Big trouble for big oil (page 2 of 2)

This was fuelled by companies betting on continued robust growth in demand in the booming Asian economy, as well as from traditional markets like North America and Europe.

Additional refineries were also built by state-owned oil companies in various developing countries as governments tried to become independent of refineries owned by foreign companies. Several other companies also expanded, attracted by margins of nearly $2 per barrel. The 1991 Gulf War saw another spike in refinery margins, which climbed to over $2.50 per barrel.

That was a peak that the refining industry can never really hope to match. The Asian crisis kicked off a slump in demand that has continued for the last five years and refining margins have been sliding ever since. In October 2002, net refining margins stood at an all-time low of $0.60 per barrel.

Industry experts believe that refiners face a Catch-22. As most of the refineries are at least 15 years old, they use outdated, less efficient technology. In order to increase efficiency, refiners need to make significant investments. But with margins in negative territory, no company is making these investments. So refiners are less efficient and losing even more money than before.

The problems created by overcapacity come at a bad time for oil companies. Since the late 1990s, most governments, especially in the European Union (EU), passed laws mandating better quality and cleaner fuels. In the last decade, most refineries have had to significantly reduce the amount of sulfur in the gas and diesel they produce, and they also have had to make sure that all the gas sold in the EU is lead-free.

Of course, this has increased the costs for the refineries, which have not been able to pass on the increased costs entirely to the consumer. Refiners have also had to clean up their acts and make significant investments in installing anti-pollution systems.

The cleanup is set to become more intensive as the Kyoto protocol on climate change, which sets clear targets for reduction in carbon emissions across the world, kicks in. Although the protocol is yet to come into force, several countries and the EU have promised unilateral action on meeting their commitments under the agreement.

This means that refiners in the EU could be forced to meet even more stringent controls on pollution caused by their fuels. This has clearly set the alarm bells ringing among the major refiners. "The Kyoto deal will definitely add to the costs for us. We need to develop new technologies that can help us meet the new emission standards," says Skinner of Shell.

Sprow of ExxonMobil is worried about the additional costs that Kyoto could mean for the refiners, precisely at a time when they are facing mounting losses. "We could be faced with a situation where Kyoto could reduce the demand or affect the economies of fossil fuels."

However, if the EU goes ahead with unilateral action on Kyoto, it could put some non-EU companies, especially super-majors like ExxonMobil or ChevronTexaco, in a tight spot. Since the United States has said it will not enforce the Kyoto deal, US players in Europe could suffer.

Additional environmental costs, overcapacities and a continued slump in demand don't leave much option for the refiners. IBM Consulting's Stephen Williamson, director of chemical and petroleum research, says that the business will remain tough for refiners for the next 10-15 years. "They need to adapt their strategies, improve efficiencies and prepare for the long haul," he insists.

If refiners are to survive they need to reduce costs significantly and even close down or sell under-performing refineries. BP has set a target of raising $3 billion by selling assets, mostly refineries. Shell says it wants to cut costs by 37 percent in the next seven years, while continuing to sell or close down some under-performing sites. Times are tough all over, and big oil is suddenly thinking much smaller.