Glut of refining capacity has Big Oil sputtering

The industry's earnings are taking a beating as demand slows, new plants to produce petrol and other products come on line and emission fears grow.

Workers at Liaohe oilfield. China has started up a number of refineries to cater for the country's fast-rising fuel consumption.

The world's biggest oil companies should be sitting pretty right now. Oil prices doubled last year and are now at their highest level in years, aside from the unusual spike in 2008. But profits are down at many of the world's biggest oil companies compared with the chaotic fourth quarter of 2008. Why?

The oil refining divisions have become their Achilles heels as the refining industry works through a massive supply-demand mismatch. The world's capacity to process crude oil into petrol, diesel and other fuels increased dramatically in the past two years, just as motorists and industry worldwide used less fuel as a result of the recession. Refining executives have described it as the sector's worst downturn in decades. Refineries make money on the difference between the cost of crude oil and the price they charge for petrol and other products. For months at a time last year, the margin was negative at many refineries, leading to plant shutdowns and big operating losses.

And refiners are hardly out of the woods: on Monday Total, the French oil firm that is Europe's biggest refiner, announced it would permanently close a plant in Flanders that has been idled since the start of the economic downturn. Total executives were quoted as saying they could find no market for the fuels at the plant, which processes 137,000 barrels per day (bpd) of oil and accounts for 7.2 per cent of French refining capacity.

North America and Europe shut 1.05 million bpd of processing capacity last year, and will probably close 1.32 million bpd more this year, Bank of America Merrill Lynch estimated last month. Refining income is normally the boring side of an oil company's balance sheet, taking a back seat to exploration and production, where the money is made. But as international oil companies reported their quarterly profits this week, the losses in refining have featured prominently.

ExxonMobil, the world's largest oil company and biggest refiner, saw fourth-quarter profit drop 23 per cent compared with the same period in 2008, mainly because it registered a loss of US$287 million (Dh1.05 billion) in its US refining division. Chevron, the second-biggest oil company, lost $613m in its refining, transportation and marketing business, pushing profits down 37 per cent. Both firms still registered healthy profits overall: Exxon made $6.05bn in the quarter, while Chevron took home $3.07bn.

BP yesterday reported net profits of $4.3bn compared with a loss of $3.34bn a year earlier, but warned that refining margins would "remain weak" this year. The firm did not disclose revenues for its refining division, but noted that the margin on each barrel of oil shrunk to $1.49 last quarter compared with $5.20 the year before, and "BP's actual refining margin declined even more than the indicator margin".

In the medium to long-term, the outlook for the sector is little better. A new generation of massive refineries in East Asia, India and the Middle East has already begun to flood the market with excess fuel production capacity at significantly lower cost than older facilities in North America, Europe and Japan. In India, Reliance switched on an expansion to its refinery at Jamnagar last year that made the plant the largest in the world, with capacity of 1.2 million bpd. The plant uses its economies of scale and advanced technology to achieve significantly lower costs than western rivals.

China has started up a number of refineries that can process 800,000 bpd and have a secure market in the country's fast-rising fuel consumption. The flood of new capacity will continue over the next 10 years, with China and India building additional plants and Gulf countries getting into the game with new refineries in the middle of the next decade. Abu Dhabi, for example, awarded contracts to double capacity to 817,000 bpd at its export-orientated refinery in Ruwais, while Saudi Arabia is building a number of similarly sized projects.

Operators of older plants would be advised to invest in their operations to keep up with the new refineries, says John Vautrain, a senior vice president at Purvin and Gertz, a refining consultancy. "The global market is likely to see some realignment with closures in the US, Europe and Japan creating room for some of these new volumes," he says. In the even longer term, refining is destined to remain a money-losing business in industrialised countries that become more serious about reducing carbon emissions to combat climate change.

Refineries use huge amounts of energy at nearly every step of the process and belch significant carbon emissions. Valero, the largest US refiner, has emerged as one of the biggest opponents to legislation that would cap carbon emissions and require industry to buy credits for each tonne of carbon they emit in the atmosphere. Bill Klesse, the company's chief executive, estimated the cost to US refiners of climate legislation at $67bn a year.

The International Energy Agency (IEA), a Paris-based group that represents the interests of energy-consuming nations, warned that new climate-change legislation could speed up the migration of the refining industry to developing countries. The refining industry, says David Martin, the IEA's lead downstream analyst, is "a brutally competitive, effectively global business". The long odds against the sector's future have not been lost on Big Oil. Chevron last month announced a major restructuring that will lead to a reduction in its global refining workforce, which totals 19,000.

And Total's refining chief, Michel Benezit, told Dow Jones late on Monday that the company would probably close more refineries in addition to the Flanders plant. "We can't do differently; we must keep adjusting to falling demand," he said. "There is no way to say when the refined products market will be balanced again. @Email:[e-mail]