Russian refining tax structure fails to promote investment

April 7, 2008
The Russian petroleum tax structure encourages the country’s operators to export refined products rather than crude oil; therefore Russian crude throughput averaged 4.6 million b/d in 2007, a new post-Soviet era record, according to the International Energy Agency’s “Oil Market Report,” published on Feb. 13, 2008.

The Russian petroleum tax structure encourages the country’s operators to export refined products rather than crude oil; therefore Russian crude throughput averaged 4.6 million b/d in 2007, a new post-Soviet era record, according to the International Energy Agency’s “Oil Market Report,” published on Feb. 13, 2008.

The crude processing rate was an increase of 4% compared with 2006 and 15% more than the 5-year average (Fig. 1), according to IEA.

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Although this strategy is common among oil-producing countries, Russian tax structures may result in strategies that fail to promote long-term investment in the industry.

Tax codes

The 2004 change to the tax code contributed to sharply higher product exports, concentrated in six refineries (Table 1), which accounted for more than half the increase in Russian crude throughput in 2007, according to IEA. Because upstream producers own these refineries, they face a clear choice between selling crude domestically, exporting it, or refining it.

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The factors that influence this decision include:

  • Domestic refining capacity and domestic product sales.
  • Crude and product pipeline capacity, both domestic and export.
  • Access to alternative export infrastructure, e.g., rail or barge shipments.
  • The incentive that the Russian tax code provides to optimize between domestic and export sales of both crude and products.

According to IEA, the Russian tax code heavily influences these companies’ revenues, which can change dramatically depending on world oil prices, providing significant incentives to integrated Russian oil companies to adjust their sales methods. Russian oil companies pay three separate taxes on their activities:

  1. Royalties on crude production; taxed at 22% after certain allowances.
  2. Export tax; based on the market price of Urals crude in the preceding 2 months. Light products have a 30% discount on the tax charged and fuel exports benefit from a 60% discount.
  3. Corporate profit tax of 24%, charged on net income, which is similar to other industries.

When the IEA report was written, Russian government tax revenues were around $65/bbl and integrated oil companies reported net income of about $10/bbl. The lagged nature of the current tax structure can also distort significantly the economic incentive to refine crude oil and, at times, sell products into the domestic market, rather than export them, according to IEA.

The lower tax burden on fuel oil reduces the incentive to invest in upgrading capacity, with the posttax margin between hydroskimming and cracking refineries much narrower than in Europe.

Figs. 2a and 2b show the incentives created by the tax system.

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According to IEA, the Russian tax structure clearly encourages running crude through a refinery, targeting the products either for domestic or export sale, vs. the alternative of exporting the crude. The increase in refining crude runs, however, has also been influenced by other factors such as pipeline capacity constraints, local demand for transportation fuels, and the imperative to sustain gas availability for export.

The overall price trend dramatically affects the net income per barrel that companies achieve—in a falling market the lagged nature of the export tax can materially depress net income. Similarly, in a rising market, the impact of the export tax is offset as revenues rise ahead of the calculated tax burden, according to IEA.

Global refining

In Europe, throughput has increased in complex refineries and simple refineries have been upgraded to a more sophisticated configuration; however, in Russia more than half of the refiners who have increased runs are hydroskimming operators rather than catalytic cracking, based on fuel oil yields.

According to IEA, this is partly due to the current tax structure, which appears to reduce a refiner’s incentive to invest in upgrading equipment in the medium term. In the short term, this is not necessarily a problem as long as the market is able to absorb or reprocess partly refined fuel elsewhere.

The tighter fuel specifications taking effect in many countries around the world may make it harder for importing countries to readily process partly refined fuel. In particular, given the uncertainty of sustainable supplies from Russia in a fluctuating oil market and the high cost of installing upgrading and desulfurization equipment, European or American refiners may not want to install surplus additional capacity to handle Russian exports, according to IEA.

The potential for Russia to require greater domestic fuel oil use as a substitute for tightening gas supplies complicates matters further.

In the future, the Russian tax structure as it currently stands may fail to deliver long-term benefits to the refining industry. A simpler tax system could have provided Russian refiners with the same incentive to boost crude throughput, while investing in upgrading capacity, as has been seen in the OECD and that has delivered significant results.