Asia-Pacific refining will recover from current overcapacity in 2005

July 29, 2002
Additions to Asia Pacific's refining capacity in the past 4-5 years have transformed the region from a major net importer to a net exporter of refined products.

Hassaan Vahidy
FACTS Inc.
Honolulu

Additions to Asia Pacific's refining capacity in the past 4-5 years have transformed the region from a major net importer to a net exporter of refined products.

The recent wave of refining capacity additions has come to an end. Many projects are being canceled or delayed due to lower-than-expected demand growth. Over the past few years, additions in refining capacity have outpaced demand growth.

Asia-Pacific refining should start to recover in 2005, depending on a revival of demand growth and rationalized refinery utilization rates.

The outlook for refining margins is not too promising; our comparison of product balances East of the Suez indicates future surpluses. For example, net Middle East gas oil exports will exceed net Asia-Pacific gas oil imports. Projected balances also reveal a gasoline and kerosine-jet fuel surplus in Asia Pacific and Middle East.

Asian margins have also declined due to the premium on Middle East crude destined for the Asia Pacific, the so-called "Eastern premium." In recent years, Asian refiners have paid almost $1/bbl more for Middle Eastern crude as compared to their American and European counterparts.

Product specifications in the Asia Pacific markets are changing. Refiners have been gearing up to produce cleaner fuels by adding desulfurization capacity. As Asian specifications eventually converge with the European and US markets, more Asian fuels will find markets in these regions.

The current state

The refining business in the Asia-Pacific market was under pressure through 2001 due to relatively high crude prices and weak product demand. In fact, 2001 was one of the worst years for the refining business in the region's recent history.

Hydroskimming margins were negative for almost the entire year, and cracking margins were negative through a whole quarter. Over the past few years, Asia-Pacific's refining capacity additions have outpaced the increment in demand growth, creating a product surplus.

Middle Eastern crude accounts for almost 78% of Asia-Pacific's total crude slate, which magnifies the effects of the Eastern premium.

Capacity additions

The first wave of additions to Asia- Pacific refining capacity has ended. Between 1999 and 2001, almost 2.5 million b/d of additional crude distillation unit (CDU) capacity came online, as the total capacity grew to almost 21.4 million b/d from 19.0 million b/d in 1998.

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Expansions continued as the region added almost 0.5 million b/d of CDU capacity in 2001 (Fig. 1). India, China, and Taiwan are the sites of most of these expansions.

Asia-Pacific refiners currently plan to add about 660,000 b/d of distillation capacity by yearend 2005. Most will occur in China, plus some additions in Taiwan, Vietnam, and a nearly completed condensate splitter in Indonesia.

In India, almost 1 million b/d of additional refining capacity came online between 1999 and 2000; refiners there initially planned to install another 1 million b/d of capacity due to high projected levels of future demand. Tariffs on crude and products provide shelter for Indian refiners. They remain relatively isolated from the poor margins faced by market-oriented refiners.

Plans for these additions have slowed because the demand growth that made these projects feasible is gone. Around 300,000 b/d that was scheduled to come online by 2005 has been delayed and will start up by 2007-08 at the earliest.

Refiners have indefinitely postponed another 350,000 b/d of projects. Some of the cancellations resulted in sizeable capital losses due to money already spent on engineering feasibility and equipment orders.

Between the start of 1999 and yearend 2001, China's CDU capacity increased by about 450,000 b/d-75% from Sinopec Corp. and 25% from China National Petroleum Corp., PetroChina Co. Ltd. During the same period, the government halved the capacity of small, inefficient, and underutilized refineries. China continues to restructure the remaining small refineries.

Between 2000 and 2001, Taiwan's Formosa Petrochemical Corp. added two units with a total capacity of 280,000 b/d. Formosa has completed another 140,000-b/d unit but its start-up has been delayed until 2003 due to slow demand growth. Besides this, there will be no new CDU capacity additions.

Regional product demand

On the whole, all the major economies in Asia Pacific have experienced slowdown. The region's demand for petroleum products grew by only 17,000 b/d in 2001, down from 550,000 b/d in 2000 and 990,000 b/d in 1999.

South Korea's demand shrunk by 19,000 b/d in 2001, down from a growth of 130,000 b/d in 1999. India's demand growth in 2001 was almost flat (3,000 b/d), down from 154,000 b/d in 1999. In 2001, a decline in Japan's consumption wiped out the incremental growth in China.

This situation, combined with excess refining capacity, resulted in surpluses and exacerbated the poor refining margins.

Refining margins, utilization rates

Refining margins declined in the past few years as some refiners persistently maintained higher utilization rates, especially in relatively profitable domestic market operations such as South Korea and India.

Refiners in South Korea reduce runs only when cracking margins are negative. South Korean refiners maintained nearly 95% utilization rates in 2000. Utilization was lower in 2001 due to a decline in domestic demand.

South Korean refiners have a significant share of the domestic market, which accounts for a major portion of their revenues, particularly since ex-refinery prices of all products in the country are significantly higher than Singapore spot prices.

Indian refiners, which primarily cater to the domestic market, similarly kept their runs high. Further slack in domestic demand forced them to find export markets. Reliance Petroleum Ltd., in particular, exported gasoline to Iran and gas oil to Brazil. It is now eyeing regional markets, e.g., Bangladesh and Sri Lanka, for diesel exports-displacing the traditional Middle Eastern suppliers.

Conversely, market-oriented refiners in Singapore and Thailand have consistently reduced refinery utilization. Singapore's utilization rates fell to less than 70% in 2001 from 85% in 1998. Thai refiners similarly adjusted their utilization to 83% in 2001 from 93% in 1998.

Effects of reduced utilization rates in these countries were offset by increased utilization from Indian and South Korean refiners. The region's refinery utilization rate averaged around 85% during the past 4 years.

Eastern premium, Asian margins

In 2001, the Eastern premium in Asia Pacific was almost $2.70/bbl higher vs. the US and $1/bbl higher vs. Europe.

Asian refining margins are historically among the highest in the world. In the early 1990s, the gross refining margin in Asia Pacific was almost $5/bbl, $1/bbl higher than European margins and more than $1.50/bbl higher than US margins.

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After the Asian financial crisis, however, margins in Asia Pacific dipped below US margins; in recent years, they have been below the European margins as well. Fig. 2 compares refining margins in the three regions.

Poor Asia-Pacific refining margins are not entirely due to the Eastern premium. They are a consequence of product surpluses arising from capacity additions, weak demand growth, and persistently high utilization rates.

Refiners in "protected" markets

Refiners in protected and regulated markets, like India and South Korea, fared better than refiners in other countries.

In India, the tariff on crude and products provides protection for refiners. In 2001, Singapore refining margins averaged —60¢/bbl and $1.20/bbl for hydroskimming and cracking yields, respectively, on Dubai crude.

During the same period, refining margins in the Indian domestic market were at least $1/bbl and $1.50/bbl higher for the respective yields, due to the structure of import tariffs for crude and petroleum products in India.

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Import tariffs on products average more than 5% higher vs. import tariffs on crude. Fig. 3 shows this comparison. Prices of domestically produced crude are kept below international prices, effectively subsidizing the Indian refiners. This protection will stop, however, when domestic crude prices align with international prices following deregulation.

Korean refiners enjoy similar significantly higher ex-refinery prices. Japan refiners are an exception, however, because they enjoy freight differentials between crude and products, and preferential tariffs, particularly for fuel oil.

The Japan refining sector is in a poor state due to declining demand, a high cost structure, and diseconomies of scale. This may cause another consolidation and rationalization drive.

Asia-Pacific refining, product balances

Asia Pacific has been transformed from a major net importer of all products to a net exporter for gasoline and kerosine-jet fuel. Gas oil net imports in Asia Pacific have dropped to 60,000 b/d in 2001 from 540,000 b/d in 1995.

In recent years, the region has had a gasoline surplus. This is a consequence of the rapid expansion in the region's refining capacity and the relatively lower share of gasoline in Asia's demand barrel (about 17%).

For some time now, Asian refiners have found markets for their products outside the region. For example, in recent years, almost half of US West Coast product imports originated from Asia. Similarly, the Indian private sector refiner, Reliance, exported around 30,000 b/d of unleaded 95-octane gasoline to Iran.

In the long term, poor margins impact the regional output slate. Refiners adjust crude throughput, which ensures that they use cracking units to the fullest.

This results in a decline of fuel oil's share in the region's output slate.

Fuel oil comprised 15% of Asia Pacific's total refining output in 2001, down from 22% in 1995.

This has outpaced the decline of fuel oil in the region's demand barrel, which decreased to 16% in 2001 from 20% in 1995. Net fuel oil imports have, therefore, increased to about 580,000 b/d in 2001 from about 320,000 b/d in 1995.

Asia Pacific continues to be a major consumer of gas oil, which accounts for almost a third of the region's demand barrel. Net gas oil imports dropped to almost 100,000 b/d in 2001 from approximately 600,000 b/d in 1995 due to additional refining capacity and the fact that refiners maximized gas oil yield.

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Fig. 4 shows the net imports of petroleum products. Increased volumes of Asian gas oil have recently found markets outside the region. For example, exports from India's Reliance to Brazil.

Asia Pacific imports significant amounts of LPG and naphtha (Fig. 4). Despite additions in refining capacity, regional net imports of LPG were about 650,000-700,000 b/d between 1995 and 2001. These imports were needed to keep up with a 5%/year demand growth rate for LPG.

Although these growth rates will decrease in the next 5 years, the region will continue to remain short on LPG, which will require net imports of 650,000-750,000 b/d. Nonrefinery sources in the Middle East will supply much of this demand.

Naphtha consumption in Asia Pacific has grown at almost 10%/year since the mid-1980s, exceeding 2 million b/d in 1998. This has resulted in net imports of naphtha rising to nearly 750,000 b/d in 2001 from 430,000 b/d in 1995.

Even with significantly lower naphtha demand, Asia Pacific will require around 800,000-875,000 b/d of net imports (Fig. 4).

Developments in the region's refining infrastructure will not have a significant impact on the output slate (LPG + naphtha = 15%, gasoline = 20%, middle distillates = 45%, heavy products = 20%), which will remain roughly unchanged until 2005. The developments are geared more for improving product quality.

Quality-related developments

Asia-Pacific refiners have increased treating and upgrading unit capacities, mainly due to evolving product specifications. Refiners added about 1.3 million b/d of middle-distillate hydrodesulfurization capacity over the last 4 years. Total capacity will be around 6 million b/d by yearend 2002 (Fig. 1).

More-stringent diesel specifications are forcing refiners to add this desulfurization capacity. In 1998, for example, Asia Pacific consumed almost 1 million b/d of 0.5% sulfur automotive diesel oil (ADO) and approximately the same volume of 0.05% sulfur ADO. In 2002, consumers will require more than 1.5 million b/d of 0.05% sulfur ADO, whereas the demand for 0.5% sulfur ADO will drop to slightly more than 0.5 million b/d.

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Fig. 5 shows Asia-Pacific demand for ADO classified by grade. By 2005, consumers will require almost 0.6 million b/d of 50-ppm ADO. Japan plans to require 50-ppm gas oil for road transportation by 2004.

Japanese refiners already have the infrastructure in place to produce 50-ppm diesel using severe treatment. Japan has about 2.8 million b/d of distillate treating capacity, which is almost 60% of the country's distillation capacity. This is twice as high as the average in Asia Pacific.

China, in preparation for increased consumption of 50-ppm gas oil, plans to add more than 380,000 b/d of distillate treatment capacity by 2005 to its current capacity of almost 790,000 b/d.

Indian refiners added nearly 180,000 b/d of distillate treatment capacity in 2000 with the start-up of Reliance's Jamnagar plant.

All the other major projects being built have substantial desulfurization capacities.

Refiners can import products or use sweeter or lighter crudes to deal with any product shortages due to more- stringent product specifications and insufficient treatment capacity. This is a temporary solution, however.

Refiners will add relatively little hydrocracking capacity. Only China plans to add approximately 150,000 b/d by 2005.

This means a relatively smaller jump in higher-cetane gas oil volumes between 2002 and 2005.

Asian countries are adopting more stringent specifications for fuel oil used for power generation. Refiners, mainly in China and Taiwan, will add approximately 125,000 b/d of residue desulfurization capacity by 2005 to the current regional total of about 1 million b/d. Fig. 6 shows the evolution of regional fuel oil consumption classified by grade.

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By 2005, almost all Asia-Pacific countries will completely phase out leaded gasoline. Refiners are currently planning to add about 200,000 b/d of catalytic reforming, 20,000 b/d of alkylation and polymerization, and almost 60,000 b/d of isomerization capacity by 2005.

These additions suggest that most of the gasoline in the region will be lead-free. Even by 2005, however, a significant portion of the region's gasoline will still be less than 92 RON clear, and refiners will continue using methyl tertiary butyl ether (MTBE) in the gasoline blend pool.

Regional refining margins

Several factors have contributed to the current state of Asia's refining margins: the capacity overhang, the Eastern premium, and persistently higher refinery utilization rates.

The recent wave of capacity additions has ended. A comparative analysis of future Middle Eastern and Asian product balances shows substantial surpluses.

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By 2005, the Middle East will have a surplus of more than 740,000 b/d of gas oil, whereas Asian net imports will be around 260,000 b/d. Both regions will have a combined surplus of almost 500,000 b/d of gasoline and 760,000 b/d of kerosine-jet fuel. Fig. 7 shows this comparison.

A mild recovery in refining margins will begin in 2005. This strongly depends on a recovery in demand growth and rationalization of utilization rates. Implied gross refining margins will still be slightly more than $2/bbl for cracking and less than or equal to $0/bbl for hydroskimming.

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Fig. 8 shows projections for regional refining margins.

Regional product specifications are transforming; long-term product surpluses in the Asian market can ease as Asian products find markets in Europe and US. This, however, would take effect only in the long term since current Asian product specifications are significantly below US and European standards.

The authors

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Hassaan S. Vahidy holds an MA in economics from the University of Hawaii at Manoa and an MBA and a BS in engineering. He is currently a senior associate at FACTS Inc. and a researcher at the East-West Center in Honolulu, involved in downstream oil and gas research for the Asia-Pacific and Middle East regions. Prior to this position, Vahidy worked for Royal Dutch/Shell in Pakistan.