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COLUMN-Facing a Kodak moment, EU oil refiners must invest or die: Kemp

John Kemp
Friday, 29 Nov 2013 | 5:55 AM ET

(John Kemp is a Reuters market analyst. The views expressed are his own)

LONDON, Nov 29 (Reuters) - There is widespread agreement on the problem facing Europe's troubled oil refining sector but no consensus about how to solve it.

Europe's refineries were mostly built between the 1950s and 1970s and geared to producing as much gasoline as possible.

The centrepiece of most refineries is a fluid catalytic cracking unit (FCCU), which cracks heavy gas oil from the atmospheric distillation column into a range of lighter products, including gasoline and diesel, using temperature and moderate pressure in the presence of a zeolite catalyst.

But regional demand for gasoline peaked in the 1990s and is now falling rapidly, while demand for middle distillates like diesel and jet fuel is still increasing.

In Britain, the crossover point came in 2006, when consumption of diesel surpassed gasoline for the first time. Britain's gasoline consumption is falling 6-7 percent every year, while demand for diesel and jet is growing 1 percent.

The result is that oil refineries have the wrong configuration and produce the wrong fuel mix.

"Our refineries are petrol-facing, if you like, and not diesel-facing, and although they compete well at the moment in Europe, the long-term trend puts them at a disadvantage," Energy Minister Michael Fallon told a parliamentary inquiry into Britain's refining industry in June.

"They are producing too much petrol, not enough high-value diesel or jet and they are less likely to compete with the refineries of the future and therefore the investment case for investing in them will probably get weaker," Fallon said to the House of Commons Energy and Climate Change Committee.

The most straightforward way to shift the fuel mix would involve adding a hydrocracking unit. Unlike an FCCU, which cracks heavy gas oil from the atmospheric distillation column, a hydrocracker cracks much heavier residuals like vacuum gas oil under tremendous pressure in the presence of hydrogen and produces mostly diesel and jet.

However, the capital cost is very high. Six inch-thick specialty steels are required to contain the intense pressure - 100-200 times atmospheric pressure - required for hydrocracking to take place efficiently.

Hydrocrackers require a source of extra hydrogen, which is expensive. In most cases, a steam methane reforming unit must be built to produce hydrogen from natural gas.

The hydrocracker will also require a sulphur recovery unit. Hydrogen reacts with any sulphur in the feedstock to produce deadly hydrogen sulphide gas which must be burned or converted to elemental sulphur to be sold.

Most refineries, struggling with low levels of profitability and relatively weak balance sheets, simply cannot afford the cost of installing major new processing units.

KODAK MOMENT

To change the gasoline/diesel output mix "you need hydrocracking technology and this is probably around 1 billion pounds per refinery", the UK Petroleum Industry Association, which represents refiners, told the Energy and Climate Change Committee. "Economically that is not really justified."

"For a refinery like Stanlow, which is the UK's second-largest refinery, it would be over 1 billion pounds and the returns would be below the cost of capital," a representative of Essar, the refinery owner, told the inquiry.

"It would have a considerable impact on our diesel and jet make and it would reduce gasoline probably below 20 percent of total output and raise diesel to about 40 percent," Essar explained. "But with the current margins we would not be able to remunerate that amount of spend."

"Refineries will keep on investing some money into de-bottlenecking ... so that you incrementally increase the diesel and jet production and reduce the gasoline," Essar said.

"We are re-lifing our refinery ... for the next 25 years and spending a lot of money. But to incrementally reduce gasoline and increase diesel and jet, the marginal environment would need to be very different before we could take the risk of spending 1 billion pounds."

Unfortunately, the mix of gasoline and diesel demand is changing faster than the refineries are adapting.

The European refining industry is facing "a Kodak digital camera moment", according to one fuel distributor. "Basically ... the demand for the core product is going away."

Kodak once dominated the market for photographic film, but was felled by the rise of digital cameras and filed for Chapter 11 bankruptcy in 2012.

That is probably putting the problem too strongly, but it is true that European refineries are doomed to a cycle of inexorable decline unless their technology is overhauled, which at the moment they cannot afford.

LEGISLATIVE BURDEN

There is fierce disagreement about why refiners are not investing more. Refiners blame the high cost of complying with new fuel standards, safety requirements and other legislative changes being imposed by the European Union and national governments, which they claim is diverting investment away from other more productive areas.

Petroineos, the owner of Scotland's Grangemouth refinery, which was briefly threatened with closure, told parliament back in June: "We have spent more than 30 million pounds ($49 million) in Scotland in the last two years putting a new unit in to meet (sulphur dioxide standards) that will not go towards growth-type projects, and what I mean by growth is addressing the petrol-diesel issue."

"UK refiners have not been able to economically modify the big investments of their refineries ... because their spend is driven to staying in business," Petroineos complained.

The company cited spending on safety improvements following the 2005 Buncefield tank farm explosion and sulphur dioxide reductions. "Legislative spending is taking up any free cash and also putting refineries into debt," it said.

Refiners complain the more stringent environmental and safety requirements being imposed in Britain and the rest of Europe put them at a competitive disadvantage compared with rivals in North America, the Middle East and Asia.

In a report commissioned by the industry, consultants Purvin and Gertz found Britain's seven refineries would need to invest a total of 5.5 billion pounds between 2013 and 2030 just to meet UK and EU legislative requirements, before any spending designed to adjust the gasoline/diesel mix.

SURVIVAL OF THE FITTEST

Refiners have successfully lobbied the European Union to conduct a "fitness check" to assess the burden on the industry of legislative changes being drafted or planned in future. But the fitness check may not help much.

The industry's real problem is overcapacity - at national, EU and global levels - which has depressed margins.

It was poor profitability that encouraged the international oil companies to sell their European refineries to smaller independents, which has exacerbated the problem because the small independents have less balance-sheet capacity to finance multi-billion dollar capital expenditure projects.

"As a small independent company, our balance sheet can't be as robust," Essar told the Energy and Climate Change Committee. "We need to have projects where banks will also support us and believe in us; that what we are doing will show the returns."

Changing fuel consumption, as well as rising competition from the super-giant refineries being built in Asia, and refineries in North America processing cheap shale oil, pose a much bigger problem for EU refineries than legislative costs, according to Andrew Owens, chief executive of Greenergy, a major fuel dealer.

Benchmarked against the rest of the world, "UK refineries are not big. They are not efficient. They are medium or small and most inefficient with a high cost base", Owens told the parliamentary committee. The same criticisms can be made of most other refineries in Europe.

"My background is refining. There is nothing I would like in the business more than to own a refinery, and I have looked at buying refineries on several occasions, but I have not found one that (can be made to) work," Owens added.

The industry's only hope is to reduce overall capacity in Europe, which would push up regional margins, especially for gasoline, and leave the remaining refineries with enough profitability to invest in new diesel units. Some must close for the rest to survive. ($1 = 0.6118 British pounds)

(Editing by Pravin Char)