South Korea's Refining/petrochemical Capacity Expansion Push Continues To Gather Momentum

Yukong Ltd.'s refinery at Ulsan, South Korea, is one of the world's largest, with distillation capacity of 610,000 b/d following several expansions this decade. More such expansions are on tap as part of a building boom in South Korea's downstream sector. Photo courtesy of Yukong and Korea Petroleum Association.

• South Korea's Petrochemical Expansions

With this transformation has come a huge expansion in both the demand and capacity of its refined products and petrochemicals.

Moreover, despite the current slowdown in the economy, the appetite for growth in these two industries continues to be apparently insatiable.

"One of the most marked features of the Koreans is their desire to become truly world-scale players in both the oil and petrochemical fields-although whether they will succeed in their aims is another question entirely," argued George Goundry, oil and chemicals analyst at HG Asia, Seoul.

Nevertheless, South Korea is already the second biggest petrochemical exporter in Asia after Japan, and proposed refining capacity expansion will soon turn South Korea from a net importer into a significant exporter of light oil products.

However, many analysts question whether this trend is economically sustainable in the long term.

At the same time, both industries are facing rapid changes and an uncertain future as competition, both at home and abroad, intensifies and the government begins to deregulate the oil industry.

Refining sector

South Korea now has five refineries, with a combined crude distillation unit capacity of 2.438 million b/d, cracking capacity of 214,000 b/d, and a desulfurization capacity of 115,000 b/d as of October 1996 (Table 1).

The industry is dominated by Yukong and LG Caltex (formerly Honam Oil), whose combined market share is around 67%, based on domestic sales volume. However, both of these are slowly losing market share to the other three players in the sector: Ssangyong Oil, Hanwha Oil, and the latest entrant, Hyundai Oil, which took over the troubled Kukdong Oil Refining Co. in 1993 (Table 2).

As the chief source of energy in South Korea, oil accounts for more than 60% of total energy consumption, up from 44% in 1987. The increase in oil consumption has been the result of a changing preference for oil products versus coal and wood due to their ease in use amid decreasing fuel oil product prices (which have been deliberately pushed down by government policies in order to help boost industrialization) and rising disposable income.

The increase in consumption has been largely supported by rapid investment in new refining facilities, increased demand by industry, and a massive rise in car ownership-jumping from about 2.1 million cars in 1990 to more than 6 million and expected to increase to 11 million cars by 2000.

The rising level of car ownership has led to exceptional growth in South Korean gasoline demand, with demand growing at more than 20%/year since 1984-although this figure is expected to consolidate from now to 2000 at about 15%/year.

This growth in gasoline demand, combined with tougher environmental regulations, has led to a dramatic shift in consumption from heavy oil products to light oil products such as gasoline, kerosine, diesel, and naphtha.

Although refiners began emphasizing production of light oil products in response to this change, the dilemma that arose from such a rapid shift in demand was the inability of domestic refiners to satisfy the increased demand for light oils due to the lack of desulfurization and cracking capacities-in 1995, the ratio of cracking facilities in Japan and South Korea was 19% and 4%, respectively. Therefore, domestic refiners were forced to export lower value-added, heavy, high-sulfur products and import certain higher value-added, light, low-sulfur oils-primarily kerosine, naphtha, and gasoline reformate.

To reduce their huge oversupply of fuel oils and shortfall of products such as gasoline and diesel, the companies are now aggressively investing in cracking and desulfurization units, most of which are due to come on stream during 1996-99.

According to the Korean Petroleum Association (KPA), from October 1996 to 2000, cracking capacity will climb 73,000 b/d, or about 35%, and desulfurization capacity will rise by 80,000 b/d, or about 70%.

Surplus capacity concerns

Industry analysts don't see South Korea's refining capacity expansion as unwarranted per se, as long as the demand for higher value-added refined products both domestically and worldwide continues to grow and domestic profits generally increase apace with expansion growth.

However, the underlying concern, in the words of one analyst, "is whether the pace of projected growth is too accelerated versus estimated demand growth, and, if so, how Korean refiners will deal with their apparent oversupply."

"There is little doubt that in the short term, at least, the industry will be faced with an oversupply situation, particularly of kerosine and gasoline," admitted one senior industry source. "Nevertheless, I think that the general consensus within the industry is that this is not a serious problem-although the Korean economy has quite definitely slowed down this year-and that it will take time for demand to catch up with the expansion in supply; however, we believe that the long-term domestic demand prospects for light oil products are good.

"In the meantime, demand from Asian countries, particularly China, will more than make up for the looming imbalance in the supply/demand situation," the executive said.

Indeed, a recent regional supply/ demand analysis completed by the Institute of Energy Economics, Japan (IEEJ) seems to support this assertion. It projects that regional primary distillation capacity will grow by 3.1%/year to 2000, resulting in a capacity shortage of 700,000 b/d versus demand, with those shortages being particularly acute in India, China, and Indonesia.

Oil deregulation

Nevertheless, in the short-term at least, expanded refining capacity is bound to intensify competition at home. Compounding this competition is the forthcoming deregulation of the South Korean domestic oil industry.

The refining industry in Korea has traditionally been a highly regulated one, with regulations imposed on product pricing, imports/exports, market entry, distribution, and company profitability.

The results of such a government stance have been mismanagement of the companies, lackluster customer service, and a loss of international competitiveness.

However, during the last few years, the government has begun to loosen its grip on the industry, with the most notable changes being increased flexibility in establishing distribution outlets and a pricing policy change that pegs the maximum local price of oil products to Singapore prices.

Moreover, 1997 will see the introduction of a wide-ranging easing of ties between government and the industry, which should see a fully deregulated oil sector by the turn of the century.

Under the deregulation plan, beginning in January 1997, a domestic company or a joint venture with no greater than 50% foreign ownership will now be able to import petroleum products for resale by simply registering with the government, eliminating the former need to apply for such a license.

Starting in January 1999, any company will be able to enter any level of the oil business by simply registering with the government. Companies, domestic or foreign, planning to build refineries will be able to build new capacity as long as the new capacity does not cause aggregate South Korea-based capacity to exceed domestic demand by 20%.

Meanwhile, petroleum product prices were poised to be deregulated in January 1997, but that plan was abruptly postponed in October 1996. The reasons cited for the postponement were potential damage to domestic competition and profitability. However, this order was rescinded, and Jan. 1, 1997, did actually see pricing deregulation come into effect-but with a proviso: Companies were obliged for the first 6 months of 1997 to inform the government of any plans to hike or cut prices.

Market share battles

Analysts say that the government is clearly worried of an all-out price war developing among oil refiners as they battle for increased market share.

Certainly, if past is prologue, the government's fears of such a battle for market share erupting are well-grounded.

In 1994, Ssangyong Oil abruptly staged a gasoline price war in an attempt to gain market share that, in short, had such damaging effects that it forced the government to modify its oil pricing system. Then, later that year, Hyundai Oil, the newcomer to the industry, shattered the sector's newly regained stability by embarking on a different sort of strategy: luring away from the competition various distributors, which operate under the pole sign system (i.e., whereby distributors have to market products under a single refiner's trademark). Once again, the government stepped in.

Interestingly, both firms failed to gain any significant increase in market share through these manuevers.

Analysts say that although competition is nowhere near as severe, South Korea's oil industry is modeled closely enough on Japan's, where deregulation is having a devastating affect on both refiner/wholesalers and retailers, to seriously concern the government on the potential effects of a total loosening of the reins.

Indeed, one industry source admitted to Oil & Gas Journal "that even with deregulation, the central authorities will still have a number of legal tools with which they can intervene."

"Nevertheless," he added, "the industry has come to realize that such open warfare achieves little, and if it means those with a larger market share giving up some of it to keep the peace, so be it. Indeed, the industry is close (although not actually there) to reaching an informal agreement not to engage in such damaging tactics in the future."

In any case, say both analysts and industry sources, the sector is currently hardly in any state to embark on a second price war: "High crude prices, a looming tax hike in the retail price of petrol, and the huge investment companies have made in expanding their refining capacity mean that we are simply in no financial position to start slashing prices," said one source.

Indeed, a number of companies have indicated that they plan to raise prices. Analysts say that the only company in a position to cut prices is Ssangyong, although it is considered unlikely to do so, at least in the short term. One industry source estimates that prices will eventually rise by 10% or more (making the retail price of petrol probably the most expensive in the world), "but this will have to be implemented on a gradual basis, since the government will continue to monitor prices very carefully-deregulation or not, we have little illusion over the government intervening if it feels things are getting out of hand." Already the government has stepped in on more than one occasion this year to curb proposed price hikes.

Indeed, on Jan. 1, in a move spearheaded by Yukong and LG-Caltex, all the country's refiners-except for Ssangyong-hiked their gasoline prices. Moreover, according to one refiner, consumers could expect prices to rise in 1997 by at least 10%. Combined with a forthcoming 16% hike in gasoline taxes, this would make South Korea's retail gasoline prices among the highest in the world.

The seriousness with which the government views this situation can be perhaps gauged by the fact that it forced Yukong and LG-Caltex to throttle back their recent price increases from a proposed 16% to a little more than 6%. Clearly, this kind of behind-the-scenes pressure will allow the government to keep some form of unofficial control over pricing policy. Therefore, any price hikes implemented by refiners will have to be done so gradually.

In a similar incident, Ssangyong Oil recently tried to hike the retail price of gasoline at one provincial town to 966 won/l. This compared with an average retail price of 828 won/l in Seoul at the time, and once again the government intervened to block the attempt. Moreover, the incident also underlines analysts' beliefs that Ssangyong Oil is unlikely to embark on a price war-or that if it does, it will only be confined to areas where competition is severe.

Deregulation benefits

As a result, in the short term it looks as if South Korean consumers will see little benefit from deregulation, given that the country's refiners simply do not have the financial resources to implement greater pricing competition.

At the same time, the government will make sure that prices do not spiral to such heights as to make driving a car or heating a house an unaffordable luxury.

Nevertheless, what is clear is that price deregulation is already allowing prices to begin to fluctuate regionally, meaning that areas requiring high distribution costs will see higher product prices.

But clearly the point of any deregulation measure is to improve production efficiency to the benefit of the final consumer. So it is likely that once refiners have had a chance to cut their costs, recover their expansion expenses, and improve the efficiency of their operations, prices will begin to fall.

A real push towards lower prices would be a new entrant into the market, something generally deemed unlikely to occur before 1998. In the medium to long-term, however, if the market stabilizes, the possibility of such a scenario is likely, although as yet the huge amount of talk over possible entrants into the market remains pure speculation. And until this becomes a reality, the most likely scenario is that one or two companies will "guide" prices, while the others will simply follow suit.

Nevertheless, domestic refiners do worry about the threat of third parties-either local companies in 1998 or foreign oil majors a year later-entering the market.

"While this is generally viewed as unlikely, oil companies are, nevertheless, having to prepare themselves for such an eventuality," said Bill Hunsekar, oil analyst at ING-Barings in Seoul.

New efficiencies

All this is making oil companies realize that, in the new deregulated environment, market share and high prices are simply not enough: "We are beginning to see that we must become far more efficient."

As a result, companies are making tentative steps towards reducing their staff and back-office, distribution, and marketing costs, as well as cutting their significant debt burdens (although at present these efforts amount to a drop in the ocean).

"At the moment, we are still trying to work out the right balance between having sufficient market share and running an efficient, profitable business," one senior executive said.

Petrochemical deregulation

South Korea's petrochemical industry, meanwhile, began its own deregulation back in 1990.

The immediate effect of this program, which opened the sector up to new entrants such as Samsung General Chemical, Hyundai Petrochemical, and LG Petrochemical, was a massive boost in production capacity.

In terms of ethylene base, the industry's capacity more than doubled in just 3 years, from 1.6 million metric tons/year in 1990 to 3.5 million tons/ year in 1993.

The obvious result was a severe oversupply problem in 1992-93, leading to heavy losses. (Although the official accumulated losses for the country's eight main petrochemical producers in 1993 totaled 522.2 billion won, some estimates put the real figure at more than 1 trillion won.)

However, the rapid recovery of the industry at the end of 1994 and 1995, thanks in part to strong demand from China, has led to further expansion programs.

Petrochemical expansion

South Korean ethylene production capacity is expected to rise from 3.95 million tons in 1995 to 5.1 million tons in 2000, as Hyundai Petrochemical and Yukong expand their production through new naphtha crackers, and other companies invest in debottlenecking.

Ethylene plant capacity utilization, meanwhile, remains steady at high levels and should reach 101% in 2000-at which time, ethylene producers will once again have to consider further capacity expansion.

Behind the expansions is the assumption that domestic demand for ethylene will continue its prodigious growth path: 10 years ago, demand for ethylene derivatives stood at a mere 807,000 tons/year.

By 1995, this had soared to 2.7 million tons/year for an average growth of almost 13%/year-far higher than that of real GDP.

Per capita ethylene demand in South Korea had risen to 62.7 kg in 1995, about 36% higher than Japan's 46.1 kg per capita.

Moreover, according to UBS Securities, ethylene derivatives demand is expected to grow by 7.9%/year to reach 3.95 million tons by 2000.

As a result, most companies are embarking on aggressive capacity expansion programs.

Paraxylene ouput, for example, is expected to grow by about 75%, vinyl chloride monomer (VCM) by 91%, styrene monomer (SM) by 56.5%, and terephthalic acid (TPA) by 55%.

Output of polypropylene (PP), polystyrene (PS), acrylonitrile butadiene styrene (ABS), polyethylene (PE), polyvinyl chloride (PVC), and linear low-density polyethylene (Lldpe) also will grow, leading to a self-sufficiency ratio in synthetic resins of more than 200% in 1997.

This means that South Korean producers, already heavily dependent on the export market, will be forced to sell more than half the resins overseas.

Profits squeeze

But 1996 was not a good year for South Korean petrochemical companies, and aggregate profits were estimated to be down by about 45%.

The main culprits were high feedstock prices (especially naphtha and ethylene, which rose in 1996 by about 35% and 30%, respectively), combined with weaker volumes and prices of exports to the rest of Asia, particularly China and Hong Kong-which absorb 52% of South Korean exports of synthetic resins.

At the same time, 1996 saw a lot of shutdowns for maintenance, many of which were due in 1995 but were postponed due to the outstanding market conditions.

Moreover, the prospects for 1997 are only slightly better, with oversupply in PP, ABS, paraxylene, SM, PS, and synthetic rubbers.

Indeed, with regards to SM, the forecast is so poor that Samsung General Chemical and Hyundai Petrochemical are temporarily closing down plants until the market improves. As for ABS, existing overcapacity is likely to be exacerbated by further expansions. In 1995, capacity stood at 579,000 tons, while domestic demand stood at a mere 231,000 tons. By 1998, capacity will have been boosted to 739,000 tons, while domestic demand will rise to just 288,000 tons.

"Clearly, utilization ratios will drop significantly in 1997-98," pointed out Woo Sung Lee, senior chemicals analyst at Hannuri Solomon in Seoul.

On the other hand, in spite of oversupply, prospects for benzene and TPA are somewhat better, due to strong demand for benzene from SM producers and equally strong demand for TPA from synthetic fiber manufacturers.

The three products that are expected to see really healthy growth are PE, for which the global supply/demand situation continues to remain very tight; PVC, where capacity expansion will be much reduced by Samsung General Chemical's recent decision not to enter the sector as originally planned, combined with strong expected demand from China; and ethylene glycol, which will see strong demand from synthetic fiber manufacturers.

Surplus strategy

Nevertheless, this aggressive strategy of building up surplus capacity in South Korea is clearly aimed at winning export business in the expectation that demand in the region will start to pick up again by about second half 1998 or first half 1999.

However, as a Samsung General Chemical source put it, "Even when the recovery finally does come, the new climate will be very different. Before, Korean petrochemical producers could control the market to a certain extent due to their sheer size. But now, with Southeast Asian nations all bringing their own plants on stream, the fight for market share will be much more severe."

"It is interesting to see how the Asians and the U.S. differ in strategy," he added. "Whereas the Americans have gone for efficiency, the Asians are going for size. It will be interesting to see who wins. We are betting that demand, particularly from China, will make up for excess capacity, while the Americans believe that the best way to gain market share will be to produce better, cheaper-priced goods without the risk of overextending capacity."

At the same time, South Korean petrochemical producers are increasingly shifting production abroad. Yukong, for example, is planning on building a refining/petrochemical complex in Guangzhou Province, China.

The Kumho group also has disclosed plans to build a napththa cracker in China as a way of vertically integrating their two existing tire manufacturing plants in the country.

LG Chemicals has a 100,000 ton/year PVC plant in Teijin, China, and plans to build a 50,000 ton/year ABS plant in Zhejiang Province.

"Despite the fact that China is expanding its own petrochemical capacity, not only is demand outstripping supply, but the Chinese companies simply do not have access to the necessary capital to fund these projects on their own," Woo Sung Lee noted.

India is also being targeted as a key market by the South Koreans: LG Chemicals recently acquired Hindustan Polymer, and is looking for a PVC partner in that country. Most South Korean companies have said that they will establish production bases there in the future, especially in the fast-growing plastics industry. Other important production bases include Viet Nam and Indonesia.

In the meantime, South Korean petrochemical producers will have to sit back and wait for the world market to pick up before they can see any real returns on their investments, both at home and abroad.

However, one thing does appear to be clear: their thirst for expansion is far from quenched. Whether they have bitten off more than they can chew, as many analysts fear, also remains to be seen.

Copyright 1997 Oil & Gas Journal. All Rights Reserved.