In 2009, Asia added 2.2 mmb/d of refining

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1 Asian Refining New Paradigm Traditionally the Asian refining market has been driven by a shortage of products. However, with greater refining capacities available now the market is expected to be shaped by the shortage of crude instead. This article provides insight into this new paradigm. R E P O R T In 2009, Asia added 2.2 mmb/d of refining capacity, the largest distillation capacity addition in the region s history, while demand growth was only 315 kb/d. This year, demand in the Asia Pacific has grown robustly at 1.1 mmb/d, while net refining capacity additions are only 820 kb/d. The average Singapore refining margin has improved from the low of US$0.28/b in 2009 to US$1.76/b in January-October Rebalancing in the refining sector seems to be on the way, but it will highly depend on: Are Asian refineries expansion plans firm; How much refining capacity will be closed in the region; and When the export refineries in the Middle come online. New Refining Capacity Additions in Asia National oil companies (NOCs) in China and India continue to expand refining capacities. China is expected to add about 6 mmb/d of new refining capacity from the start of 2010 to end The Chinese NOCs investment in the refining sector is not entirely driven by refining economics and we believe that they have the financial resources and strategic intentions to make their planned refineries become reality. Indian state refiners also have firm plans to expand their refining capacities to meet the domestic demand growth while Essar Oil, one of the key Indian private players, will carry out its Vadinar phase II expansion for export. In the Asia Pacific, 8 mmb/d of new refining capacity will be added from the start of 2010 to the end of Of which, 64% will be built by national oil companies (NOCs, Figure 1). This group includes Sinopec, PetroChina, CNOOC, and Sinochem in China, as well as the state refiners in India. There are also a few jointventure green-field projects between the Asian NOCs and the local private companies/middle Eastern NOCs/international oil majors (28% of the total addition). The investment in refining capacity by the NOCs is being undertaken for a variety of reasons, not all of which are commercially driven. We expect that they will not cancel their projects although they may delay/defer the investment. Apart from partnering with the Chinese NOCs to build integrated refinery and petrochemical projects in China, the international oil majors are not investing in the downstream sector in Asia. 6 HYDROCARBON ASIA, JAN-MAR 2011 Visit our website at:

2 Japan refiners are heading into second refining capacity reduction. JX Group, Idemitsu and Showa Shell have announced their plans to close a total of 600 kb/d of refining capacity to meet the METI ordinance. TonenGeneral Group (ExxonMobil) and Cosmo Oil s strategies to meet the METI ordinance are the key to the country s industry reorganization. If all refiners follow the METI ordinance, a total of mmb/d of refining closures in Japan are expected up until (Sinopec, PetroChina, CNOOC, Sinochem and others) have intentions to overbuild in order to have a greater presence in the refining sector. Simply put, the larger the company, the more easily it can justify its importance and argue what is good for it is good for the country. By country, 76% of the refining addition will be in China and 15% will be in India. Chinas refining capacity will reach more than 15 mmb/d by 2020, while India will overtake Japan to become the second largest refiner in Asia by Nonetheless, the Chinese government still holds the self-sufficient policy but has no intention to become a large petroleum products exporter. We believe that the National Development Reform Commission (NDRC) will pace the country s future refining build-up with its product demand growth to maintain the position of self-sufficiency in refined products, especially in diesel (Figure 3). As of mid-2010, Sinopec is the largest Chinese refiner, accounting for 46% of total refining capacity, followed by CNPC/PetroChina (30%). Sinopec s refining assets are mainly in the rich coastal cities in South, East and North China while CNPC/ PetroChina s are mainly in the inland provinces. However, the competition among the Chinese NOCs are becoming increasingly intense. CNPC/ PetroChina, CNOOC and Sinochem are keen to use their resources to expand into Sinopec s territories and business turfs in a bid to become bigger and more powerful while Sinopec is trying its best to protect its business in the coastal cities. Therefore, we expect that the Chinese national oil companies Four to five years breathing space is expected for Asian refiners because no new major capacity is scheduled for commissioning before As a consequence, the refining surplus in Asia will shrink. However, refining margins will drop significantly again as new large complex Middle Eastern export refineries start to come online from India will add 715 kb/d of CDU capacity between 2010 and 2015 and 460 kb/d between 2016 and 2020, accounting for 15% of the total expansion in the Asia Pacific. Three grassroots refineries, Bharat Oman Refinery Ltd s Bina refinery (120 kb/d), Hindustan Mittal Energy Ltd s Bhatinda refinery (180 kb/d), and Indian Oil s (IOCL) Paradeep refinery (300 kb/d), are expected to be commissioned in 2011, 2013 and 2016, respectively. Bina and Bhatinda will be owned and HYDROCARBON ASIA, JAN-MAR

3 operated by joint ventures where private players and India s national oil companies have an equal stake. IOCL, India s largest state refinery and owner and operator of the Paradeep refinery, is looking for a partner in the Middle East to secure feedstock for the refinery and perhaps even help to finance the project. Bina and Bhatinda would cater to the domestic market and increases Bharat Petroleum s share in Central India and Hindustan Petroleum s market share in Northern India, respectively. Currently these two companies market IOCL s products from their own retail outlets. Though initially labeled as an export oriented project, as the outlook for India s product demand continues to remain robust, IOCL may choose to not export any products from Paradeep. Essar Oil raised the nameplate capacity of their refinery at Vadinar in Gujarat by 70 kb/d to 280 kb/d in end To complete Phase I, Essar plans to expand the refinery by 80 kb/d. The project is on track and we expect it to be complete by the 1st quarter of Post expansion, the refinery will be able to process 360 kb/d of crude. We expect that the phase II of its refinery expansion plans will go ahead and be completed by Q Essar Group s recent listing of 25% of their energy group in the London Stock Exchange was very successful and this will be a key funding source for the Group s Phase II plans as well as other energy related activities. However, we remain skeptical on their plans of adding 320 kb/d of capacity (as originally proposed for Phase II) and believe that only half of the projected capacity will be brought online by The other main likely refining additions in the Asia Pacific are a 120 kb/d CDU addition by Byco Petroleum Pakistan in Karachi in Q2 2011, a 250 kb/d greenfield refinery by IPIC/PARCO in Khalifa, Pakistan, and a 200 kb/d greenfield refinery by a joint venture (Petrovietnam, Idemitsu, Mitsui and Kuwait Petroleum International) in Vietnam. Without the closures, refining capacity addition will be about the same as demand growth from 2011 to 2015 (Figure 4), which means that the large surplus in 2009 will remain. Thus, the key to margin strength will be discipline from suppliers in removing capacity from the market. If we take into account the Japanese and Chinese closures, net refining capacity addition will be slower than petroleum demand growth from 2011 to 2014 (Figure 4). Refining Closures in Asia Pacific Since mid-2009, there have been talks about plans for refinery closures in the region, especially in Japan. The refiners have indicated a list of likely closures, amounting to 1.4 mmb/d (50% from Japan and 50% from China) between 2010 and Securing crude supplies from the Middle East is becoming increasingly important for Asian refiners profitability and survival in a challenging market environment. We expect a huge mismatch between Asian refiners designed crude slates and additional availability of the Middle Eastern crudes, especially after 2015 as the Middle East export refineries start to come online. Asian refiners may need to compete with each other for the Middle Eastern crudes and some will be forced to use suboptimum crudes. Also, the light-heavy and sweet-sour crude differentials are expected to become narrower. In July 2009, Japan s Ministry of Economy, Trade and (METI) released an ordinance, under the law entitled Sophisticated Methods of Energy Supply Structure : the refiners must meet the cracking/cdu capacity ratio of 13% or higher by March Under the law, METI only includes resid fluid 8 HYDROCARBON ASIA, JAN-MAR 2011 Visit our website at:

4 September The Keihin Ohgimachi refinery has been operated by Toa Oil, Showa Shell s affiliate company, together with Toa s Mizue CDU as one integrated refinery. They expect rationalization of the refineries will enhance Toa s competitiveness. TonenGeneral (ExxonMobil) TonenGeneral Group (ExxonMobil) s strategy on Japanese operations is the key to the country s industry reorganization. TonenGeneral (ExxonMobil) has officially denied media reports on its withdrawal from Japan s retail business in early October and said that it has proposed a number of alternatives, including both rationalization and investment, to meet the METI requirement. catalytic cracker, coker, and resid hydrocracker when calculating the cracking/cdu ratio. Based on its definition, Cosmo Oil and TonenGeneral need to make the most significant changes (Figure 5). Up to now, JX Group, Idemitsu and Showa Shell have announced their plans to close several refineries (Figure 5) to meet the requirement. JX Group It formed a joint venture with PetroChina for its 115 kb/d Osaka refinery and PetroChina will export all the products from the Osaka refinery. Besides selling the Osaka refinery, JX Group is in the process of closing about 400 kb/d of capacity (Figure 5). Idemitsu It announced that it will close a 93 kb/d CDU unit by Q Showa Shell Showa Shell announced that it will close down the Keihin Ohgimachi refinery (112 kb/d) after Cosmo Oil Cosmo Oil has closed a total of 93 kb/ d in the first half of 2010, but more is required in order to meet the METI requirement. From Figure 5, we can see that JX Group, Idemitsu, and Showa Shell will be able to meet the METI requirement if they faithfully carry out their closure plans as they have announced (amounts to about 600 kb/d). However, TonenGeneral (ExxonMobil) and Cosmo Oil will need to firm up plans for more closures. Taking into account our forecast Japan demand decline towards 2015 and current excess refining capacity, Japan will need to close about 1.3 mmb/ d of refining capacity (Figure 5). Assuming all the refiners obey the ordinance, we expect mmb/ d of refining capacity to be closed by A highcase scenario in the industry, where a total capacity of 2 mmb/d will be disposed by 2020, is also possible due to the ordinance. We also expect that more merger & acquisitions will take place, following the formation of JX Group. China is also renewing its effort to close down some of its local refineries. The NDRC has released new policies since early 2009 to target the local refineries: the increase of fuel oil consumption tax from 0.1 yuan/liter (US$2.3/bbl) to 0.8 yuan/liter 10 HYDROCARBON ASIA, JAN-MAR 2011 Visit our website at:

5 (US$18.6/bbl) in January 2009 and the increase of fuel oil import tariffs from 1% to 3% in January These new policies make many of the local refineries, which rely on fuel oil as feedstock, uneconomical. For those, it is likely that they will be closed or will be idle most of the time. Between 2010 and 2020, we expect that China will close kb/d of its local refineries under our base case. Of course, it is likely that some large local refiners will expand their capacity and may manage to obtain a crude import license for their refineries in the future (like the Zhenhua Company). There are also talks about refinery closures in other countries, but we put them under our possible category because the companies have not made the formal announcements. Shell s refinery in Tabangao, Philippines, is running the risk of closure partly due to tax disputes and environmental pressures. Also, imports of crudes sourced from countries outside of Southeast Asia are taxed at 3%, while petroleum products imported from Southeast Asian countries, including Singapore, do not incur any tax. Such tax regimes make the Shell Tabangao refinery uncompetitive. The closure of Shell s Clyde refinery in Australia has been under consideration for many years. CPC Corp in Taiwan is under the public s pressure to close its 205 kb/d Kaohsiung refinery. However, because of the delay and uncertainties in the greenfield refinery by Kuokuang Petrochemical Technology Corporation (KPTC, a consortium led by CPC Corp), we expect that the mothballing of the Kaohsiung refinery will be delayed beyond deficit of around 650 kb/d in 2004 to a peak surplus of around 3.9 mmb/d in 2009 (Figure 6). Taking into account the likely closures in Japan and China, we expect that the surplus will be eroded, leading to better refining margins in the next 4-5 years before the start-up of the export refineries in the Middle East. In the long term, we expect that the refining sector will enter into another challenging period again after 2015 as the export-oriented Middle East refineries start to come online (Figure 7). The Middle East refineries will come online even if margins are weak because they are driven more by internal factors than refining economics. Conversion capacity is added far more quickly than primary distillation capacity in the Asia Pacific. As a result, light-heavy product and light-heavy crude differentials are expected to be lower. A larger surplus in transportation fuels and larger deficit in fuel oil will create excellent business opportunities for the trading companies in Singapore. Long-term Prospect of the Refining Sector Remains Challenging The difference between Asian refining capacity and the oil product demand has ballooned from a The new Middle East export refineries will use their domestic crudes. Under our base case, the Middle East will add 3.87 mmb/d of crude production capacity, and they will use 3.1 mmb/d for HYDROCARBON ASIA, JAN-MAR

6 their domestic refineries, leaving only 0.77 mmb/d for exports (Figure 8). At least 0.5 mmb/d of the exports will be taken up by the two KPC joint-venture refineries in Asia (300 kb/d Sinopec/KPC Zhanjiang refinery in China and 200 kb/d Petrovietnam/ Idemitsu/KPC in Vietnam), so only about 270 kb/d of new Middle East crudes are available to the other Asian refiners. However, many of the new coastal refineries in China, India and Pakistan (a total of 2.22 mmb/d, Figure 9) are designed to process the Middle Eastern crudes. Furthermore, the addition of more conversion units in Korea and Taiwan could potentially draw more Middle East heavy sour crude into the Asia Pacific, increasing competition for these grades. Because of the large mismatch between the new Asian refineries designed crude slate and additional availability of the Middle East crude, many Asian refiners will not be able to get their optimum crude slate. As a consequence, the heavy-sour crudes discount will definitely become narrower, especially during the period of the massive start-up of new Middle East refineries ( ). Conversion Capacity Addition in the Region Besides building primary distillation capacity, Asia is investing heavily in catalytic cracking, hydrocracking, and coking capacities (Figure 10). This will result in a rise in the cracking-cdu 12 HYDROCARBON ASIA, JAN-MAR 2011 Visit our website at:

7 ratio (Figure 11). It may have limited improvement in refining margins as it will potentially make light-heavy product and light-heavy crude spreads narrower. The degree of upgrading reflects the increasing sophistication of the Asian oil sector. Consequently more fuel oil will be cracked into middle distillates. We expect that the Asia Pacific s surplus in transport fuels (gasoline, kero/jet, and diesel) will rise while its deficit in fuel oil will deepen. Conclusion As demand growth continues to be strong and net refining capacity additions slow down significantly in the next 4-5 years, there will be certainly more improvement in refining margins from However, refining margins will drop significantly again after 2015 as the new export Middle East refineries come online. It will be a mistake for the Asian refiners to change their strategy of refinery closures and rationalization due to the window of improving refining margins in We also expect that the Asian refiners will need to compete with each other to get the optimum crude slates (Middle East crudes) for their refineries (Figure 8). Thus, securing crude supplies from the Middle East will be important for their profitability and survival in a challenging market environment. Because of the primary distillation and conversion capacity additions, the Asia- Pacific region s surplus in transportation fuels (gasoline, diesel, and jetfuel) will rise and its deficit in fuel oil will deepen. This trend will create excellent business opportunities for the trading companies in Singapore. As many Asian refiners still have limited trading capabilities to sell their surplus products into the end markets, they will need the traders (mainly in Singapore) to find the markets for them. Similarly, as Asia is becoming a larger sink for fuel oil, traders are in a strong position to capture this new opportunity by sourcing more fuel oil from other regions for Asian consumers. The increasing trading activities (mainly in Singapore) will also benefit the storage companies in Singapore. As Singapore has limited space for further expansion of new storage capacity for trading purposes, we expect that new storage capacity could be built in Singapore s neighboring countries, but trading activities are still likely to be carried out in Singapore. HA This publication thanks Liutong Zhang, of Facts Global Energy, headquartered in Singapore, for providing this paper. Have you read our other magazine? see us on the web at HYDROCARBON ASIA, JAN-MAR