General refinery economics reveals no overall economic justification for a state-owned oil refinery

Introduction

Last week’s column focused on reviewing the results of Pedro Haas’ feasibility study for a state-owned oil refinery, sponsored by the Ministry Natural Resources (MoNR). Its results drove me to pronounce on Decision Rule 2, which states: the feasibility study makes clear that there is no overall economic justification for proceeding with a state owned, controlled and operated oil refinery. And, specifically one based on a required production of 100,000 barrels/day, in order to be “competitive”. In this circumstance around 80 percent of the crude input would be producing refined products for export.

Rule 2 complements Rule 1, which had earlier posited: there can be no serious economic objection to either private investors (local and/or abroad) or external National Oil Companies (NOCs) building a local refinery, which they wholly own, control and operate, provided this does not require any out-of-the ordinary state support, including domestic market protection, price accommodation, or tax expenditures.

Results

I am aware the Haas Study has still not been made public. I have not seen it. Like the general public, I have only accessed the Power Point presentation on the MoNR’s Website. Last week I did indicate however, that if or when the Study is made public and it can obtain a minimum rating of 4, on a scale of 1─10 (with 10 being the highest quality), my position would still hold. This is because the results are damning and its margin for error is therefore, huge. A similar conclusion would apply to those calling for constructing a state oil-refinery, as the leading edge of downstream local value-added.

Today’s column briefly restates the key economic concerns that make a state-owned/controlled/ operated oil refinery, an unwise use of  scarce Guyana’s resources.

Refinery economics

First, Guyana’s GDP in 2016 was only US$ 3.45 billion USD; equal to 0.01 percent of global GDP. The Study strategizes for a 100,000 barrels/day refinery for which construction costs are US$5 billion. This is about 1.6 times the current GDP. Gross national saving is about one-fifth of current GDP, which necessitates foreign borrowing to build the refinery. However, with a negative rate of internal return, along with the refinery losing half or more of the investment during the project life, this would make it highly unprofitable that investors would acquire debt in such a project, or risk equity.

The capital ratio is also too high for a state whose current budget expenditures are approximately US$1 billion and revenues US$0.9 billion. Even with large anticipated oil revenues after 2020, Guyana with its current needs, cannot afford a questionable venture, requiring such relatively large capital expenditure.

Second, as noted in my earlier review of refinery economics, refinery profit is a function of 1) the range/quality of refined products sales 2) the amount of output exported 3) the amount domestically consumed at world prices. (Recall the behaviour of world prices is a function of global demand and supply) and 4) the crude oil fed into the refinery. The last, has a cost which should be taken into account at world market prices, after allowing for specification, location, and movement costs.

Historically, these prices have been quite volatile. Exposing a small economy to large asymmetric market risks pose tremendous hazards to sustainable development and job creation. Historically also, refineries operating in the “small” economies of Asia, Africa, and Latin America have faced enormous challenges, which for the most part they have never truly conquered. Such experiences include neighbouring countries like Venezuela, Suriname and Trinidad and Tobago, with their substantial resource finds, as well as several Caribbean countries with no domestic crude output!

Third, while the Haas Study claims that construction costs for a Guyana refinery have been provided by experts, and these specifically include off-site location and other related facilities, as well as energy, hydrogen supply, water, and docking costs, worldwide experiences suggest that final prices and costs often surprise investors, largely because of the recent emphasis on regulatory requirements and changes in national environmental provisions. Therefore, the construction costs and the timing of refinery completion as suggested by Haas, should make provision for large, unforeseen upward increases!

Fourth, most, if not all refineries, operate as price-takers. They have to adapt to changes in the price of their crude feedstock as well as to the market prices for refined products. Guyana’s state refinery is projected to have a capacity of 100,000 barrels per day and therefore will clearly have to adapt to global market circumstances, rather than finding itself in a position of servicing markets over which it has enough market power to affect price formation. This price-taker condition will have two notable effects.

One of these is paving the way for exchange rate behaviour to influence significantly real refinery earnings. In a small, open economy like Guyana, this becomes an added complication, because the terms of trade effect of changes in crude input prices and refined products sales will become a major pre-occupation for managing the macroeconomy.

The second price-taker effect is that, with “given” prices for inputs and outputs, operational efficiency becomes central to refinery competitiveness and profitability. Indeed, the ratio of inputs to outputs can basically improve only through innovation; constant quality upgrading; optimization; and, efficient utilization rates. These features are hard to imagine would be commonly available for a first time Guyana oil refinery!

Fifth, every oil refinery is confronted with risks, uncertainties, and therefore a range of choices. Over the short-term, as the industry saying goes: “refineries try to juggle the choices in their crude diet and its product slate”.

But in the long run each must decide whether to invest in changing its configuration or shutting down! In making this crucial decision refinery size (and hence capacity to reap economies of scale) and refinery complexity (as discussed earlier) determine the potential profitability of the refinery.

Globally, the location of Guyana’s crude (if this is used as the chief input to the refinery) because of its offshore location, below sea-level depth, and global scarcity of relevant skills (to contend with these factors), put pressure on delivered costs to the refinery.

Conclusion

Next week I shall wrap up this discussion before briefly addressing arguments concerning the construction of a state-owned refinery as Government’s contribution to upstream value added.

 

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