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Sticking with outdated refineries makes no sense

European refineries must stop being treated as strategic assets, propped up by politicians, if they want to become profitable again.

“The oil refining sector is a strategic European asset,” according to the European Petroleum Industry Association, Europia, which lobbies in Brussels on behalf of the refiners. “The EU’s ability to meet domestic demand for refined products has important security, economic, industrial and environmental advantages,” the association insisted in a white paper on refining published in 2010.

In too many instances, however, strategic is a synonym for not very profitable. If the refining industry is to keep a toehold in Europe, there must be fewer, larger refineries, and the ones that remain will need substantial investment.

Given freedom of movement within the single market, if there is an energy-security argument for maintaining refining capacity, it should apply at EU level, not in individual nation states or sub-national regions.

If politicians are allowed to protect “their” local refinery, the necessary rationalisation of refining across the EU as a whole will be blocked. The European Commission must get tough in applying restrictions on state aid.

But given the slow pace of rationalisation so far, the Commission should go further and actively promote restructuring. If Europe’s refiners are to have a profitable future, politicians and customers will have to get used to relying on fuel refined in other member states.

Given economies of scale and international competition, it is no longer feasible for each EU member state to have its own domestic auto industry or steel works. The same, unfortunately, is now true for refining.

Following the insolvency of Europe’s largest refiner, Petroplus, early in 2012, refiners have pressed the European Commission to conduct a “fitness check” to examine the damage fuel quality and other regulations are having on the sector’s competitiveness.

In October 2012, the Commission announced that the refining sector, along with the aluminium industry, had been selected for the first two fitness checks as part of a strategy to improve EU-wide competitiveness. But the refining sector’s real problems are structural rather than regulatory. There are simply too many EU refineries and they are too small to meet the challenge from a new generation of super-refineries being built in the Middle East and Asia.

Capacity utilisation has dropped to 80 per cent or below, down from 90 per cent as recently as 2005. EU refiners produce too much gasoline, for which demand is declining, and not enough diesel and jet fuel, for which the market is growing rapidly.

They do not have enough hydrocracking capacity to strip excess sulphur from marine diesel and fuel oil to meet progressively more stringent requirements for ship fuels being phased in over the next decade by the International Maritime Organisation.

With depressed profit margins and continued doubts about their financial viability, refiners are struggling to attract the new investment and bank loans they need to install new hydrocrackers and other units that could make them more competitive.

EU officials have pinned the blame for the industry’s problems on its own past under-investment. Rather than upgrading plants to produce more diesel for domestic consumption, refiners kept producing surplus gasoline, which had to be sold overseas, and high-sulphur marine fuel oil.

Even if the outlook for margins were more positive, “there would be no guarantee that the EU refining industry would make the necessary investments to meet the shortfall in the supply of middle distillates,” the European Commission concluded in a 2010 working paper.

“Tightening fuel specifications as well as the demand focus on diesel are not new phenomena, yet the industry has been slow to adapt,” Commission staff wrote. “This is because until now, there has been a market for the excess gasoline produced by refining units in the EU, such that the industry could opt not to carry out all the investments required for more hydrocracking units to produce more middle distillates and deep conversion units such as cokers and residue cracking units to produce low-sulphur marine fuel.”

The only solution is for some refineries to close to improve the profitability of those that remain, enabling them to secure the investment essential to long-term survival. “We expect that the difficult economic environment, combined with the outlook for further legislation changes… will result in further capacity reductions in the next five years,” refinery consultants Purvin and Gertz predicted in a report for the UK Petroleum Industry Association published in May 2013.

Perhaps another five to 10 of the 87 remaining refineries in the EU and the European Free Trade Association, which together comprise the single market, need to close to put the industry on a more sustainable footing. Refiners want relief from the EU rulemaking process, which they claim is making them uncompetitive against rivals in the US and Asia. But they see no role for the Commission or member states in helping to rationalise the industry.

Refiners “explicitly recommended against any form of state intervention in the restructuring process” at the first EU Refining Roundtable with member states and the European Commission held in Brussels in 2012.

Some refineries, mostly smaller, older ones with fewer sophisticated processing units, have already closed. But the pace of capacity reduction remains too slow to realign production with changing supply-and-demand conditions in the EU and global markets.

Many refineries have been put up for sale. In most cases, however, “complete closure of refineries is not occurring due to the large and costly site remediation clean-up (costs) which owners would have to incur”, according to the Commission.

National governments and local politicians have also fought to prevent closures to protect local employment and in the misguided view that closures threaten local fuel supplies. Government grants and loan guarantees to Grangemouth refinery in Scotland are just the latest example of politicians intervening to prop up refineries that would otherwise have been deemed uneconomic and closed.

Across the EU, refineries are estimated to have 100,000 employees and contractors. Grangemouth and the associated petrochemical plant had a combined workforce of over 1,000.

But the more prominent argument for keeping refineries open is that they are essential to energy security. Grangemouth is the sole refinery in Scotland; its closure would leave the region entirely dependent on fuel brought in from other parts of Britain or overseas.

Refineries remain powerful political totems.

The International Energy Agency’s Model of Short-Term Energy Security suggests relying on imports for more than 45 per cent of demand puts a country at “high risk” from disruptions. For policymakers, domestic refineries must be kept open to avoid depending too heavily on imports. But a closer inspection suggests the argument is largely without merit.

For a start, the 45 per cent threshold is arbitrary. Many countries and sub-regions already rely heavily on imports to meet a large share of their requirements for specific fuels, in some cases far more than 45 per cent.

For example, the sole refinery in southern England, Fawley, produces just 9 per cent of the jet fuel needed by the giant aviation hubs at Heathrow, Gatwick and Stansted. The rest is brought in by tanker from other parts of the UK and Europe.

The jet pipeline from Fawley, which carries a large share of imported fuel as well as the refinery’s own output, presents a far bigger risk to supply security than the closure of Grangemouth would be.

Politicians and refiners often suggest domestic refineries must remain open to avoid relying on unstable regions, such as the Middle East, or the risk shipping lanes will be blocked. But the EU already relies on the Middle East, Russia and Africa for most of its crude. The sort of crisis that could block refined product imports would leave the refiners without feedstock.

It is hard to imagine a crisis that would leave the EU physically short of refined products but not crude. More likely is disruption somewhere in the world that would drive up the price of refined fuels sharply.

Unless EU refiners were forbidden from exporting, arbitrage would ensure EU prices rose. The market for refined fuels is global. Having domestic refining capacity would not prevent prices spiking.