Refining: Understanding GRMs...

After touching historic lows in the late 1990s, the oil-refining sector has seen a significant increase in gross refining margins (GRMs) owing to two factors. One, hardening of crude prices and secondly, a favorable demand- supply equation in the global markets. As compared to GRMs in the range of US$ 1.0 to US$ 1.5 per barrel in late 1990s, GRMs crossed US$ 10 per barrel at one stage. Though margins have softened in the recent past, it is still substantially higher than the average of the last three years. Now, what is GRM? Simply put, GRMs are like the gross profit (and not EBDITA) for a steel company and it is always calculated per barrel (say, gross profit per MT for a steel company). Gross profit calculation excludes employee and administrative expenses. In this article, we analyse the composition of GRMs, how they are calculated, and how various regulatory policies in the form of protection affects the GRMs.

How are GRMs calculated?
Crude oil is the primary input cost for a refinery (90% to 95% of the total cost of refining). Refineries processes the crude oil purchased into various value-added products, which in turn are classified as light, middle and heavy distillates. A refinery tries to optimize its capacity to produce more remunerative distillates to boost margins (petrol and diesel).

GRMs (in US$ per barrel) can be defined as the difference between the costs of raw material (majorly crude) and weighted average prices of petroleum products. Given the fact that GRMs of the refining business depends on the weighted average prices of petroleum products, we need to understand the pricing mechanism of the petroleum products followed by the Indian refineries. Before deregulation, refining margins were 'administered' by the government on the basis of fixed return on capital employed (i.e. cost plus basis). However, following the dismantling of the administered pricing mechanism (APM), the refinery-gate-transfer-price (RGTP) of petroleum products was fixed on the basis of import-parity principle.

To simplify, here is a hypothetical example. Assume that a refinery processed 1 barrel of crude and derives output in the form of 28 gallon of diesel and 14 gallons of other products (say petrol and heating oil).Assuming the crude prices are US$ 65 and price of diesel (Refinery gate prices) are US$ 2.0/gallon, while the weighted average prices of other products are US$ 1.4/gallon.

Then the GRMs are = (28* 2.0 + 1.4*14) - 65

This translates into a GRM of US$ 10.6 per barrel.

How petroleum products are priced?

There are various ways to price petroleum products:

• Import parity pricing
• Export parity pricing
• Trade parity pricing

Import parity pricing is based on the principal of opportunity cost, as this pricing mechanism the mark-up of freight, insurance, ocean losses, port dues and custom duties, to the benchmark (Singapore margins). However, given the fact that country has surplus refining capacity, the pricing mechanism seems to be flawed. Recently, the government shifted from import-parity to trade-parity pricing, which is a blend of import-parity and export parity pricing (currently 80:20). Thus, import parity pricing leads to higher revenues and profits for the refineries, due to the protection enjoyed by the domestic refineries in the form of custom duties.

Given fact that every refinery can be unique (in terms of its ability to produce products and process various crude forms), the production levels can be different. Thus determination of benchmark GRMs using the weighted average production of various refineries becomes a difficult task. The benchmark Singapore margins calculation assumes a product mix of approximately 32% of gasoline (petrol), 19% of jet fuel and kerosene, 16% of diesel/gasoil, 23% of fuel oil, 3% LPG and 7% MTBE/naphtha, and Dubai crude oil as input. The prices of various products are determined on the basis of demand-supply. Thus, a refinery, which can produce more high-value products or refine various forms of crude, can post GRMs above the benchmark GRMs.

Composition of GRMs:

GRMs can be further divided into two parts:

• Core GRMs
• GRMs due to tariff protection

Core GRMs are the GRMs, which a refiner would have earned in the absence of any custom duties. GRMs due to tariff protection are the incremental profits earned due to higher domestic refinery-gate-prices (due to inclusion of custom duties in prices). Example below explains the concept in a more lucid manner.

In the Indian scenario, recently, the government reduced the custom duty on petrol and diesel from 10% to 7.5% thereby reducing the protection available to the domestic refineries. Broadly speaking, if the custom duty on crude is lower than the custom duty on products, then the protection effect is positive.

The effect of entry tax on crude: Some states in India levy entry tax on crude (for example, in Maharashtra, it is at the rate of 3%). Entry tax on crude eats into refining margins and reduces the effective protection available to the refineries. Since both HPCL and BPCL have refineries in Mumbai, they enjoy lower margins as compared to that of IOC.

To conclude, it is pertinent to understand that if refining margins are higher in the global markets, it does not necessarily translate into higher profits for Indian refiners.The level of customs duty and state-level duties (not only on crude prices but also on end-product prices) does impact margins. Also, while investing in a refining company, it is always advisable to base one's investment decision on 'normalised' GRMs (long-term averages) as opposed to temporary blips.