Indian refiner/marketers must adapt to changes with deregulation

Michael Wilcox
Wood Mackenzie
London

• Refining Complexity [52,166 bytes]
• India's Refining Efficiency [55,822 bytes]
• India's Refined Products Supply/Demand Ballance [96,038 bytes]
• Marketing Infrastructure of Indian Retail Companies [32,917 bytes]
• Average Throughput Per Retail Site [108,311 bytes]

India's downstream sector is currently almost completely isolated from international economics and global competition due to the control exercised by government in all areas of the industry.

Statutory restrictions on imports, social priorities, and the administered pricing mechanism (APM) have a vice-like grip on the production and distribution of almost all the main petroleum products, with the exception of liquefied petroleum gas (LPG) and lubricants.

However, as India's liberalization process gathers momentum, deregulation of the downstream sector-including permission for foreign investment-is being widely accepted as inevitable; only the extent and timing of deregulation are in contention.

While fulfilling social objectives and ensuring the commercial viability of the downstream industry, the cost-plus pricing regime inherent within the APM has created a number of well-documented market distortions.

The control of consumer prices and the presence of large subsidies on kerosine have severely skewed the Indian demand barrel towards middle distillates and created huge import dependence.

Adulteration of gasoline and diesel with cheap kerosine has also proved difficult to control. Public companies are given little incentive to control costs under the controlled profitability of the APM, and the system does not always encourage efficient operations or investment in new technology.

Any investment decisions are effectively under the centralized control of the government, and this can sometimes lead to sub-optimal capital allocation.

On the marketing side, price competition is nonexistent, and marketers have little incentive to improve customer services or their marketing offers.

Therefore, in a deregulating market, existing Indian downstream oil companies will have to change quickly if they are to survive, improving their flexibility and reacting more quickly to new forces from outside.

After deregulation, crude oil will no longer be purchased by the Indian Oil Corp. Ltd. (IOC) monopoly, giving refiners the freedom to make their own arrangements for crude supply.

Refineries will also have the freedom to determine their own product output dependent on local product prices. Marketers will have to contend with fierce competition for market share.

In essence, companies will be forced to make the right commercial choice on a daily basis, and the end of assured returns on investment will require that each company "manages the margin" right through the supply chain, from feedstock acquisition to the retail forecourt.

Refining impact

The impact of deregulation on India's refining industry will depend to a large extent on the competitiveness of indigenous companies when ranked against international competition.

Net cash margin is perhaps the most significant single indicator of competitive position. It is a financial indicator that is simply expressed but which captures most of the critical elements of a refinery's performance that define its competitiveness.

It is worth taking a closer look at the constituent parts of the net cash margin, to assess where the industry's real strengths and weaknesses lie.

Refinery configuration, which accounts for about 65% of the net cash margin, is generally driven by the shape of the demand barrel and product quality requirements within a local or regional market, as refiners seek to optimize their product slate and maximize gross margins.

Refinery configuration can be conveyed through a single complexity number, which gives an indication of the relative sophistication of a refinery compared with its peer group.

The bar chart on p. 32 illustrates how the Indian refining industry compares globally in terms of refinery complexity, as measured by the WoodMac Complexity Index, a modification of the Nelson-Farrar Index.

It shows a significant complexity gap between India and other major countries: average complexity for India is 2.8, well below the Asia-Pacific average of 4.6.

This low complexity is partly due to low refining margins, which result in a low surplus for investment, and also to lack of external pressure to improve the quality of fuel by adding upgrading units.

Even though refiners expect to make a number of upgrading investments over the next few years, primarily to increase distillate yield and meet the imminent higher fuel specifications-IOC has already invested in a hydrocracker at its largest refinery at Koyali in Gujarat and is planning to add one to its other large refinery at Mathura, also in Gujarat-these alone will not be sufficient to close the complexity gap between India and other major countries.

Removal of the APM will improve profitability for existing refineries and will allow more investment in upgrading capacity. The key to improving long-term competitive position will be making the right investments to build the right kit at the right time.

The second determinant of competitiveness-costs and efficiency-accounts for about 20% of the variation in net cash margin. This is best measured by processing cost, which incorporates all aspects of a refinery's costs structure, such as payroll and fuel costs.

The line graph on this page compares the operating costs of each individual refinery in India with that of a "pacesetter," a refinery or group of refineries that excels over a whole range of performance benchmarks, including energy efficiency, productivity, and yield.

The chart shows that Indian refineries appear to have a cost advantage over the pacesetter, with low labor rates seeming to more than compensate for very high manning levels.

Scale economies are also very significant in India; the best performers are IOC's two large refineries, while the losers are its smaller ones. It should be remembered that all the Indian refineries have lower processing complexity than the pacesetter. They all need investment, and that investment will add to costs.

Wood Mackenzie estimates that the additional cost of anticipated investment would be in the range of 100-200 rupees/metric ton ($2.80-5.60/ton). However, even after taking such costs into account, Indian refineries will mainly still be competitive against the pacesetter.

Location, the third and last factor affecting the refining margin, determines the cost of crude delivery and realizable prices for refinery output. A refinery situated in a high-demand, product-deficient region that receives crude by pipeline can achieve margins up to $2/bbl higher.

The second bar chart on this page shows a 5-year forecast of the overall refining supply/demand balance in India. The supply forecast includes six new refineries to be built by 2002, including the Essar and Reliance facilities in Gujarat, as well as a number of expansions of existing plants.

This forecast suggests that India may be shifting from its product-deficient position to a balanced or even slightly surplus market in the future.

However, given the size of the Indian market, regional supply/demand balances will play a key role in the product price realizations for individual refineries, and this in turn will attract investment either to increase production or to build infrastructure to deliver product to deficient areas, particularly in the north of the country.

Marketing infrastructure

The Indian market has been closed to new players for several decades and, not surprisingly, exhibits all the characteristics of a fully regulated market.

Many of the natural characteristics of a free market-price competition, product differentiation, high site investment, sophisticated network planning (particularly useful in an emerging market with rapidly developing infrastructure), and "segment strategies"-are absent, potentially exposing the domestic companies to damaging effects of competition once the market is opened up.

However, India's growth potential is huge, and there is no shortage of foreign companies lining up to enter the market after deregulation. Freeing of domestic retail markets, even without price competition, will arguably have the most far-reaching and least predictable impact on the Indian downstream oil industry.

One large factor favoring the incumbent oil companies is the extent of existing product distribution infrastructure, deemed a very strong barrier to market entry.

The requirement on each company to distribute products nationally means that each has distribution structures that stretch across the entire country, making a fairly impenetrable barrier for would-be competitors.

Retail market

In comparison with neighboring countries and two sample western markets, India appears to have a relatively high number of retail outlets per 1,000 vehicles.

Conversely, measured against the same basket of countries, its site density appears very low. This conflicting information illustrates how specific developmental, geographic, and demographic differences can have a huge impact on individual countries and thus how difficult it is to make a meaningful comment on the relative adequacy or inadequacy of a retail network.

In these circumstances, throughput per site provides a much better indicator of the relative efficiency of the Indian retail network compared with that of other countries (see chart, p. 34).

There are currently just four brands in the Indian retail market today: IOC has a market share of 40%; Hindustan Petroleum Corp. Ltd. (HPCL) has 24%; Bharat Petroleum Corp. Ltd. (BPCL) has 27%; and IBP Co. Ltd., the only non-refiner, has 9%.

Market share is tightly controlled, and all players are obliged to market nationally, including outlying areas. Strict control of prices, new site allocations, and market shares essentially prevent brand or price competition.

Consequently, forecourt services are underdeveloped, and individual site investment is low. Another interesting feature of the market is its dominance by the commercial sector-5 out of every 6 l. of fuel sold is diesel.

India as a whole stands up well to international comparison in terms of throughput per site, and there is little to distinguish the four brands. Yet comparison of throughputs still masks other opportunities and threats to the retail network.

The very high proportion of commercial diesel currently sold through the retail network is vulnerable; as markets develop, commercial bunkering activities tend to evolve, and companies will tend to operate depot-refueling, both of which tend to eat into diesel volumes currently sold through retail outlets.

Set against this are the current high throughputs and forecasts of rapid transport fuel growth, which suggest there is enormous scope for new retail outlets, particularly in and around metropolitan areas.

Lubricants market

The Indian lubricants market holds some interesting lessons, both for new entrants into the Indian downstream market and existing companies.

This sector was opened up to private competition in 1991-92. Twenty-two foreign brands have since entered the market. Indian companies have seen their market share slide, despite attempts to bolster it through technical tie-ups with foreign companies and introducing higher value lubricants.

Interestingly, however, most of the new market entrants have ended up as fringe players. Although the newcomers have made an impact en masse, none has managed large volumes individually.

It is possible that the new entrants have still not reached break-even levels.

It remains to be seen how many of these will actually stay in the Indian market over the long term.

Retail fuels marketing demands similar skills in brand and channel-building to lubricants but larger-scale investments.

Among the foreign majors that may enter the Indian retail fuels market, only some will have the ability to make the requisite investments and take the long-term view necessary to sustain a business.

Similarly, just as the Indian companies have lost share in lubricants but are definitely not write-offs, Wood Mackenzie expects them to put up a tough fight against new entrants in fuels retailing as well.

Deregulation of the downstream oil industry in India is indeed inevitable but probably not imperative for another 3-5 years. According to Wood Mac- kenzie calculations, upcoming refining capacity is sufficient to service de- mand until around 2001, and so further refining investment is only needed beyond that period.

Similarly, although India's marketing infrastructure is already stretched, resulting in imports of LPG and other mass-consumption products being constrained, it may take up to 5 years for these problems to bite hard enough to force government to invite private investment on a large scale.

Conclusions

Deregulation of the Indian market is inevitable, and when it does come it will bring fundamental changes. The pace and timetable of the deregulation process will have a critical influence on its impact.

Post-deregulation profitability will be determined by competitiveness against a global downstream, and the existing Indian industry will need to adapt in order to compete. Indian refineries appear to have a cost advantage and will have the added advantage of location, provided capacity is not over-built.

Once the market is opened to new players, the marketing environment, particularly in metropolitan areas, will begin to change. Adapting the retail network will require sizable investment and will present a significant challenge to the four existing retailers.

Many sites will need to be upgraded, and the companies will need to place greater emphasis on differentiating themselves from their competitors. The development of forecourt services to generate non-fuel revenues and to make the most of individual locations will also need attention.

Finally, companies will need to develop separate strategies for different segments of their networks.

The Author