Refining industry worldwide is performing well over the the past few years, which could be attributed to production disruptions due to natural calamities, lower spare capacity worldwide in addition to the growing demand for petroleum products worldwide. All these factors have resulted in refining companies earning significantly high (gross refining margins) and thereby, reporting higher profits. In this article, we take a look at the Indian refining sector through Michael Porter's model of competitive forces.
Barriers to entry: We believe that barriers to entry are high for the industry. Following are factors that vindicate this view.
1. Economies of scale: As far the sector dynamics goes, scale of operations does matter. Benefits from economies of scale are derived in the form of better bargaining power when it comes to sourcing of raw materials, ability to use various crude products for a given output and selling the end product to the consumers. Refining is highly capital intensive in nature (Reliance is setting up a 29.4 MMT refinery in India for a sum of Rs 270 bn or Rs 9,200 m per MT). While the cost of this refinery is lower than industry standards, this is the benefit of a larger size complex refinery.
In addition to the refining capacity, companies should have presence on the marketing side as well so as to capture marketing margins (in a completely de-regulated environment). Though the current government policy is unfavorable towards the marketing companies (which are forced to subsidise the customers on behalf of the government), globally, companies with presence in refining and marketing are able to increase/decrease prices driven purely by business environment. Even in the high crude price scenario like what we are witnessing currently, global integrated players are making profits. In India, currently, IOC, HPCL, BPCL, ONGC and RIL account for a lion's share of the industry's refining capacity. In this sense, the sector is fairly consolidated.
2. Capital requirement: As mentioned earlier, refining is a capital-intensive business. The costs associated with establishing a refining is in the vicinity of Rs 9,000 m to Rs 10,000 m per MT (depending on the complexity of the refinery). Also, a presence on the marketing front requires investments worth Rs 2 bn as per government regulations. Further, to establish retail outlets, it costs roughly Rs 15 m to Rs 20 m per outlet (depending upon the location). Even if one has the capital to set up the marketing network, , space is unavailable in many larger cities (another entry barrier). Also, integrated players need to shell out money in building pipeline facility, which costs around Rs 15 m per kilometer.
3. Government policy: Considering the current policy environment, perhaps, this is 'the' major entry barrier for companies (especially those with a marketing network plan). The government plays an active and integral role in policy determination, especially when it comes to pricing of petroleum products. Even though the energy sector was supposed to have been deregulated in April 2002, much has been on paper with very little implementation. Thus, regulations act as deterrent to new entrants.
Bargaining power of buyers: Currently high due to the government policy (indirectly). As far as the sale of refined products is concerned, either the refineries sells it directly (to the industrial sector and marketing companies) or through their own distribution networks. Exports are also an opportunity.
As far as the industrial sector is concerned, the bargaining power of refineries is less. This is because prices in this segment are internationally benchmarked (the sector is de-regulated at the refinery gate level).
As far as the revenues from the marketing network are concerned, currently, diesel, petrol, LPG and kerosene are subsidised. Government decides the pricing of these products and therefore, the bargaining power of consumers is high (indirectly, owing to the vote bank). Subsidised products account for 70% of total industry sales. As far as exports are concerned, margins are lower.
Bargaining power of suppliers: High. The major raw material for the sector is crude oil (90% of total cost), prices of which are determined by global demand-supply factors (OPEChas a major say in determining global crude prices). Since India imports 70% of its total crude requirement, that too largely Brent crude, bargaining power is close to 'nil' (unless there are specific government-to-government arrangements).
Competition: Moderate in refining. Currently, demand outpaces supply, which can be seen from higher capacity utilization across the board. The balance is in favor of producers. Competition is high on the marketing front.
Threat of Substitutes: Moderate to low. Though much has been talked about bio-fuels and fuel cell-based technologies, these are still not a meaningful threat to petroleum products, especially petrol and diesel. At the same time, higher natural gas finds (in India and liquefied natural gas transported from Middle East) is threatening the demand for naphtha and furnace oil in India (the substitution effect has been significant in the past three years).
Viewing all the aforesaid factors in conjunction with the global scenario, we believe that refining margins are likely to be higher going forward. That said, considering the capacity expansion in India in the next five years, supply is likely to far outpace demand, thus forcing players to depend on exports to maintain capacity utilisation at optimum level (some of the expansions are dedicated for exports). On the other hand, growth prospects of marketing companies are bleak, based on the current government policy regime.