Big trouble for big oil

Sultan Hussein, the CEO of Emirates National Oil Company, is worried. His company could soon be facing bankruptcy, which he blames on the regulated market - the government sets the price at which he can sell gas to retail consumers without capping the price that he has to pay for crude oil.

Hussein says that because of rising crude prices, which have jumped from $10 a barrel in 1998 to nearly $30 a barrel this year, his company is losing heavily at the pump, where the prices have failed to keep pace. His company is losing nearly $35,000 every month, he says, because of this difference in prices.

ENOC's Hussein is not the only oil executive worried about the impact of rising crude prices. His counterparts at oil majors ExxonMobil, Shell and BP are all suffering due to a combination of the sharp rise in crude prices and a slowdown in the global economy, which has reduced the demand for petroleum products around the world.

The trouble for almost every integrated oil company - those firms that deal in every aspect of oil, from exploration and production to refining and distribution - comes from their refining activities. Refining is a chemical process by which crude petroleum that is produced from the oil well is converted into the gas and diesel you fill your tank with.

Since this involves value addition and is the aspect of the oil business that is closest to the final consumer - after retail distribution - margins are usually better and risks far lower than in exploration or production. This is the reason why almost all major oil companies have been present in the refining business for several decades. For a long time now, the trend in the oil industry has been for companies to be integrated players.

But that's changing. Increasingly, companies are looking critically at their refining operations, and some have even shut down their refineries. Royal Dutch/Shell, the world's second largest oil company, is closing down 17 percent of its refineries in Europe.

The company is also axing its refining activities in North America, where it will shut down 12 percent of its refineries, and is poised to make cuts in Asia as well. According to Paul Skinner, 'The margins in the business have collapsed. For instance, in Asia the refining margin is down from $2.35 per barrel in 1997 to $0.23 this year.'

Skinner's pessimism about the sector is shared by Frank Sprow, vice president for safety, health & environment at ExxonMobil. 'Refineries are clearly under pressure. The question is: Will oil companies get out of the business?'
Overcapacity is the biggest problem facing the refining industry.

The global oil refining capacity now stands at 82 million barrels per day, while demand for refined oil products is only about 75 million barrels a day, leaving a gap of 8 million barrels. This overcapacity has resulted in a slump in profits for refineries.

According to an industry study, refineries do not make money unless they are operating at 90 percent of installed capacity. The average capacity utilization for 2001 stood at 85 percent. And a refinery needs to refine 100,000 barrels per day in order to break even. The average daily output per refinery in 2001 was less than 90,000 barrels.

Enticed by booming economies in the late 1980s and early 1990s, especially in Asia and Latin America, the construction of refineries all around the world was carried out at a frenetic pace. By 1998, the world's total refining capacity stood at a record 83 million barrels per day. 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.