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Crude Shock

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The third quarter of 2011-12 (FY12) was a shocking period for India's largest oil refiner, Reliance Industries (RIL). For the first time in its history, the gross refining margin (GRM) — the difference between value of petroleum products and cost of crude — of RIL fell below the Singapore complex refining margin. All efforts to protect the margins through hedging failed. The narrowing of the price difference between heavy and light crude hit its bottomline. In the fourth quarter (Q4), RIL did better, and managed a marginal recovery in GRMs, to $7.6 a barrel, compared to $6.8 a barrel in Q3. That's a premium of $0.40 a barrel over the Asian benchmark, the Singapore complex GRM, much better than the $1.1 a barrel discount in Q3 FY11. But even then, RIL managed an average GRM of just $8.60 in FY12, compared to $8.40 in FY11.

But the business environment for refining companies continues to be tough the world over; blame weakness in demand and capacity additions globally. Even if some of Europe's mature refineries close, the spread between light and heavy crude remains under pressure. The increase in light crude supply from Libya and the North Sea, the reduction in Iranian exports thanks to sanctions on that country and the strength in fuel crack prices are driving the demand for heavy crude.

Essar Oil, too, is struggling to protect its margins, which came down to $6.07 per barrel during Q3 of FY12 from $7.31 a barrel in the same period of FY11. Industry experts expect Essar's margin will also improve in the fourth quarter, but it won't be stellar (the fourth quarter financial results are due next month).

Analysts predict that the complete recovery of GRMs would take six to nine months. But L.K. Gupta, managing director and chief executive officer of Essar Oil says a correction has already started. "This is an abnormal condition that will not last long," he adds.

There are many reasons for a subdued second half of FY12 for refiners. The tsunami in Japan led to shutdown of its nuclear power plants, forcing the country to use fuel oil (the residue from petroleum distillation) for power production, creating unprecedented demand for fuel oil. But complex refineries like RIL produce less fuel oil, and more petrol and diesel.

The price of heavy crude rose seemingly due to surge in the demand for fuel oil. Complex refiners like RIL and Essar Oil added auxiliary units to increase complexity for producing more high value petroleum products by refining cheaper heavy crudes like Arab Heavy and Mexican Maya, and reducing production of low-value, low-demand fuel oil for better yield.

The increasing isolation of Iran on the global scene is also jacking up crude oil prices. FY12 began and ended with crude prices above $120 a barrel, but they were highly volatile in between. In October the price of Brent crude (light) went below $100. Average crude prices also increased by 31 per cent in the last financial year. Analysts at Macquarie Bank estimate that the festering tension in West Asia triggered by Iran's nuclear policy leads to a daily shortfall of 2.5 million barrels of crude.

In Search Of Greater Complexity
The complexity of RIL's two refineries at 11.3 in its first refinery and 14 in the new refinery — measured by the Nelson Index (the higher the number, the more complex the refinery) — in Jamnagar allows it to process heavy and sour crudes, which are cheaper compared to lighter crudes, and produce the same value products as from lighter crudes. Essar has almost doubled its complexity to 11.8 at its refinery in Vadinar in Gujarat. Now, the situation is not helpful for the complex refineries, says an analyst with a foreign bank.

The issue wasn't that serious for public sector refiners. "Historically, the public sector refineries were less concerned about complexity and refining margins," says a senior executive with one of the PSU refineries. "But that is changing. Indian Oil Corporation's new refineries are coming up with higher complexities. Bharat Petroleum and Hindustan Petroleum are thinking of increasing the complexity of their existing units for processing heavier crude." The complexities of old PSU refineries are below 8.

In the longer run, no refiner can survive without investing in complexity, says an official with RIL. "So everybody is running to add units for extracting maximum value products," he adds. IDFC analysts say that the configurations of refinery capacities being added globally means demand for heavy oil has grown disproportionately, reducing Arab heavy-light spreads and, therefore, impacting the premium players such as RIL and Essar, which enjoy premiums over Singapore complexity.

RIL's GRM improved in the sequential quarters as petrol prices bounced back, while LPG and naphtha spreads improved. At the same time, however, IDFC analysts believe that while demand for diesel will remain strong across Asia, the rate of growth in demand will moderate in both India and China over the next 6-9 months as GDP growth rates moderate across the region.
According to Goldman Sachs analysts, "While RIL's Q4 results were impacted by improving but still relatively low refining margins, we believe the cycle should improve in the second half of this calendar year, driven by benefits from the closures in US and Europe, delays in new projects and recovering oil demand."

RIL refining earnings before interest and tax (EBIT) were marginally higher due to improved GRM and lower segment depreciation, at Rs 1,700 crore, despite lower throughput due to a maintenance shutdown at its SEZ refinery. Macquarie Capital evaluates that the efficiency initiatives during planned shutdown will add $0.25 a barrel to GRM.

RIL's improved margins were led by a strong revival in gasoline and naphtha cracks. They were up $4.2 and $6.6 a barrel, respectively. However, diesel cracks, which have a higher share in RIL's slate vis-a-vis Singapore GRMs, declined $1.5 a barrel on the back of weak industrial demand, write Edelweiss analysts in their report.

Way Forward
RIL is taking a balanced refining outlook, with capacity additions in Asia being offset by shutdowns of high-cost refineries. The company has implemented several initiatives during the planned shutdowns taken last year (will improve GRMs by $0.25 a barrel), including debottlenecking of secondary units, increased ability to process more crudes, and some work on the Crude Distillation Unit (CDU) which will improve the yields of high-value products.
GRMs were impacted by higher LNG cost as well. So RIL has decided to implement the petcoke gasification plant with a capex of $4 billion. RIL estimates this plant will add about $3 a barrel to its refining margin by replacing the high-cost LNG with synthetic gas produced from petcoke.

Petcoke, which costs less, will produce syn-gas that would be used to meet refining energy needs, and lead to savings on high-cost imported LNG and higher-value fuels currently used. The off-gas cracker project is still in the planning stage, and would be taken up once work commences on petcoke gasification. The project is expected to be completed in the first quarter of FY15.

Credit Suisse thinks that the gasifiers will produce the equivalent of 20 mmscmd of natural gas; a little under half of which may be used to substitute LNG currently used at the refineries. The rest is likely to be used as (part) feedstock for and to power the proposed off-gas cracker.

Similarly, Essar Oil is setting up a coal-based power plant for feeding its Vadinar refinery. According to Gupta, the captive power capacitywill increase the GRM by $1, which means Rs 750 crore to the bottom line.

Kotak Institutional Equities Research estimates that refining margins of FY13, FY14 and FY15 for RIL would be $8.4 a barrel, $8.7 and $8.9, respectively. The reasons are: limited supply additions globally, announced and expected shutdowns of refineries and incremental oil demand of 2 million barrels per day in two years.

Citibank has marginally lowered their FY13 estimation on GRM of RIL to $7.8 compared to $8 earlier. "We expect Asian refining demand-supply balance to be relatively stable in 2012-13 following large refinery closures. New supply from India in 2012 (~300 kbpd) will keep the Asian market well supplied," analysts with Citi say in a report.

According to Bank of America Merrill Lynch Global Research, the factors in favour of GRM are: a healthy rise in demand for global oil in Q2-Q4 2012; recently closed refining capacity in US and Europe, with more closures likely. Also, incrementally, over 2 mbpd of OECD refining capacity is under review, and this should support refining margins against upcoming new capacity.

There's another hope. Light-heavy spreads that fell to an average $2.6 a barrel have started recovering. Light-heavy crude differential has weakened further during the quarter and is likely to remain subdued in the medium-term, predict Deutsche Bank analysts.

However, UBS's outlook on RIL's GRM remains weak for the next two quarters. This is primarily on the back of: narrowing spreads between the Arab heavy and light; Brent prices likely to sustain amidst ongoing Iran issue; ongoing weak spreads for RIL's product slate — especially diesel; and regional forecast factoring complex refining margin to decline from $8.2 a barrel in 2011 to $6.5 in 2012 and $6.0 in 2013. "We have lowered RIL's GRMs marginally by 2-3 per cent to $8 per barrel and $7.75 per barrel for FY13-14E respectively," according to UBS.

It's a tightrope walk for the refiners for the next six months at least.


(This story was published in Businessworld Issue Dated 07-05-2012)