WHAT ARE THE CHALLENGES AND FUTURE PROSPECTS OF INDIAS PETROLEUM PRODUCTS REFINERIES?

Ruqayah Olowonirejuaro*

ABSTRACT: The petroleum refining industry is a vital link in the energy chain in many developing and
industrialised countries as it plays a key role in providing energy for all sectors of any economy. The structure, economic conditions, and developments in the industry are therefore important matters of national interest. In recent times, significant changes have taken place in Indias refining industry with resultant challenges. This paper seeks to evaluate the challenges faced by Indias petroleum refining industry in view of its recent performance and discuss the industrys future outlook. Pricing is identified as a most important challenge which if addressed and combined with other complementary remedies could help maximize the industrys potentials.

The author is currently an MSc candidate in Energy Studies specialising in Oil and Gas Economics at the CEPMLP, University of Dundee, UK. She has a Bachelor of Science (B.Sc Hons) Degree in Accounting from Igbinedion University, Nigeria. She is a student member of the Association of Chartered Certified Accountants (ACCA), and the Energy Institute (EI). Email: oruqayah@yahoo.com

TABLE OF CONTENTS

ABBREVIATIONS............................................................................................................iii LIST OF FIGURES............................................................................................................iv LIST OF TABLES..v 1. 2. 3. INTRODUCTION..................................................................................................1 PETROLEUM REFINING IN INDIA: AN OVERVIEW.................................2 CHALLENGES OF PETROLEUM REFINING IN INDIA.............................5 3.1 3.2 3.3 3.4 4. 5. The Need to Invest.......................................................................................6 Effect of Subsidies on Product Pricing........................................................7 Cost of Product Refining.............................................................................9 Quality of Petroleum Products....................................................................10

OPPORTUNITIES OF PETROLEUM REFINING IN INDIA.......................10 CONCLUSION......................................................................................................12

BIBLIOGRAPHY

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ABBREVIATIONS APM Bbl/d CO2 EIA LPG MMT Mtpa OGJ OMC PPAC Administered Pricing Mechanism Barrel(s) per day Carbon Dioxide Energy Information Administration Liquefied Petroleum Gas Million Metric Tonnes Million tonnes per annum Oil and Gas Journal Oil Marketing Company Petroleum Planning and Analysis Cell

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LIST OF FIGURES Figure 1 Figure 2 Figure 3 Figure 4 Domestic Crude Production and Imports in India Production and Consumption of Petroleum Products in India Crude Oil Imports Indian Basket of Crude Oil Prices (US$/barrel)

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LIST OF TABLES Table 1 Table 2 Product Prices in Neighbouring Countries (Indian Rupees/Litre) Subsidies on Petroleum Products /OMC under - recoveries

1. INTRODUCTION The oil refining industry is the cornerstone of a modern economy (Seneviratne, 2006)1. Refined Petroleum products remain fundamental to our economic life in everybodys daily life and economic activities of the nation (Wauquier and Favennec, 2001)2 ranging from domestic cooking to transportation, employment, etc. Rapid economic growth in many developing countries has led to increased demand for oil products (Tang, 1994)3. As such, the refining industry has grown rapidly in such countries whether or not there is crude oil production in the domestic scene. Asian developing nations have experienced significant growth in petroleum product demand and refinery expansion over the years (Tang, 1994). Between 1976 and 1993 for instance, oil product demand and refinery capacity expansion recorded average annual increases of 5.2% and 4.3% respectively. Though in comparison with world figures, there was in effect no change recorded for the same period, the considerable gains in the regions crude oil production in the 1970s are believed to have also facilitated refinery expansion. This trend of rising demand for petroleum products coupled with the concentration of petroleum reserves in few geographical areas as well as the difference in crude quality and environmental legislations amongst other factors pose challenges as well as opportunities for the global petroleum refining industry as a whole. The ability of Indias refining industry to meets its economic challenges will likely determine, in part, the nature of the energy challenges facing India, taking cognisance of the fact that it is a developing country with growing demands. This paper seeks to describe the recent performance of Indias petroleum refining industry, to evaluate the nature and effects of the challenges facing the industry and discuss future outlook for the industry. Sequel to this introduction, Section Two (2) will present an overview of petroleum refining in India, Section Three (3) will discuss the challenges faced
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Seneviratne, M., Practical Approach to Water Conservation for Commercial and Industrial Facilities, (Amsterdam, USA: Elsevier Ltd, 2006) pp. 330-342 2 Wauquier, J., and J. Favennec, Petroleum Refining: Refinery Operation and Management, Editions Technip, Paris (2001) 3 Tang, F.C., (1994), Analyzing the Oil Refining Industry in Developing Countries: A Comparative Study of China and India, Journal of Energy and Development, 19(2), pp. 159-178, available at http://www.osti.gov/energycitations/product.biblio.jsp?osti_id=443419 (last visited on 4th May 2010)

by the industry, Section Four (4) will discuss the potential opportunities, and Section Five (5) will give the concluding remarks. 2. PETROLEUM REFINING IN INDIA: AN OVERVIEW Indias downstream refining sector has the eighth largest refinery capacity in the world (EIA, 2009)4. Indias oil refining sector is dominated by state-owned enterprises, though the market share of private companies has increased of late (EIA, 2009). The Indian Oil Company (IOC) is the largest state-owned company, and it operates 10 of Indias 18 refineries. Reliance Industries, a private Indian firm opened Indias first privately-owned refinery in 1999, and has gained a significant market share in Indias oil sector. As of January 2008, the country had 2.26 million bbl/d of crude oil refining capacity according to the Oil and Gas Journal (OGJ)5. Reliance Industries, a privately owned petroleum company in India has the largest refining complex in the world with a capacity of 1.24 million barrels per day (bbl/d) the Jamnagar refinery. India plans to add 1.6 million bbl/d of refining capacity through 2015 based on current proposed projects. Anticipated high demand for petroleum products in the region makes further investments in Indias refining sector likely. India is steadily emerging as an international destination for oil refining with investment requirements lesser by 25% to 50% compared to its Asian counterparts6. Being the fifth biggest nation in the world in terms of refining capacity, it enjoys 3% of international capacity share and is expected to enhance its refining competence by 45% in the next 5 years according to Deutsche Banks analysis7. In a bid to make their presence felt strongly in the global market, Indian petroleum firms are also considering increasing their refining capacity from the existing 149 Million tonnes per annum (mtpa) to 243 mtpa by 2011 and 2012. India is a net importer of crude oil. Figure 1 below shows the domestic crude production and imports in India.

4 5

EIA (2009): Factsheets, available at www.eia.doe.gov (last visited on 2nd May 2010) Lewis, E., Indias Refining Prospects Linked to Economic Growth, Oil and Gas Journal, 94(24) (1996) pp. 4353 6 India petroleum industry: India as an International Refining Destination, at http://business.mapsofindia.com/india-petroleum-industry/ (last visited on 17th April 2010) 7 Supra note 1

Figure 1: Domestic Crude Production and Imports in India

Source: Petroleum & Natural Gas Statistics, Petroleum Planning & Analysis Cell (PPAC). Figure 1 shows a wide disparity between domestic production and imports, an indication of a high degree of crude import dependence over the years. Being a largely import dependent nation, is a challenge for Indias refining industry in a number of ways. First, this trend makes it more vulnerable to international crude price shocks. Next, depending on the sources of crude imports, quality issues arise. Coping with domestic demand increases with petroleum products heavily subsidized, is another. However, Indias strategic location in a major maritime route from Middle East to Far East (Sarangi, 2009) gives it a geographical advantage to serve western and eastern markets and as transit landfall for Middle East crude. Figure 2 below shows Indias production and consumption of petroleum products over the period 1990 - 2009

Figure 2: Production and Consumption of Petroleum Products in India

Source: U.S. Energy Information Administration

A steady increase in oil consumption as against a quite stable production level is evident in the above diagram. Though other factors such as increase in population may be responsible in part for this significant increase, the role of the governments pricing policy cannot be undermined. The retail prices cut for instance in December 2008 and January 2009 by about 12% for diesel and over 20% for gasoline following the 15% price increase in the first half of 2008 all in a bid to stimulate the domestic economy which depicts the practicality of the governments pricing policy.

Finally, it is worthy to take a look at the sources of crude oil imports to India. Figure 3 below shows Indias crude oil imports from other countries. A large percentage of Indias oil imports are sourced from the Middle East whose crude quality is sour.

Figure 3: Crude oil Imports

Source: World Trade Atlas 3. CHALLENGES OF PETROLEUM REFINING IN INDIA

Key changes faced by the refining industry have come with challenges alongside. First is the increase in demand for light petroleum products gasoline, diesel, jet fuel and kerosene. Regulations on product specifications are also stricter (Zhang 2008)8. Specifications on sulphur, aroma and olefin for gasoline, and sulphur, cetane number and poly-aroma for diesel are strengthening. The implications for the future being the tightening of the supply - demand balance for high quality gasoline and diesel, with the situation for diesel being more serious as its demand is almost double that of gasoline. Studies by Zhang (2008) of the changes and challenges of Asias refining industry revealed that sharp increases in demand for light petroleum products as a result of advances in the transport sector has been recorded over the years. He identified limited proved oil reserves alongside increasing demand as drivers of increase in volume of the regions oil imports 9.

8 9

Zhang, Y., An Analysis of Asias Petroleum Refining Industry: Changes and Challenges, IEEJ, February, 2008 Supra note 5

Tightening regulations on petroleum product specifications and dependency on oil supplies from the Middle East are challenges peculiar to the regions refining industry. Furthermore, as part of Indias 11th Five Year Plan from 2007 to 2012 (EIA, 2009)10, the government aspires to promote India as a competitive refining destination, and industry experts postulate that the country would be a significant exporter of refined products to Asia in the near future. However, the lingering challenge in this regard will be obtaining secure supply of crude oil for its refineries considering the fact that it is highly dependent on crude oil imports mainly from a particular region. The resultant challenges from these major changes would be discussed in more details in the following subsections: 3.1 The Need to Invest The need to invest in capacity expansion for the future in India is important considering expected demand increase and current capacity utilisation at about 90%. Indias refining capacity based on Institute of Electrical Engineers of Japan (IEEJ) report is expected to increase to 4472 thousand bbl/d in 2015. There is also need to invest in all-inclusive approaches like the DuPont acid plant to equip refineries with a twofold capability to process acid gas and sulphuric acid regeneration which would enable maximizing a refinerys sulphur recovery unit capability, emissions reduction, and direct manpower and capital towards hydrocarbon processing projects (Ye, 2006)11. As put forward by Pirog (2007), technological investments can improve refinery economics by allowing refiners to use cheaper heavy, sour, crude oils as inputs and still produce a light, high value mix of products. He further stresses that investments must be undertaken to keep both the refinery site and the products it produces in compliance with evolving environmental standards. The relationships between crude oil quality, product price mix, and technological improvement make capital investment management important to the refining industry as well.

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Supra note 1 Ye, E., Alternative Sulphur Management Solutions to Help Refiners Meet Clean Fuel and Environmental Challenges, Presented at The Sulphur Institutes Tenth Biennial, International Sulphur Market Symposium, 4-6 April, 2006, Beijing, China.

In refining, there are several competing demands for investment funds and capacity expansion is necessary to keep pace with growing demand. The siting of a new refinery is a long and expensive process. These thus present a challenge for investing in refinery building / capacity expansion. As a result, most capacity expansion projects of late have been in the form of enhancing and modifying existing refineries (Pirog, 2007)12. Finally, Refining projects in India being assessed by international investors the same way comparable projects elsewhere in the world are assessed that is, based on their expectations about returns on investment (Lewis, 1996). Investment decisions in Indias refining sector must therefore carefully weigh market fundamentals, the business environment, and likely investment performance. Refiners now must earn market rates of return for investors, as well as returns sufficient to make investments in expansion, technological improvements, possible business restructuring, and to meet environmental regulations, both with respect to refined product specifications and refinery site operations and expansion. 3.2 Effect of Subsidies on Product Pricing The process of price and market liberalisation is another issue to be addressed. Petroleum products prices in India like in many developing countries are controlled through subsidies. Petroleum product prices in India were regulated through the Administered Pricing Mechanism (APM) (Chandra, 2010)13. From 2002, the Indian government introduced measures designed to deregulate the downstream oil sector. This enabled private refiners to directly trade petroleum products to customers. The APM operated such that refineries, Oil Marketing Companies (OMCs) and pipelines were assured a 12% post tax return on net worth and were reimbursed for operating costs. A self balancing oil pool account was used to balance prices of petroleum products as well as to protect customers from volatility in international crude prices. The oil pool account however ran into deficit whenever domestic prices were not raised in line with prolonged international crude price increases. The assured 12% post tax return however did not promote efficiency, or the most efficient investment decisions.
12

Pirog, R., Petroleum Refining: Economic Performance and Challenges for the Future, Congressional Research Service Report for Congress, March, 2007. 13 Chandra, A., Oil and Gas Scenario in India, RITES Journal, available at http://www.rites.com/rites-journal2010/PDF/Apurva%20Chandra.pdf (2010) (last visited on 18th April 2010)

The Administered Price Mechanism (APM) on petroleum products was gradually removed and replaced by the new Market Determined Price Mechanism (MDPM) which is hypothetically benchmarked to international oil prices. However, diesel, Liquefied Petroleum Gas (LPG), and kerosene which still remained heavily subsidized undermined this new pricing policy. The result being a significant rise in demand for petroleum products, particularly diesel whose price is much lower than other fuels. These were back drops of the mechanism which led to its gradual and eventual withdrawal in 2002 after which for a while, domestic prices of diesel and gasoline moved together with international crude prices. This encouraged entry of private companies to set up retail outlets in the market. However, this was short-lived as continuous crude price increases since 2005 led government to decide the prices of petroleum products in a bid to protect consumers from the international price shocks. Under-recoveries by OMCs are compensated through Oil Bonds and crude price discounts from state-owned upstream oil companies. These are however not extended to the private investors. The consequence of the price controls being that private companies are unable to sustain operations when international crude prices are very high thus having to shut down their retail operations, and those who have restarted have no confidence to invest in capacity expansion or upgrade their operations as crude price increases could render them unprofitable since they have no protection from international crude price changes. Figure 4 below shows the Indian Basket of Crude Oil in dollar per barrel from 2002 when the APM was dropped, to 2009. Figure 4: Indian Basket of Crude Oil Prices (US$ / barrel)

Source: PPAC
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Petroleum product prices are also dependent upon and vary with taxation (Chandra, 2010)14. Government tries to reduce taxes during periods of crude price increases to protect consumers from the effects of ad-valorem taxation. Average taxation levels are 49% on gasoline, and 25% on diesel. Kerosene and LPG prices have remained the same for a long period. Table 1 below presents petroleum product prices in India and neighbouring countries whose per capita income is much lower than what obtains in India. Kerosene and LPG prices in India are substantially lower than their prices in these neighbouring countries.

Table 1: Product Prices in Neighbouring Countries (Indian Rupees/Litre) India Petrol Diesel Kerosene LPG
(Per 14.2 Kg Cylinder)

Pakistan 35.13 36.93 32.99

Bangladesh 50.91 30.27 30.28

Nepal 48.15 34.17 34.17

44.63 32.87 9.22

281.2

520.0

547.06

698.94

Source: PPAC

Table 2: Subsidies on Petroleum Products / OMC Under-recoveries 2004-05

2005-06 14,384 10,246 2,723 12,647 40,000

2006-07 17,883 10,701 2,027 18,776 49,387

2007-08 19,102 15,523 7,332 35,166 77,123

2008-09 28,225 17,600 5,181 52,286 103,292

2009-10 16,773 11.886 3,763 5,164 37,586

9,480 8,362 150 2,154 20,146

Petrol Diesel Total

Source: PPAC, Ministry of Petroleum & Natural Gas

3.3 Cost of Product Refining The cost of refining petroleum products is of concern, as can be seen from data presented in earlier sections. Indias oil consumption exceeds what is available or produced locally and this is a pointer to the fact that in order to maintain the same level of consumption, it has to resort to imports which have got their cost implications. Historically, refining has been
14

Ibid.

significantly less profitable than other segments of the petroleum industry. As such, refiners have had to be careful to control costs to make a profit (Mohamed, A. L., et al, 2010)15. In some countries, refineries are not productively utilized. Since refineries make low profits, investors may not be willing to engage in competition. This affects both investments in infrastructure as well as in refinery capacity expansion. Government controlled low prices also cause another problem (Zhang, 2008). This is because in order to sell refined petroleum products at a better price, national oil companies tend to export as much as they can, and this can cause supply shortage on the domestic market 16. Though, to combat this, the government has issued emergent policies such as imposing export taxes to limit export, the situation depicts pricing not being reflective of the true cost of product refining. It is a further indication that the prevalent pricing need be addressed. The supply and demand balance therefore shows random fluctuations which inhibits the markets ability to represent fundamental demand and supply. 3.4 Quality of Petroleum Products The quality of petroleum products is also of concern. In line with climate change objectives and environmental legislations, every country is to cut down its Carbon dioxide (CO2) emissions and make fossil fuels more environment-friendly. The quality of crude oil imports to India mainly sour is a challenge as a result of the stringent product quality requirements currently in place. A reorientation of consumption towards light fractions, or installation of hydro cracking plants for heavy fractions17 (Raimbult, 1992) is thus required. 4. OPPORTUNITIES OF PETROLEUM REFINING IN INDIA There are ample opportunities abounding in Indias petroleum refining industry. The creation of additional refining capacity during the near future of 110 million tonnes per annum will require an investment of over US$22billion18. This will cause a remarkable growth in the refinery sector, transfer of technologies and export of capital goods etc., to India. It is

15

Mohamed, A., L., Refinery Economics in Fundamentals of Petroleum Refining, (Fahim, M. A., Al-Sahhaf, T. A. and A. Elkilani eds., Amsterdam, USA: Elsevier Science,2010) pp. 403 - 421 16 Zhang, Y., An Analysis of Asias Petroleum Refining Industry: Changes and Challenges, IEEJ, February 2008 17 Raimbault, C., Refining Situation in India, Rev. Inst. Fr. Pet.; (France), 39(5) (1992) 18 India's Spectacular Story in Petroleum Refining, Opportunities and Indias Advantage, available at http://www.managementparadise.com/forums/archive/index.php/t-25582.html (last visited on 9th May 2010)

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designed that the technologies will be for upgrading the bottom of the barrel and to meet the pressing demand for middle distillates which will improve the quality of petroleum products to make them globally competitive and environment-friendly. The strategy behind the new capacity addition is to locate the new refineries on the coasts while the main centres of demand for the petroleum products are in the inland locations, particularly in North/North-West regions. This leaves India with the opportunities of building inland refineries. The government also allowed the existing refineries forward integration in the fields of petrochemicals etc., for better value addition, which opens up another area for investment19. India also is adopting strict measures that will increase the quality of fuels which will make them environment friendly. These measures include phasing out lead, reducing benzene in gasoline, cetane improvement of diesel and sulphur reduction. Although the up gradation of fuels will require huge investments of about US$2.5billion, it has added advantages considering that refinery operating cost are low. This will make Indias refineries to be economically attractive for the domestic markets as well as for exports. Government promotion of joint sector and private sector participation could also potentially lead to growth in the refining industry.

5. CONCLUSION The challenges mentioned above leave much uncertainty towards the optimization of Indias refining Industry. The pricing regime in particular needs to be addressed not because it is the only solution to the several challenges faced by petroleum refiners, but because it appears to be the most weighty with multifarious effects. The existing low petroleum prices in India are gravely affecting the investment returns and profitability of the national oil companies which invariably restrain investment to broaden and optimize refining capacity. A consequence of which is the supply-demand imbalance. In most instances, prices are set far below what prevails in the global crude oil market. Therefore, prices appeared to be inconsequential in the pattern of demand for oil products in India. These capped fuel prices also make financial losses inherent in the domestic market for private refiners who unlike the state-owned retailers have no support from government. An
19

Ibid.

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indication that the right pricing signals are not sent to consumers and that governments pricing policy in practice has been a huge influence on the demand for petroleum products in India. Therefore, it is recommended that the government regulated pricing policy should be gradually reduced and eventually eliminated within the shortest time possible. In addition to this, should come a host of complementary remedies, such as encouraging energy conservation; further building regional cooperation, streamlining market supply and demand, etc. If this broad array of policy considerations is implemented, Indias refining industry could be healthy enough and well able to maximize its potentials.

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BIBLIOGRAPHY SECONDARY SOURCES JOURNALS, ARTICLES AND REPORTS Lewis, E., Indias Refining Prospects Linked to Economic Growth, Oil and Gas Journal, 94(24) (1996)

Mohamed, A. L., Refinery Economics, in Fundamentals of Petroleum Refining (Fahim, M. A., Al-Sahhaf, T. A. and A. Elkilani eds., Amsterdam, USA: Elsevier Science, 2010)

Pirog, R., Petroleum Refining: Economic Performance and Challenges for the Future, Congressional Research Service Report for Congress, (2007) Raimbault, C., Refining Situation in India, Rev. Inst. Fr. Pet; (France), 39(5) (1992) Seneviratne, M., Practical Approach to Water Conservation for Commercial and Industrial Facilities, (Amsterdam, USA: Elsevier Science, 2007) Wauquier, J. and J. Favennec, Petroleum Refining: Refinery Operation and Management, Editions Technip, Paris (2001)

Ye, E., Alternative Sulphur Management Solutions to Help Refiners Meet Clean Fuel and Environmental Challenges, Presented at The Sulphur Institutes Tenth Biennial, International Sulphur Market Symposium, 4-6 April, 2006, Beijing, China. Zhang, Y., An Analysis of Asias Petroleum Refining Industry: Changes and Challenges IEEJ, February, 2008

OTHERS INTERNET SITES Chandra, A., Oil and Gas Scenario in India, RITES Journal, (2010) available at http://www.rites.com/rites-journal-2010/PDF/Apurva%20Chandra.pdf (last visited on 18th April 2010) EIA (2009): Factsheets, available at www.eia.doe.gov (last visited on 2nd May 2010)

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India's Spectacular Story in Petroleum Refining, Opportunities and Indias Advantage, at http://www.managementparadise.com/forums/archive/index.php/t-25582.html (last visited on 9th May 2010) India petroleum industry: India as an International Refining Destination, available at http://business.mapsofindia.com/india-petroleum-industry/ (last visited on 17th April 2010)

Tang, F.C., Analyzing the Oil Refining Industry in Developing Countries: A Comparative Study of China and India, Journal of Energy and Development, 19(2), (2010) available at http://www.osti.gov/energycitations/product.biblio.jsp?osti_id=443419 (last visited on 4th May 2010)

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