No. 3, 2012



Russian downstream sector: problems and prospects

THE BEGINNING OF THE 21ST CENTURY SAW THE INTRODUCTION of stringent environmental rules, while requirements to new technology and motor fuel are changing with dizzying speed. The Euro-2 and Euro-3 were introduced in Europe just 4-5 years ago, yet we are now on to Euro-5, and many car manufacturers are already preparing to produce Euro-6 level vehicles. The growing numbers of aircraft passengers engender a rising demand for quality jet fuel. In other words, the development of the economies of the most advanced countries dictates the need for oil refining in greater volumes and of better quality. This applies fully to Russia, too.


Today, laws are being passed in many countries of the world to reduce harmful emissions (of hydrocarbons, sulphur dioxide, nitrogen and heavy metals), improve the quality of purification plant, and create advanced, more environment friendly technologies for crude refining. All these changes are engendering a need to build new and update existing oil refining units and produce high quality ecologically clean petroleum products.

The main problem facing refineries is to increase the output of light petroleum products and, at the same time, reduce the share of furnace oil and other such oils. Refineries in the U.S. and Western Europe have already achieved a maximum output share of light petroleum products, whereas in Russia and a number of other developing countries, this indicator stands at less than 75%. Russian refining has reserves for its further growth and deepening, which the West does not, but the other side of the coin consists in technological lag and inefficient use of the raw materials produced.

At the same time, in recent years it has been a global problem that has come to the fore: proven deposits of so-called light oil are gradually being exhausted, so heavier and more expensive crude is being drawn into refining. For the majority of refineries, this means the need to invest in construction and modernization of deep refining complexes.

If one looks carefully at current global trends in the sector's development, it may be definitively concluded that they are all heading towards a reduction in the market value of refining assets. For instance, the rise in the prices of crude cuts company profits and, as a consequence, capitalization. The demand for an increase in the output of light petroleum products entails additional investment, this also "eating away" at value. The more stringent environmental rules and regulations lay an additional financial burden on refineries, since outlays on all types of purification plant are not productive, meaning that they do not contribute to increasing output or cutting costs.

The only way out of the situation for downstream is a price rise on petroleum products proportional to the growth of production costs.

Plants are virtually compelled to lay all additional costs, including investments, on the shoulders of the consumer.

Speaking of development of the Russian downstream sector, it should be noted that the volume of crude produced in the country is still double the quantity refined. There are several reasons for this. First, the low level of industrial output in Russia, which engenders a rather small demand for petroleum products. Second, the pricing "skew" between crude and refinery products. Third, the high degree of wear and tear on fixed assets, amounting to up to 80%, as well as use of obsolete, energy-intensive, environmentally harmful and economically inefficient technologies. All this gives grounds for asserting that Russian downstream has now acquired a number of specific features that, in the main, adversely affect the market value of its refining assets.

The majority of refineries in Russia were started up in the late 1940s to the mid-1960s and, after the collapse of the USSR, Russia inherited the oldest enterprises, with a high degree of obsolescence and physical wear of fixed assets (about 80% against 60-70% in the other segments of the Russian fuel and energy complex). This sector in the Russian Federation is currently in the throes of a deep crisis, as is evidenced by the extremely low depth of oil refining, averaging 72% compared to 87-95% in developed countries. From 1999 to 2009, this indicator rose by under 4%. Only the group of Bashkiria refineries meets world standards - 86.2%. Russian refineries produce 16% of gasoline, while the respective figure in the United States is 44%; 32% fuel oil (in the USA - 5%).

According to the Energy Strategy of the Russian Federation for the period up to 2030, refining depth should rise by 2015 to 83%, and by 2030 to 89-90%. Yet it is already clear that these targets are unlikely to be reached. The key explanation is the absence of effective economic incentives to modernize production equipment. The government still has not answered the question as to whether it is feasible to invest millions of U.S. dollars in reconstructing refineries. Domestic demand for quality petroleum products is still very weak and the vehicle fleet consists 70% of locally manufactured ones. Air carriage is contracting and airlines are going under with frightening speed, since solvent demand for aircraft fuel is falling. Yet road building and repairs are proceeding at a high rate and the government allocates billions of rubles every year for these purposes, so there will always be a demand for black oil and bitumen.

Development is also held back by current export duties on light petroleum products, which do not take into consideration refining technology. The rates do not change depending on whether the exports consist of high-octane fuel produced by a modernized refinery or straight-run gasoline obtained simply by heating the crude. The current opinion is that, in the near future, refineries will more likely invest in purification systems than in refining depth, since transfer to Euro-3 fuel standard is drawing near.

It may thus be stated that the incentives to modernize refineries will not work in their present form. In fact, investments will entail a reduction in the market value of refineries, which is actively opposed by shareholders.


Western Europe can still, to a certain extent, increase the output of light petroleum products at its refineries, mainly by applying the latest production processes: catalytic cracking, hydro-cracking, catalytic reforming and alkylization. The U.S., however, has already done this and its refining industry has been operating at the maximum possible level for at least five years now, obtaining 450-500 liters of petrol from each ton of crude. The country's aggregate output of petrol reaches 380-400 million tons a year and that of diesel fuel - 205-215 million tons a year.

In the United States, secondary refining capacity accounts for 140% of primary capacity, whereas the average level in the world is 91%, and that in Russia - less than 70%. The structure of Russian refinery assets differs from that in the developed countries. At the majority of domestic refineries, the requisite secondary processes are lacking, especially isomerization, alkylization, hydro-cracking, and the latest versions of catalytic reforming.

In the Russian Federation, deep processes increasing the output of light petroleum products, account for only 20.3% (in the USA - 73.3%, Western Europe - 42.9%, Japan - 32.6%). For instance, the U.S. catalytic cracking capacity equals 35% of total refining; the Russian - 6.6%; the respective figures for hydro-cracking are 9% and 0.4%. For Russia, the main secondary refining process, apart from hydrofining, is reforming, whereas the rest of the world prefers cracking.

The Nelson ratio of Russian refineries ranges from 7.3 to 1, averaging 4.37, whereas the average global level is 6.59, the U.S. figure - 10.16 and that of Western Europe - 7.42.

Also of some significance for Russian downstream is the excessive distance between the refineries, on the one hand, and the sales markets for the petroleum products and export sea ports, on the other. The majority of this country's refineries, apart from Kirishinefteorgsyntez and the Tuapse Refinery, are located in the remote provinces, this making Russia virtually the only country in the world that produces oil on its own territory and then exports it over distances of up to 2.5-3 thousand km. All the other major oil-producing countries transport over land no more than 200-300 km. As a result, the extra petroleum product export costs for refineries in the European part of Russia amount to $20-30 a ton, while refineries in Omsk, Achinsk and Angara should pay an additional $80, this substantially cutting profits and, as a consequence, the market value of the refineries themselves.

The situation is similar with respect to the location of the plants in the country. Since relevant decisions were taken depending on the demand in a given region 40-50 years ago, some places now experience an excess of production capacities, whereas others - an acute deficit. As a result, the capacity loading of refineries differs greatly. The Volga Region and the Western Urals accommodate about 50% of oil refineries; the Central region - 18%, and Siberia - only 16%.

In the developed countries the petrochemical sector nowadays accounts for about 8% of the oil consumed. In the developing countries, this figure fluctuates between 2% and 5%, standing at less than 3% in Russia. Meanwhile, it is quite likely that, by the end of the 21st century, the petrochemical industry will be virtually the sole remaining sphere of use of oil.

Finally, Russian refineries are characterized by a high level of energy consumption, which reflects negatively on the economic efficiency of the entire sector. The last few years have seen a tendency for the fuel and thermal energy consumption rates to fall, where electricity consumption has virtually stabilized at two to three times the figures in other countries. This is connected with plants being electrically over-equipped: extensive use of electric motor pumps, electrification of the production process, construction of purification plant and so on. So the unit consumption of fuel in the catalytic cracking process is 1.6 times higher than in primary refining and, in catalytic reforming - 3.1 times.

In the future, in connection with deepening of crude refining, factors will increasingly emerge that promote a further rise in the unit consumption of fuel and energy resources. As a consequence, additional measures will need to be developed to slow down this process.

Overloading of petroleum product pipelines and railways, as well as a shortage of cisterns, impedes normal development of the sector and stable supplies of fuel to consumers and cuts refinery profitability and market value.

Petroleum product exports accounts for only 50% of the crude oil exported. Since 2000, this share has risen slightly but customs policy makes production and export of high value added output unprofitable. This ratio is irrational from the economic point of view and many of the countries' refineries are departing from this practice. The Brazilian Petrobras is, for instance, endeavoring to focus on exports of petroleum products, which are drawing close in volume to those of crude supplies.

As a matter of fact, the statistics refute the myth of a gradual reorientation of the Russian oil industry from crude exports to sale of high value added output. This is because foreign buyers consider Russian petroleum products as raw material for further refining, since they are based mostly on fuel oil. Today, Russia sells them to Western partners with a stable approximately 30% discount on the price of crude. In 2006, exports of Russian petroleum products accounted for 80% and in 2009 up to 100% of total production. Back in 2006, the Ministry of Fuel and Energy planned to cut supplies of this product to 30 million tons a year, but in fact they more than doubled. The situation may be changed by improving customs policy: as long as light petroleum products are subject to higher export duties, fuel oil will remain the chief export item.


Modernization of oil refining and the petrochemical industry will allow efficient use to be made of Russia's two main competitive advantages: its high scientific and technical potential and its rich hydrocarbon reserves. The current government policy in this sphere does not, however, encourage shareholders in refineries to invest in their reconstruction. The existing mechanisms are designed to be an incentive to an exclusively "compulsion system" for investment, which merely reduce the market value of plants, since they do not produce any tangible economic benefit in the form of significantly rising incomes or falling production costs.

In order for refinery modernization to at last gain impetus, a number of steps need to be taken.

First, to form a big solvent demand for light petroleum products through beneficial crediting of a program for utilization, increasing air carriage and stimulating development of the petrochemical industry.

Second, to develop and implements a government program for further improvement of the oil refining sector. On the basis of one of the state corporations, several refineries could be built in solvent regions where there is also a fuel shortage, thus reducing transportation constraints. In addition, to strengthen internal competition in the sector, the given facilities should operate using exclusively customer supplied materials. With the participation of Transnefteprodukt or Rosneft, new pipelines should be laid not only in the east of the country but also in other federal territories.

Third, to elaborate a fair pricing policy for petroleum products for the purpose of stimulating deep refining of crude. Having "cleansed" petrol prices of taxes, vertically integrated oil companies should at the same time be compelled to allocate the entire sum saved for reequipping refineries.

Fourth, to implement a government support program for existing refineries, at which secondary refining complexes are introduced.

Fifth, to develop an effective tax and customs tariff policy for cutting the costs of supplying raw materials to refineries, as well as for exporting finished products.

Sixth, to reduce excise on high quality, environmentally clean motor fuels.

Seventh, to strengthen the positions of the leading Russian design organizations by reorganizing the design market, particularly by introducing more stringent requirements on engineering in the Russian Federation.

Implementation of these measures would, we believe, help bring the oil refining sector out of its deep crisis, improve the structure of exports, increase tax revenues, and stimulate development of new technologies.

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