity is likely to increase by 7.3 million bpd and the Middle East contribution may be 1.6 million bpd.

This in my view is conservative and does not take account of current plans in Kuwait and Iraq, to say the least. Without closures, worldwide capacity utilisation rates could be as low as 75 per cent, says Opec, but the closure is evidently coming to bring back utilisation and margins to reasonably acceptable levels.

Cyclic behaviour is no stranger to the refining industry and closures have been a feature of past decades especially in the 1970s and 1980s.

It is a way of renewal in the industry where old and non-competitive plants and technology are replaced by new and more efficient processes and as long as Middle East refineries gradually and prudently pursue capacity expansion, the risk can be turned to opportunity.

The writer is former head of Energy Studies Department at Opec Secretariat in Vienna.