Cap on oil margins may backfire

Refinery margins jump to record highs as demand for fuel rises sharply

KARACHI:

The refining margins in the international market for oil products, especially diesel, have risen to record highs, triggering calls in Pakistan for capping the margins. But such a move could do more harm than good.

The ongoing conflict between Russia and Ukraine has not only disrupted crude oil shipments but also squeezed fuel supplies. The fact that the world is facing a shortage of refining capacity due to years of underinvestment did not help.

Roughly, 3.3 million barrels per day (bpd) of oil refining capacity has gone offline since the early 2020, primarily in the US, Europe, China, and Russia and more closures are expected in the coming quarters, such as LyondellBasell’s 268,000bpd refinery in the US, which will shut down by the end of next year.

The demand for crude oil has bounced back this year after the global economies recovered from the Covid-19 slump. But the oil products’ demand has risen even more sharply as governments around the world seek growing quantities of
refined products.

As a result, the petrol and diesel prices have risen sharply and the gross refining margins (GRM) have jumped to record highs.

The GRM, simply put, is the difference between the price of crude oil and the value of final refined products. It is what a refiner expects to make by processing a barrel of crude oil and converting it into different types of fuels.

GRM on 10ppm gasoil in the Singapore market, which is a closely followed benchmark for diesel GRM in Asia, has been trading at a premium of more than $50 a barrel over Dubai crude, data from Refinitiv shows. That’s up from $12.80 at the end of last year and just $6.10 at the end of 2020.

Refiners from around the world, as well as in Pakistan, are capitalising on the rise in GRM. Some refiners in Asia, particularly India and South Korea, have ramped up diesel production and are looking to capture export opportunities in Europe and other regions that want to replace Russian barrels.

Meanwhile, other refiners are running their plants at maximum capacity on hopes of making windfall profits after incurring massive losses in the aftermath of the pandemic.

In Pakistan, however, some quarters are calling for capping refinery margins to curtail prices at petrol pumps. This may sound good on paper but it is not economically viable.

That’s because firstly, this will amount to blatant government intervention in a sector that has already been held back due to excessive regulation. From prices to commissions, many critical aspects of the petroleum sector are determined by the government, as opposed to the market forces.

Due to the lack of a favourable policy framework and limited incentives for growth, no new major player has entered this market and the existing petroleum companies find it tough to significantly enhance and expand their capabilities.

If the government further interferes in this market in a big way, then that can have unintended, yet harmful consequences. Such a tactic will not only hurt the sentiment of the local petroleum companies but may also scare away any new, potentially foreign, investors seeking to develop a new oil refining plant. Secondly, if the government determines a ceiling for GRM, then it will also have to offer a floor or a minimum margin guarantee in return.

Policymakers likely won’t simply trim a sector’s profitability during the upcycle and leave the industry high and dry when the down-cycle arrives. There will likely be a certain amount of give and take or negotiations between the government and sector participants.

But the cash-strapped government may not be in a position to offer much, which makes capping refining margins impractical.

However, even if policymakers go in this direction, then that will only further increase the government’s interference in the market. That will make a complicated situation even more difficult, particularly in terms of the industry’s long-term prospects.

Thirdly, it is worth remembering that GRM will likely come down any way since oil refining is a highly cyclical business. When refining margins move up, they also invariably come down.

The current unusually high margins have been caused primarily by the geopolitical situation in Europe. However, there are several factors at work that can help bring down GRM soon.

This includes the arrival of monsoon season in this region, which can push down fuel demand due to the decline in travel and industrial activities.

Moreover, the increase in diesel prices all over the world may also dent consumption.

Fourthly, we must remember that the surge in margins gives Pakistani refiners an opportunity to make up for the massive losses they incurred in the recent past and build up cash reserves to fund the much-needed upgradation and
expansion projects.

During the pandemic, when oil prices crashed and fuel demand plunged, the local petroleum companies incurred billions in losses.

At that time, the industry was already reeling from the effects of the Pakistani rupee’s devaluation and the drop in furnace oil consumption.

Even at the start of this year, the refiners were facing a challenging situation and one major company had to export its furnace oil at a loss since it didn’t find any buyers at home.

However, now, the business environment has finally turned. This will put the petroleum companies in a better position to grow profits and invest in modernising their plants to deep-conversion technology so they can produce greater quantities of high-value products.

But since refining is a cyclical business, it is unclear how long the good times will last. Therefore, the policymakers should ignore suggestions of capping GRM and instead should ask refiners to use this time well by taking steps that can lift petrol and diesel production, especially since this can cut down Pakistan’s reliance on fuel imports and help reduce the burden on the country’s foreign reserves.

Besides, by enhancing and expanding their crude oil processing capacities, the refiners will be able to compete effectively on a global scale, perhaps even earn export revenues in the long run.

The writer focuses on subjects of business and economics, specialising in the energy sector

 

 

Published in The Express Tribune, July 4^th, 2022.

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