Russian Downstream – Riding Through The Storm. Developing Future Strategies In Uncertain Times

After being announced in the 2020 OPEC+ deal, Russia, along with other countries, re-evaluated their capital expenditure in E&P. The major global investment cut announced totalled more than $32 billion. This included Russian NOCs – Rosneft and Gazprom neft.

During the pandemic, experts forecasted Urals oil price to be around the $20-30 /barrel mark – and this till the end of the year. They also predicted that oil demand would slowly start to recover during the 4th quarter of 2020 - but it seems that the real situation is more optimistic.

Upstream economics are getting stronger: netbacks are close to pre-crisis levels, climbing to over $11 /barrel. The Downstream sector has resisted the peak of the crisis – many refineries reduced production during spring, but have since been operating at normal capacities, generating margin, despite quite negative predictions.

Petrochemical companies have experienced some disruption, notably in methanol production, price levels affecting business activity and forcing a number of projects to be put on hold. At the same time, fertilizer producers have been riding the wave of a price surge of carbamide, etc., and being the only sector to declare profitability during these ‘hard times’.

These are some of the principal reasons why Russian IOCs companies are looking into diversifying their downstream activities – decreasing O&G reserves and lower production, export and tax policy, attractive examples of large refining/petrochemical clusters operating in the Middle East and Asia, supplying high-margin products, fast-growing demand for plastics and other chemical products globally.

Pic. 1 – General overview

In 2019 Russia had over 80 refineries operating – with a total capacity of 327 mtpa – half of them being small refineries (‘pots’). Since 2000 about 60% of existing mini-refineries have been closed, and current tax manoeuver has forced more plants with insufficient levels of deep conversion to disappear.

Only a few refineries can be considered large on a global scale – about 16 plants with primary distillation capacity over 9 mtpa, most of these belong to IOCs and were constructed in Soviet times and have been continuously modernized. Generally speaking, this has led to a more monopolistic market in refining than E&P in Russia.

Completion of the tax manoeuver led to an increase in state budget revenues - over 3 trillion rubles over the next 5 years. What was the effect on companies? Completion of the tax manoeuvre means a transition from "indirect" to "direct" budget subsidizing of refineries and end-users.

Is the modernization completed? Investments have been declining since 2015

Pic.2 Refining CAPEX in Russia (billion rubles)

The cost to modernise refineries to process high sulphur oils is 15-20% more in terms of capital investment when compared to plants processing oils with a sulphur content of up to 1.8% wt.

Depending on the initial level of the company and complexity of the implemented scheme, it is estimated at $50 to $120 per ton of processed feedstock.

Plans for modernization of oil refining facilities in 2018-2027 - 50 units:

• Revamps of existing assets
• Grassroot units
• Primarily for producing motor gasoline and diesel fuel components (85% of projects) & processing of residues

The bill introducing the investment coefficient for oil refining companies has been submitted to the State Duma for consideration. Earlier the document was considered and supported by the Russian government.

According to the text:

• recipients of investment coefficient of 1.3 to the rate of the reverse excise tax on oil raw materials will be companies, which signed an agreement on modernization of their capacities with the Ministry of Energy of the Russian Federation before July 1, 2021.
• As an "input barrier" the capacity for raw materials processing "in the amount of more than 600 thousand tons", starting from 2017, has been set.
• Equally important, the total investment in the refinery modernization from January 1, 2019 to any date after January 1, 2023 should be at least RUB 30 billion; or at least RUB 50 billion in the period from January 1, 2020 to December 31, 2026.
• Revamped units are taken into account. Thus, refineries operating in the Russian Federation, which systematically upgrade their facilities in order to increase the production of motor fuel and other marginal oil products, will be able to qualify for the investment coefficient.
• The volume ratio of motor gasoline (class 5) produced to the total oil volume processed shall be not less than 0.1 each year.

According to the preliminary calculations of the Ministry of Finance, the total amount of refinery compensation may be 47.1 billion rubles by 2025.

At the same time, new incentives for oil refining are expected to increase investment in the industry and increase the output of light oil products to 75-80% by 2025, today the average level is about 70+%.

After the implementation of the bill on the investment coefficient, investments in secondary processes of oil refining are expected to exceed 1 trillion rubles.

Internal rate of return of typical projects:

Pic.3 - IRR of new units in Russia, % (without support of vs. with investment coefficient)

Profitability of Russian refineries operation:

• No domestic market premiums
• Subsidies are needed for export-oriented refineries

Analysis of the refinery margin in the western part of Russia in 2018 showed that there is a significant logistic lag when compared to a refinery in Rotterdam, which was compensated by a customs subsidy and allowed to receive up to $50/t vs. $40 /t - the margin of the European refinery located in Rotterdam.

According to the Argus scenarios, in 2020 the margin of Russian refineries may amount to $50/t vs:

• Fact of Q1 2020 +$28 ($30 /t on average in 2019)
• Optimistic scenario +$7 /t
• Base -$3 /t
• Crisis scenario -$6 /t

Product sales margins - gasoline retail was "damaged"

Petrol stations in 2017-2018 earned a minimum of AI-92 gasoline, but in 2019, due to the preservation of the "freeze in prices" in retail and the decline in exchange prices, the margin of retail sales increased sharply.

In the first half of 2020, the margin in retail sales was kept at an increased level, but already in June, it became negative. Diesel fuel sales were traditionally characterized by an increased margin. However, we are seeing a shift away from diesel fuel to other options in Europe, e.g. Hybrid and EV’s and this will impact those Refineries who export Diesel from Russia.

In 2019, due to a marked increase in retail prices and a drop in wholesale prices (net of excise tax), the margin more than doubled. In January-May, a record high margin for diesel fuel was recorded. According to the government plans, gasoline and diesel prices will be balanced and kept at the same level in 2020.

Conclusion

It will be necessary for Russian O&G Companies to reevaluate future development strategies in this changing environment. We are seeing now more focus on renewables and sustainable solutions for Petrochemicals. Russian O&G companies will also have to consider this if they are to maintain access to the export markets.

Some of the key challenges and opportunities will be related to:

• Energy Transition - Renewables
• Biofuels development
• Refining Petrochemicals Integration
• Circular Economy- Plastics recycling
• Gas to Chemicals