Mohammed Saleh, Shaikh Ali
Bahrain National Oil Co.
Awali, Bahrain
Oil industry interest in refining has revived in the past few years in response to rising oil consumption.
The trend creates opportunities for countries in the Middle East, which do not own refining assets nearly in proportion to their crude oil reserves. By closing this gap between reserves and refining capacity, the countries can ease some of the instability now characteristic of the oil market.
Some major oil producing countries have begun to move downstream. During the 1980s, Venezuela, Kuwait, Saudi Arabia, Libya, and other members of the Organization of Petroleum Exporting Countries acquired refining assets through direct total purchase or joint ventures. Fig. 1 shows major movements into refining by producing countries.
Nevertheless, the oil industry remains largely unintegrated, with the Middle East , holding two thirds of worldwide oil reserves but only a small share downstream (Fig. 2).
As worldwide refining capacity swings from a period of surplus toward one in which the need for new capacity is increasingly apparent, the crucial question is where the new capacity will be built.
BACKGROUND
The refining capacity surplus coincided with, and was related to, the end of the old system of integration, in which international oil companies owned both crude oil reserves and the refining assets necessary to convert crude into useful products.
The system enabled vertically integrated oil companies to exercise effective control over the free-world oil business. Producers were linked to final consumers through a chain from the wellhead to refining, transportation, and marketing and could be very sensitive to changes in downstream requirements. They could distribute revenue where it was needed, allocate capital as necessary, and plan expansions to meet demand growth well in advance of the need.
The system was predictable and stable. It served the industry very well. But it did not always serve the interests of producing countries.
By the 1970s, producing-country governments, having decided to redress the imbalance in the industry's distribution of economic rent, began to take control over crude oil reserves, production, and pricing. They initially did not become involved in refining and marketing because most of the assets were in consuming centers, and they lacked expertise in these areas.
Thus the pricing of oil, to a large extent, was separated from market forces. It became a political exercise governed by national aspirations, including the redress of injustices in distribution of economic rent, demands of developing economies, and improvements in living conditions of the countries' people.
One result of this partial breakup of the vertically integrated system was market instability. Producing nations and oil companies are still learning to adapt to this structural change.
MOVING DOWNSTREAM
As producers became comfortable with their upstream acquisitions and built domestic refineries, they began to recognize the need to move downstream internationally. One reason is that there was added value in refining and marketing. Another is that there was no effective control over pricing and market share without access to downstream assets.
Several factors helped the movement of producing nations downstream:
- The political pricing of crude was clearly unworkable and led to turmoil in the market. Either prices were out of line with market realities, or disagreements arose among producers.
- This led to major losses from refining operations, which were still in the hands of major oil companies, and the gradual disappearance of long-term contracts, which had been a source of stability and confidence.
Oil companies, now short of crude but long on refining capacity, looked for security of supply but could not enter long term contracts with producing countries because of price disparity and unpredictability. Focus on the short term and volatility replaced the long term view and stability. Refining assets, to some extent, had become a liability for the majors.
- The loss of many producing assets and a general downturn in the economies of industrialized countries weakened the financial positions of most major companies. The companies used cash to seek reserves to replace the ones they had lost, which further weakened their positions, and had no intention of investing in loss-making downstream assets.
- Producing countries, cash-rich as a result of crude price increases, eventually began to complete their takeover of the industry by moving downstream.
THE SURPLUS SHRINKS
The long and painful restructuring of the industry eliminated a large chunk of surplus and unprofitable refining capacity.
The surplus peaked in 1981 at over 23 million b/d, or almost 40% of consumption (Fig. 3). Today, it is about 11 million b/d, about 15% of consumption.
Much of the present surplus is either necessary for normal operations, approaching obsolescence, or located in regions such as Russia where it is of little use to distant markets. Utilization of crude oil distillation capacity has been running over 90% in the U.S., 85 % in Europe, and 100% in Singapore. Use of conversion units is even greater.
Strong economic growth in Asia during the last few years has stimulated oil consumption in the region. Relaxation of state controls in China and movement toward privatization in India will add to the growth.
The Asia-Pacific region has added 3.5 million b/d of oil consumption in the last 5 years, and most forecasters expect at least another 3.5 million b/d to be added by 2000.
The region consumed about 15.7 million b/d of oil in 1993-more than twice its crude oil production. Net oil product imports totaled about 500,000 b/d.
With little prospect for significant increases in Asia-Pacific crude oil production, the expected growth in consumption will require additional flows of crude or products into the region. Someone, either the producer or the consumer, will have to refine crude oil into products to satisfy this increased growth.
So who will build the required refining capacity? And where will it be built? Is it the major consuming countries near markets or where oil is produced?
Will crude oil be shipped to these refineries to be converted into products, or will finished products be shipped? Who will finance these projects?
Will consumption centers like Japan, the European Community, other Asia/Pacific countries, and the U.S. allow producers to move into their markets and build refineries there? Will it make economic sense to build refineries in countries with restrictive product specifications and costly environmental requirements?
These are some of the questions that need to be answered today.
INVESTMENT REQUIREMENTS
It is estimated that the oil industry will require $100-150 billion/year from the mid-1990s for investment in various sectors to keep up with demand.
The refining industry alone will require at least $200 billion (1990 $) in the first 2 decades of the next century to comply with new regulations and build the capacity necessary to meet demand.
World refinery investment is estimated at about $125 billion between 1993 and 2010.
The growth in oil consumption in the Asia-Pacific region over the last 5 years led to numerous proposals to expand facilities and build new refineries. Expansions have taken place, but most new refinery proposals have been delayed.
Generally, investments in grass-roots refineries require huge capital outlays, almost half of which are for infrastructure, which offers no return for the investor. It is estimated that new refining capacity costs $12,000/b/d, about twice the cost of new production capacity (Fig. 4).
Yet the proportion of the wholesale product price going to the producer is far greater than that going to the refiner. Traditionally, capital requirements for investment in refining had come from within the industry itself. But with low oil prices, the industry's cash-generating ability will be limited, and the industry will have to seek funding from outside.
Refining projects by nature are risky, characterized by long lead times, heavy investment, and low and volatile economic rates of return. As such, it will be difficult to attract external capital investment.
SOURCES OF CAPITAL
Who, then, can afford to build the necessary refining capacity?
Fig. 5 shows the distribution of economic rent. The small and volatile refining margin indicates that there is no place for the independent, commercial refiner.
For every barrel of oil sold, producers get $11-15, but the majority of what the consumer pays at the pump goes to governments in the industrialized consuming countries as taxes (in excess of $50/bbl).
It is obvious that only these governments and producers of oil can generate the cash necessary for reinvestment. If governments are excluded, then only holders of large crude oil reserves with an interest in selling crude-such as national oil companies (NOCs), producing countries, and major oil companies-can embark on such a strategic but risky investment. And they will do that for two main reasons: to add value, especially at low crude oil prices, and to control and maintain their market shares and out-lets for crude.
Currently, there is about 2.4 million b/d of crude distillation capacity under construction, almost 80% of which is in Asia and the Middle East (Fig. 6). Only about one-third represents grassroots refineries; the rest represents expansions.
While numerous projects are under consideration, the tendency is to avoid grassroots refineries because of the huge infrastructure costs associated with them. Projects under consideration total about 6 million b/d, with almost 80% in Asia and the Middle East. Over two thirds of these are in Asia, with China dominating the plans.
Many proposals will fall by the wayside as the economics of locating in consuming areas will be insufficient. Because of the huge capital outlay required to meet stringent product specifications and to comply with new environmental regulations, only producers seeking added value or outlets for their crude will have the incentive and wherewithal to invest in refining.
Where will refining capacity be built? Not any more in the U.S. and Europe, where environmental concerns and congestion have led to very restrictive air and water pollution laws that will cost the industry huge amounts of money over and above the base investment costs.
Several producing countries did move into refineries in consuming countries, but this approach is now more difficult, as Saudi Arabian Oil Co.'s experience with the Japanese demonstrated. Hurdles to building refineries in major industrialized and consuming countries include environmental constraints, congestion and land limitations, high labor costs, economic maturity, taxation and tariffs, local pricing, and high infrastructure development costs.
In the future, refining capacity will or should largely be built in the producing countries and mainly in the Middle East, where most of the reserves and production are.
As the economies in producing countries grow, the additional demand will require new refining capacity. It will be easy and comparatively less costly to build incremental capacity for exports or to build refineries dedicated primarily to exports nearer the crude oil sources.
These new refineries should be joint ventures between producing and consuming countries so that both will have an interest in security of supply and stability.
SHIPPING CONCERNS
The traditional view of oil delivery is crude oil being shipped in bulk carriers from producing countries to refineries in consuming countries (Fig. 8). The future delivery of oil will probably see refineries built near crude oil production centers and final products shipped to consumers increasingly in bulk parcels.
The only advantage consuming countries have is that the cost per barrel of delivering crude oil in a very large crude carrier (VLCC) is lower than the cost per barrel of delivering products in small tankers. The advantage is often lost if local refinery yields do not match consumption patterns because importing some products and exporting others add to costs.
Increasingly, the trend will be to ship products in larger tankers, which will reduce the cost per barrel of product shipped. Recently, for example, VLCCs have been used to ship diesel.
Like refining and production, marine transportation has been changed by break-up of the integrated oil system. In 1970, less than 10% of the tanker business was spot-related, while today the spot share is about 75% with over two thirds of tanker owners independent of upstream or downstream operations.
As Fig. 9 shows, tankers and VLCCs are reaching the ends of their technical lives and will have to be replaced. Legislation enacted as a result of oil shipping disasters such as the Exxon Valdez spill and others will require the existing fleet to be replaced by double-hull tankers at huge cost. All this will strain the supply of funds for investment in the oil industry and create competition for investment in refining. But this will also provide an opportunity to change the nature of shipping oil and perhaps move to very large product carriers, which would carry products in large quantities from export refineries in producing countries to various markets.
This has been proven feasible. Kuwait and some others have done it. The imminent and necessary modernization of the oil tanker fleet will provide a golden opportunity to seriously consider this option.
New refinery investments and tanker building by NOCs and producing countries will essentially reintegrate the oil industry. These kinds of investors can design refineries to match available crude, can raise capital more easily than others can, have lower energy costs than other refining centers, can control environmental mandates, and don't need to worry about corporate taxation.
Furthermore, they should be able to expect some help from abroad. Since a large part of the required future investment aims at compliance with environmental legislation by industrialized countries, and since governments of these countries get most of the revenue from sales to final consumers, industrial-country governments should contribute something.
Such contribution can be in the form of tax relief for the refining industry or oil companies, removal of tariffs on product imports from the Middle East, elimination of certain taxes, and avoidance of new taxes such as BTU and carbon taxes.
No one entity can take the responsibility for providing the elements of stability and predictability that the market requires. It is incumbent on consuming and producing governments, oil companies, and financial institutions to cooperate and jointly ensure the availability of this vital commodity to the world and to provide the means to deliver it to the final consumer in a safe and economic manner.
Copyright 1994 Oil & Gas Journal. All Rights Reserved.
