FOCUS: REFINING State of European refining industry is less bleak than reported

John H. Jenkins
Pace Consultants Inc.
Houston

It is difficult to pick up a trade publication without reading of the imminent demise of the European refining industry. Major oil companies are combining operations to minimize costs. Refineries are being shuttered. And analysts are calling for the immediate closure of many more plants.

There is little doubt that European cracking margins have fallen since the early 1990s, in step with the rest of the world. However, the refining industry in Europe does not, in the opinion of Pace Consultants Inc., suffer from some overriding fundamental flaw that dooms it to low margins forever.

The intent of this article is to put some of the industry's recent events in perspective, to discuss some of the fundamental differences between American and European operations, and to perhaps lay to rest the idea that refining is somehow dead in Europe.

History of European refining

In examining European refining, it is appropriate to divide the markets into two segments: northern and southern Europe. Although the geographical delineation is rather inexact, most analysts include France in northern Europe and Spain in southern Europe, despite the countries' exposure to both markets.

The two markets function differently and are exposed to different competitive forces. Southern Europe competes directly with the large exporting refineries of the Middle East. By comparison, northern European refiners compete more with one another.

While there are competitive forces between northern Europe's refining center and the other refining centers of the Atlantic Basin, northern Europe is more insulated than the U.S. Gulf or East Coasts.

Total refined products demand in northern Europe is approximately twice that of southern Europe. While making a direct comparison of southern and northern European margins is somewhat premise-laden, Pace estimates that, over the past decade, northern European margins have averaged 10-15 ¢/bbl higher than those in southern Europe. This is consistent with the more direct competition from the Middle East.

In Europe, many refineries were originally constructed by state-owned companies. Even in the case of publicly held companies, the government frequently was a major shareholder. As such, refining was regarded more like a public utility than a true, fair-market business.

The early objective of most plants was simple. They were designed to produce sufficient gasoline, heating oil, and diesel for nearby communities, and to produce fuel oil for the local utility.

At the time, there was almost no natural gas production in Europe, so heating oil was used for domestic heat. Most European power plants in the 1960s and early 1970s burned fuel oil, which led to a ready market for this product.

In the early 1970s, demand for refined products climbed more than 5% annually as the economies of Europe developed and grew. The first oil price shock of 1973 drastically reduced growth. By 1974, total demand in Europe had fallen to pre-1970s levels. Product demand again increased, however, and by 1979 Europe was consuming more product than ever before.

The second oil price shock of 1979-80 again reined in consumption and led to a number of structural changes in the market, and in the nature of the European refining industry. As in the U.S., higher prices led to conservation and fuel substitution.

Perhaps the most important change was the introduction of natural gas from the Soviet Union, which eroded the market share of gas oil for home heating. Demand for distillate declined nearly 10%/year from 1979 to 1982. The nuclear industry proliferated, especially in France and Belgium, reducing demand for fuel oil.

Increases in the price of oil, and the belief that the price of oil would increase forever, also colored the strategic thinking of the major oil companies. Although it is well known that shipping crude is less expensive than shipping product, major companies invested heavily in Middle Eastern export refineries. Mobil Oil AG, for example, shut down its almost-new refinery in Wilhelmshaven, Germany, which had a current (1996) replacement cost of about $1 billion, and began construction of a refinery at Yanbu, Saudi Arabia.

Italy was particularly hard hit by competition from the Arab Gulf. From 1980 to 1989, 40% of its refining capacity was shut down.

Since the early 1980s, the European industry, like that of the rest of the world, has become far more global, interacting with other refining centers in the international market for crudes and products.

Product mix, specifications

In the U.S. refining industry, gasoline is king. In Europe, despite the introduction of natural gas for home heating, diesel/gas oil is the prime product. (In Europe, gas oil is taken to mean diesel and home heating oil, not fluid catalytic cracking unit feed, as in the U.S.)

Table 1 [20089 bytes] compares U.S. refined products demand in total, and by product, with that of Europe as a whole and divided into the two major markets (northern and southern Europe). The table shows the effects of a number of structural differences between the continents.

Europe's petrochemical industry is predominantly based on naphtha as a feedstock, rather than LPG. Fuel oil is more widely used in industry and power generation than in the U.S.

Most striking is that the ratio of gasoline to distillate is almost four times higher in the U.S. than in Europe. While there are several factors, the dogged insistence of European legislatures to favor diesel automobiles over gasoline is one of the major driving forces.

Table 2 [16521 bytes] compares the cost to fuel gasoline and diesel-powered automobiles in various European countries with costs in the U.S. As shown, in France and Germany, taxes make a gasoline-powered automobile nearly twice as expensive to operate, on a per-mile basis, as a diesel powered model. By comparison, there is essentially no difference in the U.S.

Given the higher capital cost of diesel cars and the differences in driving characteristics, it is clear why diesel has minimal penetration into the U.S. automobile sector.

In Europe, unlike the U.S., there is clearly a different market for home heating oil and diesel fuel. While normal heating oil specifications in Europe are similar to those in the U.S., motor diesel specifications are more restrictive in Europe, which has higher cetane and lower pour point requirements. The combination of high cetane with low pour point specifications strongly influences winter production.

One critical specification, cold filter plugging point (CFPP), is not used in the U.S.

In colder climates, even more rigorous diesel specifications apply. Ultralight diesels, for example, are sold in the winter months in Norway, Denmark, and other Scandinavian countries. Although these fuels are sold as diesel, their properties and prices are much closer to those of kerosine.

As a result of the high demand for diesel and heating oil, as a percentage of the product slate, and of tight winter specifications, the most profitable periods for European refineries are normally the first and fourth quarters-the winter months. This, of course, is opposite of the normal U.S. trend.

Although several of the "greener" countries in Europe have been using low-sulfur diesel (0.05 wt %) for several years, the product was accepted officially throughout the European Union (EU) in October 1996. Because of tighter pour point specifications and other factors, the price differential between the newer grade and high-sulfur diesel has been much better in Europe than is the premium for low-sulfur diesel in the U.S.

In addition, there are several grades of diesel designed for very environmentally sensitive services. Swedish City Diesel, for example, is a light diesel with very low aromatics (5%) used primarily in buses. Prices are reported to be $40-80/metric ton (12-25¢/gal) more than conventional diesel.

LPG sales are also much different in Europe than in the U.S. In Europe, while butane is used typically as petrochemical feed and for gasoline blending, much of the propane is marketed locally for domestic and farm consumption. This is especially true in northern Europe. The netback price for the product is well above the comparable U.S. price.

Octane differentials for unleaded gasoline are also higher in Europe. For the past several years, the differential between premium 98 RON gasoline and 95 RON product has averaged $18-21/metric ton (over 5¢/gal)-nearly twice the differential for similar octane levels in the U.S. market.

The business environment

A number of factors affect the viability of refining assets in Europe. These will be looked at individually in the following sections.

Location

Unlike the U.S., which is literally crisscrossed with product pipelines, Europe has very few. Most product moves from refineries or import terminals via truck, train, or barge. Thus, higher transportation costs tend to insulate a refinery's local market from competition.

As a result, the difference between prices at major refining centers and those in smaller import areas is considerably higher than in the U.S. For example, over the past 5 years, the difference in the rack price of standard heating oil in Hamburg has averaged about $7.50/metric ton (nearly 2.5¢/gal) higher than the price in Rotterdam. By comparison, rack differentials between Houston and Dallas, roughly the same distance apart, are about 1¢/gal.

The Hamburg/Rotterdam differential is almost entirely a result of the cost to ship from Rotterdam to Hamburg, and to pay terminal fees at Hamburg. By contrast, Houston and Dallas are connected by pipeline.

In the sense that the U.S. Mountain State refineries enjoy niche markets protected by transportation differentials, many European refineries have some niche component.

Taxes

Federal income taxes have not been a major concern to U.S. refiners for the past several years, because a company has to make money in order to pay income tax. Nevertheless, profits are taxable at the normal corporate rates, thereby reducing cash flow.

In Europe, however, some refiners have agreements with taxing authorities which allow them to operate the refinery as a processor for a set fee per barrel. This fee, which is negotiated with the taxing authorities, is the only income made by those refineries. Profits made on the normal refined product margin can be taken in a non-U.S. company, which may have reduced, or even no, tax exposure.

Environment and government

One of the biggest fallacies held by most U.S. citizens is the belief that environmental laws are far more stringent for European refineries. Some specifications are, in fact, very rigorous. In parts of northern Europe, for example, sulfur dioxide limitations can be an order of magnitude tighter than U.S. regulations.

In Pace Consultants' experience, however, environmental agencies and industry work together much closer in Europe than in the U.S. As an example, several years ago, U.S. refiners were beset by a regulatory dilemma regarding hazardous wastes. While landfills were being either closed or severely limited, it was practically impossible to obtain a permit for a hazardous waste incinerator.

The U.S. Environmental Protection Agency's performance during the fuel reformulation debacle has been an incredible demonstration of politics over reason.

In Europe, by comparison, coalitions of government and industry provided safe, effective incineration facilities. Some European countries even allow refiners to gain a return on investment for facilities to meet new product specifications through tax or product pricing policy.

Despite cries for a market economy, much of Europe's industry is firmly grounded in socialism. In the government's view, the role of industry is to employ people. While this may lead to a lower "up cycle," incentives and intervention tend to protect the "down cycle," because local government will support industry through taxation, environmental rules, and other means of keeping a plant operational.

Sustaining capital

European refineries are generally newer than their U.S. counterparts. As noted, few plants are older than about 30 years. By comparison, many U.S. plants have operating equipment well over 50 years old.

This, coupled with the rather random state of affairs in U.S. environmental rules, makes it necessary to assume higher ongoing capital expenditures (sustaining capital) when evaluating the purchase of U.S. refineries.

In the U.S., for example, most analysts assume 2.0-2.5% of replacement cost as sustaining capital. In Europe, data show 0.5-1.5% to be more typical.

Because sustaining cash comes directly out of cash flow, this difference has a big impact on a discounted cash flow evaluation.

Working capital

In the U.S., inventory costs are a major component of the total employed assets of a refinery. The cost of holding inventory can easily add 5-15¢/bbl to the cost of refining. This is not necessarily true throughout Europe.

Table 3 [17588 bytes] compares working capital requirements for a 100,000 b/sd refinery in Germany with a similarly sized U.S. Gulf Coast plant. In these calculations, a North Sea crude slate and 50% local product sales were assumed for the German plant, and a domestic/imported crude mix with no product exports were assumed for the U.S. plant.

For the receivables account, payment terms for products sold are very short-typically 3-5 days or less-at both plants. Inventory requirements are impacted by a number of factors and one cannot generally state that plants on either continent have a particular advantage. Thus, the uses of funds are essentially the same.

However, there are significant differences in sources of funds. In Europe, much of the crude is short-haul. The Mediterranean is supplied chiefly from the Middle East and North Africa, while northern Europe is heavily dependent on the North Sea.

At coastal European refineries, crude is received within 2-3 days of loading. However, payment terms are usually 30 days from loading, secured by letter of credit, making it possible to have processed the crude before it is paid for.

In the U.S., by comparison, overall payment terms are shorter. For foreign crudes, 30 days is still the norm, but most imported crudes are longer-haul. For U.S. crudes, terms range from 20 days to cash on delivery.

For these reasons, the payable accounts of European refineries are somewhat higher than in the U.S. The significant cash flow difference, however, is in cash collection.

In Germany, taxes are collected at the rack, not at the pump. The refiner settles accounts with the taxing authorities quarterly. This, coupled with Europe's higher taxes on refined products (especially gasoline), leads to a very significant cash "float" in the payable account for products sold within the country, minimizing overall working capital.

Thus, the German refiner shows a cash surplus, on average, because of the tax float. Although the need to settle tax accounts quarterly leads to a "sawtooth" cash situation, excess funds can be banked for short-term interest.

Comparable sales

Table 4 [21543 bytes] compares sales of refineries in Europe and the U.S. over the past 6 years. It should be noted that sales data in Europe are not as readily available as they are in the U.S. Further, many of these transactions, both in Europe and the U.S., included multiple assets such as marketing companies, retail outlets, and terminals. Nevertheless, Pace Consultants believes that these figures are reasonable and indicative of the fair market value.

In the table, we have calculated the replacement cost for each refinery and expressed the sales price as a percentage of replacement value. As would be expected, there is a relationship between profitability and the buyer's willingness to pay a higher percentage of replacement costs. Transactions in the early 1990s garnered higher relative prices than recent sales.

The more interesting aspect of this table, however, is that European refinery values have not fallen through the floor, as have values in the U.S. While transactions in the U.S. have taken place at literally pennies on the dollar, European sales have not dropped below about 40% of replacement value.

In Pace's opinion, this difference is, in part, a reflection of the level of uncertainty resulting from U.S. environmental legislation and enforcement.

If all of the above is true, why have there been consolidations and shutdowns in Europe? There are a number of reasons:

Obsolete technology-Although European plants, on average, are newer than U.S. refineries, European refiners have not upgraded older plants to the same extent as their U.S. counterparts. Many of the plants are still operating with their original catalytic cracking and reforming technologies. The recently shut down Mobil Oil AG plant at Woerth, Germany, for example, was operating one of the few remaining thermal crackers outside the former Soviet Union.

Size issues-Fixed costs are high in Europe. In some European countries, strong unions make labor costs per hour several times higher than those on the U.S. Gulf Coast. As a result, a small refinery with many units that is not isolated from competition could be in serious trouble.
Gasoline demand-Forecasters believed that gasoline demand would grow rapidly in the more mature economies of Europe. Most (including Pace) forecast modest growth. According to statitics recently released by the Organisation for Economic Cooperation & Development, however, total gasoline demand has fallen by an average of 1.2% annually for the past 2 years. The overall growth rate since 1990 is essentially zero.
U.S. reformulation-Traditionally, the U.S. East Coast has been a major outlet for excess European gasoline, especially in the summer. Since much of the gasoline consumed in the area must be reformulated, which does not fit well with the capabilities of many European refiners, exports to the U.S. fell by 70,000 b/d between 1994 and 1995.

The future

There is a general perception that the European refining industry is currently suffering from overcapacity. In a current global study of refining profitability called, "The Bottom of the Barrel: Residual Fuel Oil Supply, Demand and Pricing," Pace constructed linear models of the refining industry in Europe. These were "tuned" using actual 1995 data on capacity, crudes, and product output to determine utilization rates, constraints, and excess capability.

Although cokers, fluid catalytic cracking units, and hydrocrackers were operating at close to 100% of capacity, the model showed that European refineries were capable of producing nearly 20% more gasoline than was actually produced, given prices. In contrast, when the price of diesel was increased by $20/metric ton (5¢/gal), no more diesel was produced.

In short, Pace believes that excess European refining capacity lies in gasoline production capability, not in the ability to produce diesel.

In Pace's view, most of the shutdown refineries in Europe were shuttered for good reason: they couldn't compete. Some were high-cost, environmentally unfriendly, or unable to efficiently produce the products demanded in the marketplace.

To a considerable extent, the changes of the past few years are part of a normal business rationalization that should have occurred 10 years ago. There are opportunities, niches, and very good refining assets in Europe, however, and there is money to be made in the future.

The Author

John H. Jenkins is a vice-president at Pace Consultants Inc. in Houston, where he manages single-client and industry studies dealing with business and market analyses for new and existing products, processes, and services in the energy and petrochemical industries. He has completed projects involving the design, revamp, and evaluation of refinery and primary petrochemical units. He also has developed a number of programs and systems to analyze and optimize energy usage in operating units.

Jenkins began his technical career at UOP. He also served as a technical consultant with Wright Killen & Co. He has a BS in chemical engineering from the University of Tulsa and an MBA from the University of Houston.