Financial Times: ENERGY: “Aramco, the Saudi kingdom's national oil company, is considering a plan to boost the output of its Motiva refinery in Houston by 45 per cent, along with its joint venture partner, Shell.”: “This summer, Jeroen Van der Veer, Shell's chief executive, commented that he did not see any tankers of crude sitting idle for want of refining capacity.”: Thursday 29 September 2005
By Thomas Catan and Kevin Morrison
Published: September 29 2005
When British protesters angered by the country's high fuel prices threatened to blockade oil refineries earlier this month, Gordon Brown, the chancellor of the exchequer, pointed the finger in a familiar direction: the Organisation of the Petroleum Exporting Countries. The only way to bring down prices, he declared, was by putting pressure on the oil cartel to step up production.
Opec promptly called his bluff, proposing to make available another 2m barrels of oil a day - if consumers wanted it. "We're offering everything in our pocket and this is my message to Gordon Brown: if he would like to have it, I would be happy to sell it to him," said Sheikh Ahmad Fahad Al-Ahmad Al-Sabah, Opec's president. The announcement had a limited effect on prices. As Sheikh Al-Sabah well knew, even if Opec were suddenly able to double its output of crude, it would not be going anywhere. There simply would not be enough capacity to refine the oil into a usable form.
In recent years, Opec has blamed the high price of oil on a host of factors, from the falling dollar to speculation by investors in oil futures markets and general geopolitical instability. But the cartel's latest justification is more persuasive. The bottleneck in refining represents a ceiling on production that analysts say could take a decade to overcome, meaning that high prices at the petrol pump could be here to stay.
Finding and producing oil - the so-called "upstream" part of the business - has captured the public imagination since the 1860s, when prospectors descended on Pennsylvania. The downstream business - which transforms crude into products ranging from petrol to plastic bags - has always seemed humdrum by comparison. International oil companies have long viewed refining as a necessary evil, a low-margin business required to market their oil rather than a potential source of profits. "There are lots of companies that just don't like refining," David Knapp, of the Energy Intelligence Group, told a recent conference.
Even before Hurricanes Katrina and Rita temporarily took nearly one-quarter of US refining capacity off-line, the global refining system was stretched. According to figures from BP, the oil major, global average refinery utilisation increased to 87 per cent in 2004, the highest level for more than one-quarter of a century. In the US, refineries have been running at a 95 per cent utilisation rate this year, according to Purvin Gertz, the oil consultancy. That level, up from a low of 68.6 per cent in 1981, is considered about the maximum achievable on an annual basis.
Wood Mackenzie, the oil consultancy, projects that the US will consume almost 32m tonnes of petrol more than it refines this year. Similarly, the country will face a shortfall of more than 10m tonnes of diesel and gas oil. Those shortfalls are currently made up through imports, largely from Europe, which produces a surplus of petrol. But it is unlikely that Europe alone will be able to satisfy US thirst for petrol in the future. Moreover, Wood Mackenzie predicts that, without major new investment in refining capacity, Europe will be 50m tonnes short of diesel by 2010 - one-fifth of projected demand.
One way to measure the soaring demand for oil products is to measure the price gap between a barrel of crude oil and a barrel of refined product, called "crack spreads" in the industry. "The [petrol] crack recorded over the last two weeks has broken all records," said Philip Verleger, an independent energy economist. "Two weeks ago, margins were nine times higher than the 20-year average."
How did we get here? After a construction boom in the 1970s, many refiners were caught by the sudden downturn in demand in the 1980s and profit margins all but vanished. During the 1990s, the refining industry went through a painful process of consolidation, with oil companies selling off plants they saw as outside their core business. Refining margins hovered close to zero, choking off investment in the sector.
Nowhere is the problem so visible as in the US. No refineries have been built since 1976 and many closed during the lean times. The number of refineries in the US has more than halved since 1981, although improvements in the remaining plants mean that total output has slipped by a smaller 10 per cent. During that time, petrol consumption in the US has risen by 20 per cent.
Oil companies have been investing in their refineries - but not necessarily to boost their capacity. For example, regulation by US states and the European Union has forced refiners to spend Ă‚Âbillions cutting the level of sulphur and other pollutants in the fuels they Ă‚Âproduce.
"The US refining and marketing industry has been characterised by unusually low product margins, low profitability, selective retrenchment and substantial restructuring throughout the decade of the 1990s," the US Energy Information Administration summarised in 1999. "Costs involved in complying with environmental laws have grown substantially during the period and have also affected the profitability of the domestic industry. Consequently, refiners' abilities to recoup their investment have been impaired."
At the same time, the quality of the oil that refineries receive has been changing, requiring further outlays. As supplies of easily refined "light, sweet" crude from places such as the North Sea dry up, oil companies are having to upgrade their refineries to handle the heavier and more sulphurous "sour" crude that Opec producers now have to offer.
Much more investment is needed to make use of Opec's oil, which is expected to account for more than half of all output by 2020, up from 40 per cent today. Ali Al-Naimi, the Saudi oil minister, told the World Petroleum Congress on Tuesday that there was a "mismatch between configuration of the refineries and the available sour, heavy crudes".
In 2004, the International Energy Agency, the consuming nations' watchdog, estimated that the world will need $122bn of investment in refineries by the end of the decade. The industry will need to spend $410bn in refining by 2030 if it is to increase capacity by the 50 per cent the IEA believes will be needed.
Suddenly, for the first time in decades, the refining business is hot - one of the most profitable segments of the global energy business. In the past four years, US refining margins have gone from close to zero to around $23 a barrel. After Hurricane Katrina, margins soared to around $40 a barrel. Independent refiners such as Valero are making record profits (see below left).
So, given the promise of high returns, surely oil companies are falling over themselves to invest? Not yet. The first hurdle is that refineries cannot be built just anywhere - environmental and planning regulations make it particularly difficult in the US. However, some believe the government could help streamline the approval process, as it did with the siting of liquefied natural gas terminals in the recent energy bill.
More importantly, investment decisions taken today could take five years or more to come to fruition. Industry executives worry that margins will not stay this high for long. Speaking about the industry as a whole, Rex Tillerson, president of ExxonMobil, said on Tuesday: "At current crude prices, the reward appears great. This will change. Ours is a cyclical industry - what goes up will invariably come down and will undoubtedly go up again."
Mr Tillerson, who is expected to take over at the helm of the world's largest publicly traded oil company and refiner this year, warned against taking long-term investment decisions on the basis of short-term price movements. "Short-term price fluctuations do not significantly affect the pace of our projects at ExxonMobil," he said. "Nor should Ă‚Âcurrent prices significantly affect the pace of investment or market Ă‚Âliberalisation."
A company deciding to commission a refinery today would also have to contend with a market for engineering and construction services that is stretched to the limit. Building costs have doubled or, in some cases, tripled over the past three years, making financial projections even more uncertain. "It's sort of an Alice in Wonderland deal," says Matt Simmons, an independent energy banker. "Once we've solved one bottleneck, we realise there's another bottleneck right behind it."
In a survey of new refinery investments in June, Merrill Lynch, the investment bank, found plans for 8m b/d of capacity to come on-stream worldwide by the end of the decade - enough in theory to satisfy annual demand growth of 1.8 per cent. But most projects were due to start up only after 2009. Two-thirds of the planned capacity additions were in Asia and the Middle East, particularly in China and India, where price caps could put the fate of many projects into question.
Interestingly, it is Opec that seems most keen to build refineries. Aramco, the Saudi kingdom's national oil company, is considering a plan to boost the output of its Motiva refinery in Houston by 45 per cent, along with its joint venture partner, Shell. Saudi Aramco also unveiled plans in June to boost domestic petroleum and petrochemicals refining capacity at a cost of $4bn to $5bn. "Saudis are worried they have lost control of the market, and one of the ways to win it back again is through expanding downstream," says Francisco Blanch, an energy strategist at Merrill Lynch.
Kuwait is also moving into the downstream sector. Nawaf al-Sabah, assistant managing director and legal counsel at the state-owned Kuwait Petroleum Corporation, says the prime minister of Kuwait offered to build an oil refinery in the US during a visit to Washington in July. This was renewed after Hurricane Katrina knocked out several refineries along the US Gulf coast last month.
Mr Nawaf said that KPC wanted to build the refinery, which would cost more than $3bn, in partnership with an international oil company. But that was not proving easy. "We have to overcome a very difficult hurdle, and that is that the [international oil companies] don't want to invest in new refineries," he said. "We are willing to accept a lower rate of return for this type of investment because we see it as a more strategic investment."
Many international oil companies deny there is much of a problem. This summer, Jeroen Van der Veer, Shell's chief executive, commented that he did not see any tankers of crude sitting idle for want of refining capacity.
Although no refineries are being built, companies are squeezing more out of their existing plants, a process known as "capacity creep". ExxonMobil says it is adding 150,000 b/d of additional capacity every three years - roughly the equivalent of one mid-sized refinery. But many analysts doubt such incremental moves can solve the problem. They say that "capacity creep" has largely reached its limit and that additional enhancements would require much greater investment.
Frustrated by the perceived inaction of the oil companies, some consumers are taking things into their own hands. Sir Richard Branson, chairman of Virgin Atlantic, has said he intends to build his own refinery, at a cost of $2bn. Like all airlines, Virgin has been hard hit by soaring jet fuel prices. "The world is short of up to 20 oil refineries and the oil companies are not investing in new ones," Sir Richard complained recently.
If oil companies do not invest part of their huge profits in new refineries, some analysts believe governments could use taxation policy to push them to do so. Thierry Breton, the French finance minister, recently threatened oil companies with a windfall tax and managed to extract pricing concessions from Total and BP. Dominique de Villepin, France's prime minister, has also called for Total of France to put more of its oil profits into refining.
Tempting though it may be for governments under pressure over soaring fuel prices, state intervention is unlikely to help: any new refineries could take between five and ten years to come on-stream. In the meantime, refinery capacity could limit the consumption of oil products and, in turn, the production of crude. Consumers may simply have to adjust.
"The grim reality is that it will take at least a decade [to solve the bottleneck]," said Mr Simmons. "All we can do now is mitigate against getting deeper in a hole."
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