Shortage of crudes, not products, to drive Asian refining market

Feb. 7, 2011
National oil companies in China and India have continued to expand refining capacities as 2011 begins. Japanese refiners, on the other hand, are heading into a second round of capacity reductions.

Liutong Zhang
FACTS Global Energy
Singapore

National oil companies in China and India have continued to expand refining capacities as 2011 begins. Japanese refiners, on the other hand, are heading into a second round of capacity reductions.

At the same time, up to 5 years will pass before any new major capacity will be commissioned East of Suez, securing crude from the Middle East will become more important for Asian refiners, and conversion capacity is being added far more quickly than primary distillation capacity in the Asia-Pacific.

New Asian capacity

In 2009, Asia added 2.2 million b/d of refining capacity, the largest distillation capacity addition in the region's history, while demand growth was only 315,000 b/d. In 2010, estimated demand in Asia-Pacific grew robustly at 1.1 million b/d, while net refining capacity additions reached only 820,000 b/d.

The average Singapore refining cracking margin improved to $1.83/bbl in January-November 2010 from the low of $0.28/bbl in 2009. Rebalancing in the refining sector appeared under way but will highly depend on:

• Are Asian refineries' expansion plans firm?

• How much refining capacity will be closed in the region?

• When will export refineries in the Middle East come on line?

In Asia-Pacific, 8 million b/d of new refining capacity will be added from the start of 2010 to yearend 2020. Of this, 64% will be built by NOCs (Fig. 1). This group includes Sinopec, PetroChina, CNOOC, and Sinochem in China, as well as the state refiners in India. There are also a few joint-venture green-field projects between the Asian NOCs and local private companies-Middle Eastern NOCs-international oil majors (28% of the total addition).

Investment in refining capacity by NOCs stems from a variety of reasons, not all commercial. While they will not cancel their projects, they may defer the investment.

Apart from partnering with the Chinese NOCs to build integrated refinery and petrochemical projects in China, international oil majors are not investing in downstream in Asia.

By country, 76% of the refining addition will be in China; 15% in India. China's refining capacity will reach more than 15 million b/d by 2020, while India will overtake Japan by 2012 to become the second largest refiner in Asia (Fig. 2).

At mid-2010, Sinopec was the largest Chinese refiner, accounting for 46% of total refining capacity, followed by CNPC/PetroChina (30%). Sinopec's refining assets are mainly in the rich coastal cities in south, east, and north China, while CNPC/PetroChina's are mainly in inland provinces.

Competitions among Chinese NOCs, however, are becoming increasingly intense. CNPC/PetroChina, CNOOC, and Sinochem are keen to use their resources to expand into Sinopec's territories and business turfs in a bid to become "bigger and more powerful," while Sinopec is trying its best to protect its business in the coastal cities. Therefore, we expect that the Chinese NOCs—Sinopec, PetroChina, CNOOC, Sinochem, and others—intend to overbuild in order to have a greater presence in refining. Simply put, the larger the company, the more easily it can justify its importance and argue "what is good for it is good for the country."

Nonetheless, the Chinese government still holds the self-sufficient policy but has no intention of becoming a large petroleum products exporter. We believe that the National Development and Reform Commission will pace the country's future refining buildup with its product demand growth to maintain self-sufficiency in refined products, especially in diesel (Fig. 3).

India will add 715,000 b/d of crude distillation unit (CDU) capacity 2010-15 and 460,000 b/d between 2016 and 2020, accounting for 15% of total expansion in Asia-Pacific. Three grassroots refineries, Bharat Oman Refinery Ltd.'s Bina refinery (120,000 b/d), Hindustan Mittal Energy Ltd.'s Bhatinda refinery (180,000 b/d), and Indian Oil's (IOCL) Paradeep refinery (300,000 b/d), will be commissioned in 2011, 2013, and 2016, respectively.

Bina and Bhatinda will be owned and operated by joint ventures in which private players and India's NOCs have an equal stake. IOCL, India's largest state refinery and owner and operator of the Paradeep refinery, is looking for a partner in the Middle East to secure feedstock for the refinery and perhaps even help to finance the project.

Bina and Bhatinda would cater to the domestic market and increase Bharat Petroleum's share in central India and Hindustan Petroleum's market share in northern India, respectively. Currently these two companies market IOCL's products from their own retail outlets. Although the 300,000-b/d Paradeep is initially labeled as an export project, as the outlook for India's product demand continues to remain robust, IOCL may choose not to export any products from Paradeep.

Essar Oil raised the nameplate capacity of its refinery at Vadinar in Gujarat by 70,000 b/d to 280,000 b/d at yearend 2009. To complete Phase I, Essar plans to expand the refinery by 80,000 b/d. The project is on track to be completed by first-quarter 2012. After expansion, the refinery will be able to process 360,000 b/d of crude. We expect that Phase II of its refinery expansion plans will go ahead and be completed by first-quarter 2017.

Essar Group's listing in April 2010 of 25% of its energy group in the London Stock Exchange was very successful, which will be a key funding source for the Group's Phase II plans as well as other energy activities. We remain skeptical, however, of the company's plans to add 320,000 b/d of capacity (as originally proposed for Phase II) and believe that only half the projected capacity will be brought on line by 2017.

The other main likely refining additions in the Asia-Pacific are a 120,000-b/d CDU addition by Byco Petroleum Pakistan in Karachi in second-quarter 2011, a 250,000-b/d green-field refinery by IPIC/PARCO in Khalifa, Pakistan, and a 200,000-b/d green-field refinery by a joint venture (Petrovietnam, Idemitsu, Mitsui, and Kuwait Petroleum International) in Vietnam.

Without closures, refining capacity addition will be about the same as demand growth 2011-15 (Fig. 4), which means that the large surplus in 2009 will remain. Thus, the key to margin strength will be discipline from suppliers in removing capacity from the market. If we take into account the Japanese and Chinese closures, net refining capacity addition will be slower than petroleum demand growth 2011-14 (Fig. 4).

Asia-Pacific closures

Since mid-2009, there has been talk about plans for refinery closures in the region, especially in Japan. The refiners have indicated a list of likely closures, amounting to 1.4 million b/d (50% from Japan and 50% from China) between 2010 and 2015.

In July 2009, Japan's Ministry of Economy, Trade, and Industry (METI) released an ordinance, under the law entitled "Sophisticated Methods of Energy Supply Structure": Refiners must meet the cracking/CDU capacity ratio of 13% or higher by March 2014.

Under the law, METI only includes resid fluid catalytic cracker, coker, and resid hydrocracker when calculating the cracking/CDU ratio. Based on its definition, Cosmo Oil and TonenGeneral need to make the most significant changes (Table 1).

Up to now, JX Group, Idemitsu, and Showa Shell have announced plans to close several refineries (Table 1) to meet the requirement:

• JX Group formed a joint venture with PetroChina for its 115,000-b/d Osaka refinery, and PetroChina will export all the products from the Osaka refinery. Besides selling the Osaka refinery, JX Group is in the process of closing about 400,000 b/d of capacity (Table 1).

• Idemitsu announced that it will close a 93,000-b/d CDU unit by first-quarter 2014.

• Showa Shell announced that it will close the Keihin Ohgimachi refinery (112,000 b/d) after September 2011. The refinery has been operated by Showa Shell affiliate Toa Oil with Toa's Mizue CDU as one integrated refinery. The company expects rationalization of the refineries will enhance Toa's competitiveness.

• TonenGeneral (ExxonMobil)'s strategy on Japanese operations is the key to the country's industry reorganization. In October last year, TonenGeneral officially denied media reports on its withdrawal from Japan's retail business and said it has proposed several alternatives, including both rationalization and investment, to meet the METI requirement.

• Cosmo Oil closed a total of 93,000 b/d in first-half 2010, but more is required in order to meet the METI requirement.

Table 1 shows that JX Group, Idemitsu, and Showa Shell will be able to meet the METI requirement if they faithfully carry out their closure plans as announced (amounts to about 600,000 b/d). TonenGeneral (ExxonMobil) and Cosmo Oil, however, will need to firm up plans for more closures.

Taking into account our forecast for Japanese demand decline towards 2015 and current excess refining capacity, Japan will need to close about 1.3 million b/d of refining capacity (Table 1). Assuming all refiners obey the ordinance, we expect 1.1-1.3 million b/d of refining capacity to be closed by 2014. A high-case scenario—a total capacity of 2 million b/d disposed of by 2020—is also possible due to the ordinance. We also expect that more merger and acquisitions will take place, following formation of JX Group.

China is also renewing its effort to close some of its local refineries. The NDRC has released new policies since early 2009 to target local refineries: the increase of fuel-oil consumption tax to 0.8 Yuan/l. ($18.6/bbl) from 0.1 Yuan/l. ($2.3/bbl) in January 2009 and the increase of fuel oil import tariffs to 3% from 1% in January 2010. These new policies make many local refineries, which rely on fuel oil as feedstock, uneconomic. For those, it is likely that they will be closed or idled most of the time.

Between 2010 and 2020, we expect that China will close 700,000-800,000 b/d of its local refineries under our base case. Of course, it is likely that some large local refiners will expand their capacities and manage to obtain a crude import license for their refineries (such as the Zhenhua Co.).

There are also talks about refinery closures in other countries, but we put them under our "possible" category because the companies have not made the formal announcements.

Shell's refinery in Tabangao, Philippines, is running the risk of closure partly due to tax disputes and environmental pressures. Also, imports of crudes sourced from countries outside Southeast Asia are taxed at 3%, while petroleum products imported from Southeast Asian countries, including Singapore, incur no tax. Such tax regimes make the Shell Tabangao refinery uncompetitive.

The closure of Shell's Clyde refinery in Australia has been under consideration for many years. CPC Corp. in Taiwan is under public pressure to close its 205,000-b/d Kaohsiung refinery. Because of the delay and uncertainties in the green-field refinery by Kuokuang Petrochemical Technology Corp. (KPTC, a consortium led by CPC Corp.), however, we expect that the mothballing of the Kaohsiung refinery will be delayed beyond 2015.

Long-term prospects

The difference between Asian refining capacity and oil product demand has ballooned to a peak surplus of around 3.9 million b/d in 2009 from a deficit of around 650,000 b/d in 2004 (Fig. 5). Taking into account the likely closures in Japan and China, we expect that the surplus will be eroded, leading to better refining margins in the next 4-5 years before start-up of the export refineries in the Middle East.

In the long term, the refining sector will enter a difficult period again after 2015 as the export-oriented Middle East refineries start to come on line (Fig. 6). The Middle East refineries will come on line even if margins are weak because they are driven more by internal factors than refining economics.

The new Middle East export refineries will use their domestic crudes. Under our base case, the Middle East will add 3.87 million b/d of crude production capacity, and 3.1 million b/d of those will be used for domestic refineries, leaving only 0.77 million b/d for exports (Fig. 7).

The two KPC joint-venture refineries in Asia (300,000-b/d Sinopec/KPC Zhanjiang refinery in China and 200,000-b/d Petrovietnam-Idemitsu-KPC in Vietnam) will take up 0.5 million b/d of the exports. Only about 270,000 b/d of new Middle East crudes are therefore available to the other Asian refiners. Many of the new coastal refineries in China, India, and Pakistan (a total of 2.22 million b/d; Table 2), however, are designed to process the Middle Eastern crudes. Furthermore, addition of more conversion units in Korea and Taiwan could potentially draw more Middle East heavy sour crude into the Asia-Pacific, increasing competition for these grades.

Because of the large mismatch between the new Asian refineries' designed crude slate and additional availability of the Middle East crude, many Asian refiners will be unable to obtain their optimum crude slate. As a consequence, the heavy-sour crudes discount will definitely become narrower, especially during the massive start-up of new Middle East refineries (2015-17).

Besides building primary distillation capacity, Asia is investing heavily in catalytic cracking, hydrocracking, and coking capacities (Fig. 8). This will result in a rise in the cracking-CDU ratio (Fig. 9). It may have limited improvement in refining margins as it will potentially make light-heavy product and light-heavy crude spreads narrower.

The degree of upgrading reflects the increasing sophistication of the Asian oil sector. Consequently more fuel oil will be cracked into middle distillates. We expect that the Asia-Pacific's surplus in transport fuels (gasoline, kerosine/jet, and diesel) will rise while its deficit in fuel oil will deepen.

Margin trends

As demand growth continues to be strong and net refining capacity additions slow sharply in the next 4-5 years, there will certainly be more improvement in refining margins 2011-14. Refining margins after 2015, however, will drop again as the new Middle East export refineries come on line. It would be a mistake for Asian refiners to change their strategy of refinery closures and rationalization due to the window of improving refining margins 2011-14.

We also expect that Asian refiners will need to compete with each other to obtain the optimum crude slates (Middle East crudes) for their refineries (Fig. 7). Thus, securing crude supplies from the Middle East will be important for their profitability and survival.

Because of the primary distillation and conversion capacity additions, the region's surplus in transportation fuels (gasoline, diesel, and jet fuel) will rise and its deficit in fuel oil will deepen. This trend will create business opportunities for trading companies in Singapore. As many Asian refiners still have limited trading capabilities to sell their surplus products into the end markets, they will need traders (mainly in Singapore) to find markets for them.

Similarly, as Asia is becoming a larger sink for fuel oil, traders are in a strong position to capture this new opportunity by sourcing more fuel oil from other regions for Asian consumers. Increasing trading activities (mainly in Singapore) will also benefit storage companies in Singapore. As Singapore has limited space for further expansion of new storage capacity for trading purposes, we expect that new storage capacity could be built in Singapore's neighboring countries, but trading activities are still likely to be carried out in Singapore.

The author

Liutong Zhang is a senior analyst, East Asia Information and Analysis Group, for FACTS Global Energy, Singapore. Before joining FGE, he worked briefly as a market and strategy analyst with Standard Chartered. At FGE, he covers the downstream Asia-Pacific oil and gas sector, focusing on China and Taiwan. In addition, Zhang conducts in-depth research and analysis on the refining and petrochemical sectors. He holds bachelors (first class) in chemical engineering from the National University of Singapore.

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