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COLUMN-Grangemouth's reprieve leaves other UK refineries vulnerable: Kemp

John Kemp
Monday, 28 Oct 2013 | 6:57 AM ET

LONDON, Oct 28 (Reuters) - "Grangemouth now has a great future," its operator Ineos said on Friday, a remarkable turnaround from a week earlier, when the company described Scotland's sole refinery as financially distressed.

But Grangemouth's reprieve will still leave all seven of Britain's oil refineries under intense pressure in the coming years.

One or two will probably close in the next few years, according to a report prepared for the UK Petroleum Industry Association (UKPIA) by consultants Purvin & Gertz.

The remaining group will require 1.5 billion to 2.0 billion pounds ($3.2 billion) worth of investment to cope with changing fuel demand and up to 5.5 billion to meet more stringent environmental regulations.

AGAINST THE TIDE

"Existing UK refineries were either constructed or expanded in the 1960s with further major additions of distillation and catalytic cracking capacity in the 1970s and 1980s," according to Purvin & Gertz.

The problem is that the refineries were built to produce gasoline. But domestic gasoline consumption has peaked. Instead, demand for diesel and jet fuel is growing rapidly.

Gasoline consumption reached a maximum of 24 million tonnes per year in the mid 1990s, declining to just 15 million tonnes in 2010. By contrast, diesel usage has surged from 12 million tonnes in the mid 1990s to 22 million tonnes in 2010. And jet fuel consumption has risen from under 8 million tonnes to more than 12 million.

"The UK industry configuration remains more suitable for supplying the UK demand profile of the 1990s rather than for 2012," Purvin & Gertz wrote.

There is little chance of major new investment: "A whole refinery site requires a very large area, typically more than 200 hectares for a mid-sized refinery. Given land and planning permission, it would cost around 4-5 billion pounds to construct one today, therefore these vital assets are unlikely to be replaced."

Instead Britain has become a major trader of refined products. In 2011, Britain's refineries exported over 5 million tonnes of gasoline and 4 million tonnes of fuel oil, while the country imported 5 million tonnes of diesel and 6 million tonnes of jet fuel.

Overall, Britain was able to cover 83 percent of its requirements from domestic refineries in 2011. But while the country had a 37 percent surplus of gasoline above its domestic consumption, it relied on imports for 29 percent of its diesel and 45 percent of its jet fuel.

REGULATION COSTS

Purvin & Gertz were particularly critical about the impact that new regulations, mainly focused on protecting the environment, would have on refiners' survival.

To comply, UK refiners will need to make some 5.5 billion pounds in capital expenditure between 2013 and 2030, none of which will be profitable.

Of the total, 4.6 billion pounds would have zero return (costs would be passed through to the consumer but with no addition to profitability) and 900 million would actually have a negative return (costs could not even be passed through).

"No industry would bear such an investment burden for no return," Purvin & Gertz wrote in a report entitled "The role and future of the UK refining sector in the supply of petroleum products and its value to the UK economy" published in May.

"When faced with such a large mandatory capital expenditure requirement that provides no return on investment, a number of UK refiners could be forced to close UK refineries as they may not have access to adequate finance," Purvin & Gertz observed.

"Those refiners fortunate to have access to adequate finance would still be likely to conclude that operating in the UK would not provide an adequate return on investment compared to other regions and voluntarily decide to close UK and European operations," the consultants added.

UKPIA is lobbying the government to cut the costs of new

regulations, which may colour the dire warnings in its

consultants' report.

But Purvin & Gertz is one of the world's leading refining experts. The report provides the most comprehensive overview of the state of Britain's plants, and the picture it paints is not healthy.

INTO THE FIRE

Britain's refineries have an average capacity of just 210,000 barrels per day and Nelson Complexity Index of around 9.0. Nelson complexity is a measure of the sophistication of a refinery -- its ability to produce a higher share of premium products from lower quality crude by processing and upgrading them. The European Nelson average is around 7.6.

Britain's refineries are bigger and more complex than the European average but quite small and unsophisticated in comparison with the giant refineries on the U.S. Gulf Coast and in Asia, which industry sources say have Nelson Complexities in double figures.

UK refiners make a long-term average cash margin around $2.6 per barrel, according to Purvin & Gertz. Once turnaround and depreciation charges of roughly 86 cents per barrel are deducted, the operating margin is $1.84 per barrel, which is thin.

Purvin & Gertz nonetheless labels them "core refineries": not hugely profitable but ones the consultants expect to survive in the long-term and will still be needed to keep European and global markets adequately supplied.

But the industry is commercially fragile. Purvin & Gertz conclude the discounted return on capital could be as low as 2-3 percent.

Purvin & Gertz doubt whether the financing can be found to invest 5.5 billion pounds in environmental upgrades to meet a long list of UK, EU and global regulatory requirements, as well as 1.5-2.0 billion in commercial upgrades, over the next two decades, when profitability is so poor.

Among other items, refiners must invest heavily to meet new low-sulphur standards for marine bunker fuel (MARPOL Annex VI), increased compulsory stockholding obligations (CSO), and new safety standards for tank farms.

REFINERIES AT RISK

European refining needs further rationalisation. Based on their throughput and complexity, Purvin & Gertz argue Britain's refineries could all survive. Most of the European refineries that have closed so far have been smaller and less complex than Britain's remaining seven units.

Provided UK refineries are not subject to greater environmental and regulatory requirements than their counterparts in Europe and the rest of the world, they might all survive.

But given the intensifying regulatory pressures within the EU, Purvin & Gertz thinks at least one and perhaps two will close.

Closures would worsen the country's dependence on imported diesel and jet fuel. But by eliminating the gasoline surplus, they would raise domestic gasoline prices and strengthen the financial position of those refineries which remain.

REGIONAL RIVALS

Britain's distribution system for refined products is strongly regionalised.

Southern England, which is home to only one refinery at Fawley but hosts major aviation hubs at Heathrow, Gatwick and Stansted, has a severe shortage of all products.

Scotland, where Grangemouth is located, has surplus gasoline and jet fuel but is short of heating oil and diesel.

By contrast, the Central England and Wales region, which contains the country's other five refineries -- at Milford Haven and Pembroke in Wales, Stanlow in Cheshire, and Lindsey and South Killinghome in Lincolnshire -- has a surplus of all products except diesel.

Purvin & Gertz compared UK refineries with their European counterparts, both those that remain open and those that have already closed.

In terms of size and complexity, the most marginal refinery Britain is Milford Haven because of its small capacity (just 130,000 barrrels per day) and lower-than-average Nelson complexity (just 7.0).

Grangemouth (210,000 barrels per day, 7.8 complexity) and Pembroke (210,000 barrels per day, 9.2 complexity) are the next most at risk. But both are much larger than the refineries that have closed so far, so their economies of scale give some degree of protection.

Fawley, which is the largest (246,000 bpd) and most sophisticated refinery (11.6) is the least endangered. It is also the sole source of supply in the region which is already short of the supply of all products, especially diesel and jet.

Grangemouth too is the sole source of supply in its region, Scotland. So if a refinery must shut, it is most likely to be one of the five in the Central England and Wales region, which has the most excess capacity and a surplus of gasoline, jet and heating oil.

Grangemouth's workforce has reason to be relieved after the company agreed to keep it open, but the outlook for the sector remains fragile.