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Refining: A case for higher spreads! - Views on News from Equitymaster

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Refining: A case for higher spreads!
Jan 10, 2007

While rising petroleum product prices have indeed been a cause of worry in recent times, the fact that this is not entirely crude price driven, makes us believe that they are likely to remain stronger on account of certain structural changes in the refining industry. Put otherwise, we believe that the spread between crude oil and product prices is likely to remain stronger than what it was historically. Here are a few reasons as to why we believe this would happen:

  • Clean fuels Specifications: On the back of environmental concerns, the fuel specifications are expected to change significantly over the next 5 to 10 years. The gasoline sulphur specification, which was 750 (ppm) in Latin America, is expected to decline to 300 (ppm) in 2010 and further to 100-200(ppm) by 2015 (source Reliance Industries). In Asia pacific, the same is expected to fall from 400 (ppm) to 100 (ppm). Tighter product specifications increase desulphurization requirements, which inturn leads to higher capital cost. Higher capital cost increases the desired minimum return for the investment. Also, the increased regulatory adherence restricted the investment in the distillation capacity, which failed to keep pace with rising consumption.

  • Increased global heavy, sour crude slate: As per estimates, almost 30% of the world crude reserves are light sweet, compared to 63% of light/medium sour crude. This is likely to increase the price spread between the sweet-light crude and heavy sour crude. Increased heavy crude slate will keep processing costs higher, which in turn is expected to keep the refining margins higher.

  • Vintage refining capacity in the world: Age-wise profile of the refining capacity reveals the fact that more than 70% of the world’s refining capacity is aging (more than 25 years old), thus, meeting the tighter product specification is getting increasingly difficult for these refiners. Also, as these vintage refiners are capable of refining only sweet and light crude, the spread differential is likely to increase between sweet/light crude and heavy and sour crude. The same is vindicated from the fact that difference between Arab light and heavy crude, which averaged US$ 1.6 barrels (during January 2000 to December 2005), increased to US$ 5.2 barrel in 2006.

    Composition of world refining capacity...
    Feedstock Number of refineries % of Total
    Extra heavy crude 31 4.7%
    Heavy crude 114 17.2%
    Medium crude 260 39.3%
    Light crude 135 20.4%
    Extra light crude 121 18.3%
    Total 661  

Apart from these facts, the increased demand from the Asian countries (especially for the light and middle distillates), rising green field projects costs (due to increase in the prices of steel and other commodities) are also likely to keep the refining margins on the higher end. There has been a sea change in the refining industry over the last few years driven by regulations, crude oil availability and demand dynamics. With no significant capacity coming up in the next 2-3 years, the margins are likely to be strong.

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