Refinery Projects Outlook 2012: Cracking times for Eastern markets

Gaurav Sharma 29/02/2012

Refineries are key components of the petroleum products supply chain with 10 per cent of the average price of retailed distillates being attributed to refining costs. However, given the wider macroeconomic climate, refinery infrastructure investment continues to face severe challenges in developed jurisdictions and Western markets. Concurrently, the balance of power in this subsector of the oil & gas infrastructure market is rapidly tipping in favour of the East. Even if refinery investment of state-owned Chinese oil & gas behemoths, which rarely approach the debt markets, is ignored there is a palpable drive in emerging economies elsewhere in favour of refinery investment as they do not have to contend with overcapacity issues hounding the EU and North America.

Refineries project finance valuation 2005-2011 Infrastructure Journal 2012

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For some it is a needs-based investment; for others it makes geopolitical sense as their Western peers holdback on investing in this subsector. The need for refined products is often seen superseding concerns about low refining margins, especially in the Indian subcontinent and Asia Pacific. IJ data, empirical, anecdotal evidence and direct feedback from industry participants do not fundamentally alter our view of tough times ahead for refinery infrastructure. As cracking crude oil remains a strategic business, investing in refinery infrastructure reflects this sentiment, investor appetite and financiers' attitudes. Examining project data: Its not all rosy (or cosy) According to IJs current data series which commenced in 2005, investment in refinery infrastructure via private or semi-private financing continues to remain muted; a trend which began in 2008. In fact, 2011 has been the most wretched year since our journal began recording refinery project finance data.

Number of refinery project finance transactions 2005-2011 Infrastructure Journal 2012

Updated figures suggest the year 2010, which saw the artificial fillip of Saudi Arabias mega Jubail refinery project (valued at US$14.04 billion) reach financial close, has been the best year so far for refinery project finance valuation despite closing a mere two projects. However, industry pragmatists would look at 2008 which saw ten projects valued at US$9.39 billion as a much better year.

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From there on it has been a tale of post global financial crisis woes with the market struggling to show any semblance of a recovery and most of the growth coming from non-OECD jurisdictions. In 2009, three projects valued at US$4.79 billion reached financial close, followed by two projects including Jubail valued at US$15.04 billion in 2010, and another two projects valued at US$1.49 billion in 2011. By contrast, the pre-crisis years of 2005, 2006 and 2007 averaged US$6.71 billion in terms of transaction valuations.

Top five refinery project finance transactions 2005-2011 (Source: Infrastructure Journal 2012)

A general market trend in favour of non-OECD project finance investment in refineries is obviously mirrored in the table of the top deals between 2005 and 2011 (above). Of the five, four are in non-OECD countries led by Jubail Refinery (Saudi Arabia) valued at US$14.04 billion which closed in 2010, followed by Guru Gobind Singh Bhatinda Refinery, India (valued at US$4.69 billion, financial close 2007), Jamnagar 2 Refinery, India (US$4.50 billion, financial close 2006) and Paradip refinery, India (US$2.99 billion, financial close 2009). Only one deal from an OECD nation, which is a very recent member of the club, made it to the top five, namely Polands Grupa Lotos Gdansk Refinery Expansion valued at US$2.85 billion which reached financial close in 2008. Switching from project finance to corporate finance for refinery projects does not make the investment scenario any better. In fact, the situation gets worse as the corporate finance market unlike the project finance market is or rather was heavily reliant on transactions in North America and Europe which have steadily declined. The year 2008, saw refinery projects corporate finance valuation at US$3.09 billion followed by a valuation of US$3.49 billion in 2009. The bulk of the investment over both years went towards corporate financed refinery (and ancillary) asset acquisitions. While not particularly healthy, the market performance for both years was acceptable to say the least something which cannot be attributed to the two years that followed. In 2010, corporate finance valuation came in over a third lower on an annualised basis at US$963 million followed by a massive dip to US$325 million in 2011; the latter being on the back of a solitary refinancing deal in the US the Western Refining Refinancing which reached financial close in March 2011. Western capacity non utilisation and crude margins What haunts European and North American refinery project financiers, and has done so for a while now, barring a brief period between 2005 and 2007, is refining overcapacity and uncertain margins. Starting with the former, oil giant BPs 2011 Statistical Review of World

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Energy confirms that 2010 saw non-OECD countries overtaking the OECD for the first time in refining capacity as well as throughputs[1]. At a global level, BP notes that refining capacity grew by 0.8 per cent in 2010 to 91.79 million barrels per day (mbpd), while global refinery throughputs rose by 2.4 per cent to 74.8mbpd. Admittedly, a process of capacity rationalisation took place over the course of 2010 in some regions. So the aggregate growth figure hides net reductions in the OECD markets of Europe, Japan, the US and Canada.

Regional refining margins 2011 BP Plc 2011.

Capacity additions were concentrated in the non-OECD markets, with growth in China to the tune of 640,000 bpd accounting for almost 90 per cent of the global total. Hence, installed refining capacity in the non-OECD now exceeds that of the OECD by 1.5mbpd, says BP. Additionally, global crude runs grew by 1.8mbpd in 2010, led by a 1mbpd increase in China. For the first time, refinery throughputs in the non-OECD exceeded those of the OECD. Concurrently, global average refinery utilisation improved to 81.5 per cent, the first increase since 2005. On the subject of refining margins, there was some welcome news at least. Regional margins improved in all three major regions, with the USGC West Texas Sour Coking and NWE Brent Cracking margins around US$5 per barrel by year-end, while the Singapore Dubai hydrocracking margin was still below US$4 per barrel. Yet the ICE Brent forward month future price the price benchmark for IJs oil & gas reports averaged above US$90 per barrel for much of 2010-11 and recently spiked to an eightmonth high of US$121.15 per barrel in intraday trading on February 20, 2012. Problem is that while the crude price often fluctuates wildly, refining margins do not alter all that significantly or with the same velocity. It is precisely why the refinery business does not bear

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that direct a correlation with crude prices. Refiners may or may not make money based on margins. Arkadiusz Wicik, Director at Fitch Ratings European Energy, Utilities and Regulation team, notes, Our fundamental view is that European refining remains in very difficult conditions and 2012 will be another challenging year for refiners mostly due to the overcapacity and a weakening of demand for petroleum products. He believes that even though global oil consumption is rising, it is not in Europe and the picture is quite bleak. Operational dynamic has regional discrepancies too as not all crude oils are the same ranging from fluids to near solids with some 160 different varieties of crude oil being traded worldwide[2]. The type of crude oil (by its hydrocarbon composition and nonhydrocarbon impurities, especially but not limited to Sulphur) being refined and the infrastructure needed to refine it impacts refiners' margins. Description varies from light to heavy and from sweet (under 1 per cent sulphur) to sour (over 1 per cent sulphur) - with light sweet crude being the most cost effective to refine with a price differential to the tune of as much as 12 to 17 per cent according to selected petrochemists contacted by IJ. The crack spread, i.e. differential between the price of crude oil and petroleum products extracted from it, or in short an oil refinery's profit margin differs from region to region and the cracking method (process of breaking long-chain hydrocarbons into petroleum products and allied hydrodesulphurisation processes). Both leading benchmarks, i.e. West Texas Intermediate (WTI) and Brent Blend Crude (North Sea Brent) are light sweet crudes, whereas OPEC's basket varies according to the cartel from member country to member country. Unfortunately for refiners and the gasoline consuming public, light sweet crude accounts for only 20 per cent of global output according to industry sources[3]. Production of light sweet crude is led by the US, UK, Nigeria and Iraq. A strange sort of a paradox exists in the case of US and UK where although refinery capacity is adequate, crude production has peaked. Alternatively, in Nigeria and Iraq where crude production has not peaked - refinery infrastructure is abject. Conversely, leading producers of heavy sour crude are Saudi Arabia, Russia and Kuwait where refinery infrastructure is largely acceptable along with Iran, Venezuela and Mexico where it is not. Where a lack of infrastructure investment exists, business margins are blamed with Iran being the only exception owing to geopolitical complications and international sanctions. Given the state of affairs coupled with overcapacity, project financiers and their energy company partners would think more than twice before contemplating new refinery infrastructure build.

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Kenneth McKellar, a Deloitte partner and their Middle East Energy & resources leader, says, Given the macroeconomic climate, some European refiners must be feeling they are in the wrong place. The refining business and ancillary infrastructure build is now more localised than ever at any point in the history of energy business. Tight margins mean transportation costs of the distillates have to be factored in by integrated or R&M only owners of refining assets. Examine the project plans of new refineries in the Middle East, India and China and you will increasingly see them in sync with local operational conditions and not just gelled with the supply and demand equation. European refining investment is suffering as a direct consequence of overcapacity something which is not applicable to MENA, India or China, he adds further. Refinery assets abound but takers not around Many refineries assets are on offer in European and American jurisdictions, some at a massively cut price, but as IJs corporate finance data suggests few of these downstream assets have changed hands. Apart from buyouts fronted by US private equity firms, which added up to a little over 1.1mbpd spread over all of last year, project transaction volumes remain low. Carl D. Hughes, Global Head of Energy & Resources at Deloitte, notes that is hardly surprising. It is all about big-ticket acquisitions versus what forms the long term business case for the said acquisition or in a refinerys case what would be the long term view of refining margins? So just because the asset is cheap and you are scrutinising the cash flow of that asset which happens to be in the red or negative, no matter how cheap the asset is you will not buy it!, he says. Refining margins in the US and EU continue to be significantly under pressure and Hughes feels it would be unwise to forget that when a business is under pressure there is also a significant amount of competition as happens to be the case in Europe and the US. Old refining assets would find it hard to compete against (relatively) newly built ones. Put it all together and you can see why there arent many or in some case any takers for the refineries that have been put up for sale, he adds. There is also an additional challenge on top of all this that of a refining asset needing maintenance and upgrading on near regular basis. There are costs associated with it all. Some then ponder the option that in the face of declining margins do they continue running it incurring operating costs or do they mothball it. In the EU, the picture gets complicated further, for as soon as you stop refining you need to decommission it. Hence, in Europe not only is the economics proving tough, the termination costs would prove even tougher. All of this is enough to put off most, bar the most committed of buyers, he concludes.

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Refineries corporate finance valuation 2008-2011 Infrastructure Journal 2012

Scrutinising the four quarters of 2011 and the first few months of 2012 more than vindicates Hughes stance. Sunoco is selling Marcus Hook and Philadelphia refineries; the former was mothballed in December. ConocoPhillips put the Trainer, Pennsylvania refinery up for sale that same month which has since been mothballed as well. BP also wants to put two of its US refining assets up for sale. Neil Donoghue, a Partner at Baker & McKenzie, assigns a different reason to there being more refining assets on sale over 2011 than there were over the preceding year. The issue of refining margins remains one of concern. In Europe, not much has changed over the last 12 months, but in the US there is a minor uptick in margins. So in case of the latter, we see some of the majors selling off their refineries divisions because margins are getting better and they think they can get better value for their refining & marketing (R&M) infrastructure assets; at least relative to 2009-10, he says. Just as the industry was drawing some positives out of the Valero-Chevron deal over the Pembroke refinery in Wales, Swiss refiner Petroplus troubles started resurfacing leading to shutdowns of its Belgian, French, Swiss and finally British refineries and subsequent bankruptcy proceedings this year. All the three leading ratings agencies Moodys, S&P and Fitch Ratings believe that access to bank funding is likely to worsen and become more expensive, especially for European independent refiners as European banks optimise their credit portfolios in 2012. In fact on December 12, 2011, Moodys revised its outlook for the global R&M sector to negative from stable. Gretchen French, a senior Analyst at Moodys, notes the change reflects the agencys belief that new capacity additions will outpace demand in 2012. High unemployment and anaemic

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economic conditions will weigh on refined product demand in the OECD member countries, while growth outside the OECD in such countries and regions as China, India, the Middle East and Latin America will drive stronger demand for refined products, largely diesel, French adds. This represents an additional challenge for independent refiners given that European refining faces another difficult year in 2012 within a long industry downturn that begun in 2009, says Wicik of Fitch Ratings. "The highly cyclical nature of the refining industry, European refiners weak cash flows since 2009 and the persistent overcapacity make the refining industry one of the corporate sectors to which European banks are likely to reduce credit exposure this year. We believe that the lower availability of credit will particularly affect leveraged independent refiners, especially those who rely on uncommitted lines or have large debt refinancing plans in 2012," he adds. Meanwhile, India continues to gain prominence as a leading market for refinery finance and it is not alone among its BRIC and emerging market peers. State-owned BRIC National Oil Companies (NOCs) are also becoming more than just part players in the refinery infrastructure asset acquisition market as well if 2011 is anything to go by. BRICs & developing markets: Refiners R Us In February 2011, PetroChina paid US$1 billion for a 50 per cent stake in UKs Grangemouth refinery and Frances Lavra refinery. Then in April, Indian conglomerate Essars energy arm paid Royal Dutch Shell US$1.3 billion for its Stanlow refinery in the UK. Both moves, signal a change from the last time IJ analysts visited the subject[4]; it seems that emerging market NOCs are willing to venture abroad for acquiring refining assets even though they may well be behaving as strategic investors rather than white knights for troubled refiners. Additionally, as they buy refinery assets abroad, they build at home. All four Brazil, India, China and Russia are handling the issue of their domestic refinery infrastructure very differently and for somewhat different reasons. Of these, Russia could become a Mecca for refinery upgrading projects owing to recent changes to a taxation regime. Known as the "60-66" tax regime, which became effective on October 1, 2011, the ruling reduces the maximum crude oil export duty rate in Russia to 60 per cent from 65 per cent and harmonises export duty rates for light and heavy refined products at 66 per cent of the export duty on crude oil. However, the gasoline export duty remains unchanged at 90 per cent. The new taxation aims at improving the profitability of the upstream segment and stimulating an upgrade of the refining assets in Russia by investing in their modernisation and the construction of more complex refineries. The tax initiative could result in the rationalisation of

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a number of small unsophisticated refineries whose output is skewed towards heavy oil products. Angelina Valavina, Senior Director at Fitch Rating, says, It could also correct the imbalance created in the Russian oil industry by the previous taxation regime whereby the heavily-taxed upstream operations subsidised the production and export of low value-added refining products. It is likely to have an immediate positive impact on most Russian upstream and integrated oil companies the agency rates but further changes to the taxation system are necessary to secure the country's oil industry's long-term prospects. Sometimes a positively intentioned short term measure might well be all that is needed, as the industry is right in its belief that quite a few Soviet era refineries are in need of a serious upgrade. Elena Lazko, Partner and CIS Oil & Gas Leader, at Deloitte, notes, Over the last six months this thought has gained traction with the government changing the local excise tax law levelling it for heavy and light products. This along with domestic demand gives an impetus for investment. It is feasible that some refinery upgrades will be project financed but the initiative is likely to be majority Russian-led whether we are talking about a sponsors stake or involvement from Russian banks. Given the task at hand, Lazko does believe that some of the possible upgrades could be bigticket projects and an opportunity for foreign investment over the next two to three years. Service companies could benefit too, with various owner/operators of Russian refineries whether NOC or private. Optimism is warranted, but it should be cautious optimism. The next 12 months to two years should be interesting, she concludes. As Russia contemplates an upgrading bonanza, China is the most vociferous of all BRICs about its intentions for refinery infrastructure build. A spokesperson for PetroChina told IJ at the 20th World Petroleum Congress (WPC) that China, while being a net importer of crude oil, is determined to become self-sufficient in refining. By 2015, Chinese companies aim to boost our domestic capacity by 25 per cent to 15mbpd, he added. Two of its NOCs make for good case studies in how to turn things around via bullish investment CNOOC and Sinopec. Starting with the former, in May 2009, CNOOC shed its image as a Chinese crude oil producer without a refinery with its Huizhou 12,000 kilo tons annually refinery project located in Guangdong province. Since then, according to a spokesperson, CNOOC refineries have acquired a crude oil processing capacity of 33 million tons per annum (and rising). Huizhous phase II construction is underway and a number of new projects are under construction according to the company. Sinopec, which already had refining assets, astounded the regional and international markets by announcing that the groups crude processing exceeded 200 million tons for the first time in 2010. Revised data suggests that processed crude capacity was actually 213 million tons

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for the year up 13.4 per cent on an annualised basis. This was achieved via 11 new refinery projects coming onstream between 2002 and 2011. The ambitions of two Chinese companies alone are indicative of where the countrys market is heading although not much of it is likely to be project finance. Or rather to quote one financier at a Japanese bank, If even 5 per cent of the new or proposed Chinese refinery infrastructure build is project financed, your market data will look completely different next year. While Chinese NOCs may wish to avoid debt markets, the Indian government and the countrys private sector players such as Reliance and Essar conglomerates are making the right noises going forward. Three of the top five project finance initiatives in this subsector as noted earlier in this report are Indian ones. Furthermore, India may well be a net importer of crude oil, but it is a regional exporter of refined petroleum and petrochemical products. At the 20th WPC, S. Jaipal Reddy, Indias Minister for Petroleum & Natural Gas, announced that his country would increase investment in refinery infrastructure as the country wants to maintain both domestic demand for refined petroleum as well as its position as an exporter of refined petroleum products to regional partners[5]. Refinery infrastructure in India has seen phenomenal growth. We have a capacity of 193 million metric tons annually* (mta); by 2014 the target is to raise this to 240 million mta not only will this maintain the export quota but will ensure domestic self-sufficiency in refined petroleum products until 2020, he said. Sharing its data exclusively with IJ, the Indian Ministry of Petroleum and Natural Gas breaksup the countrys current refining capacity as: Indian Oil Corporation Ltd. (Digboi 0.65 million mta, Guwahati 1.00 million mta, Barauni 6.00 million mta, Koyali 13.70 million mta, Haldia 7.50 million mta, Mathura 8.00 million mta, Panipat 15.00 million mta, Bongaigaon 2.35 million mta, Chennai 9.50 million mta and Narimanam 1.00 million mta) Bharat Petroleum Corporation Ltd. (Mumbai 12.00 million mta, Kochi 9.50 million mta, Bina 6.00 million mta, Numaligarh 3.00 million mta) Hindustan Petroleum Corporation Ltd. (Mumbai 6.50 million mta, Visakhapatnam 8.30 million mta) Oil and Natural Gas Corporation Ltd. (Tatipaka 0.078 million mta, Mangalore 11.82 million mta) Reliance Industries Ltd. (Jamnagar 60.00 million mta) Essar Oil Ltd. (Vadinar 10.50 million mta)

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A ministry spokesperson notes that some of the aforementioned refineries figure prominently on IJs database, and more were likely to. Four of our 14 public sector oil & gas companies are in the Fortune 500 and all would make for robust project sponsors and partners, given the right conditions and debt structuring when discussing new build or upgrades to existing facilities, he adds. From an outside-in standpoint, Hughes of Deloitte believes the Indian market is not perfect but remains immensely attractive with most western markets seeing muted sector growth or declines and the Chinese not giving many hints about approaching the debt markets. For India though, the challenges for its NOC-owned or private owned refineries (and indirectly the government exchequer) are the huge fuel subsidies which remain a politically sensitive issue. Not only are the subsidies a drag on the economy and the exchequer, if you are looking for foreign direct investment in the refining business it could put off prospective partners as it makes project margins in India circumstantially hard to achieve (in theory), despite high demand for distillates, he says. That said, Hughes believes, the issue is a hindrance only for some. In a tough global refining projects market, Indias distillate demand and export potential for the neighbourhood makes investor participation attractive, he concludes. Admittedly, among the BRICs Brazil is being the least proactive of the four, despite rising domestic demand. Mexico, another Latin American jurisdiction with a dire need for petroleum distillates has also been lax. Both emerging markets are attractive, but in a direct opposite of what we see in Russia, legislative hurdles work the other way and could stunt investment. Abreu E Lima Pernambuco Refinery Project valued at US$12 billion is Brazils signature transaction in recent memory. The 230,000 bpd refinery, expected to be commissioned in 2013 remains a largely public financed affair. Petrobras holds the majority stake of 60 per cent in the project with the rest held by Venezuelas PDVSA. With a third of the construction work already completed, bulk of it has been financed by BDNES Brazils own development bank. That too is not without its own set of problems, as earlier in February, PDVSA said it had failed to secure a US$10 billion loan from Brazil's state-development bank BNDES that it was counting on to pay its 40 per cent stake in the refinery. A new deadline has been set for later this year. Existing refinery infrastructure and ongoing construction is nowhere near enough to meeting the countrys need and commentators believe that Brazil ought to do more to attract private finance, in keeping with trends seen in India. Brazilian consumption of petroleum products has more than doubled from 1988 to 2009; but refinery capacity has remained nearly-flat since 2005 at just above 1,900,000 bpd[6]. Rio de Janeiro - based law firm Trench, Rossi & Watanabes attorney Danielle Valois, notes, Extra heavy oil poses a challenge for Latin America as well and its largest economy Brazil.

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So while Petrobras capex on pre-salt (offshore prospection) grabs all the headlines, it often goes under the radar that Brazil is actively looking at enhancing downstream investment. It is actually an economic imperative based on rising demand for distillates above anything else. Brazil and Mexicos refining scenario at present has some similarities with near identical frustrations says Benjamin Torres-Barron, a lawyer for Baker & McKenzie, Mexico. While Mexico is a major producer of crude oil, it actually imports 40 per cent of its gasoline for domestic consumption. Here there is a clear lack of refining capacity a direct opposite to the EU. Problem is that Mexico restricts private sector involvement in the refining business. Pemex is the only company permitted to refine crude oil. The only foreign direct involvement is from service companies and technical advisers involved in the construction phase all hired by Pemex, he adds. The intention was there to include refineries projects in the liberalisation drive allowing private entities to participate in building and operating projects. However, Mexicos parliament excluded the subsector from its energy reform bill three years ago and continues to do so. Elsewhere in Latin America, over 2011, Venezuela a country hit by refinery outages, provided both of the two PF transactions for 2011 on IJs database. These include a processing expansion project at the El Palito refinery from 140,000bpd to 280,000bpd and an upgrading project at Puerto La Cruz refinery from 180,000bpd to 210,000bpd. However, most independent observers regard the Venezuelan projects, financed via 15-year loan with an interest of Libor plus 3.8 per cent from a group of banks led by the Japan Bank for International Cooperation, as an exception rather than an indication of a project finance drive in Latin America. Another emerging market Turkey could possibly provide a bit of positivity in terms of new European refinery projects. There are likely to be two new developments in Turkey as Tupras is proceeding with a project to upgrade its Izmit refinery. The company has just recently signed an agreement to raise US$2.1 billion funding for the project (The project is valued at US$2.4 billion with an equity of US$300 million). Another project in Turkey is a new refinery, which is planned to be built by Azerbaijans SOCAR and Turkeys Turcas, says Wicik of Fitch Ratings. Moving away from Europe, akin to India, the Middle East and North Africa (MENA) region nations are just as keen on refinery investment based on a split business model banking on domestic sales and exports of petroleum distillates to the near region. In fact, there is increasing competition in the petroleum distillates business between the Indian subcontinent and the Middle East in terms of market share and for time being it is also competitive between the MENA nations. Nonetheless, in the current macroeconomic climate, even in the Middle East, bringing new refinery projects onstream is neither linear nor simple says McKellar of Deloitte.

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Look at the Kuwaitis for instance. State-owned KNPC wishes to bring two refinery projects onstream but the first one was delayed so much owing to the decision making processes within the government that now the economics of the second project are under severe scrutiny, he adds. Additionally, the Qataris and indeed the Saudis are aiming not just at their respective local markets but at South East Asia. So you will see some mega projects in Qatar and Saudi Arabias Ras Tanura region (for instance with Dow Chemical); but all will be accompanied or preceded by some serious feasibility studies and market sales projections in what is a very competitive cut-throat industry, McKellar concludes. That on the whole, NOCs, especially BRIC and MENA NOCs, have proved to be willing investors and project sponsors for refinery projects at home and abroad is not under dispute, but Baker & McKenzie partner Donoghue notes that often, reconciling the drivers of an NOC with an International Oil Company (IOC) in a joint venture is the tricky bit. NOCs often have a range of politically based drivers rather than commercial objectives and join hands with IOCs because that attracts funding. Look at some of the success stories in emerging markets which have been developed on the basis of a debt/equity mix with a fairly high percentage of low cost debt. I would say bringing in an IOC helps with that as well as attracting ECAs, etc, he adds. Furthermore, NOCs have also displayed a great knack for adaptability in the refining business. We have seen a number of NOCs looking to continue exporting their premium, lighter, sweet crudes and refining their heavier and sour crudes for domestic consumption. State of the art refineries would hold key to this and the thought is gaining traction among the exporters club, Donoghue says. Is the integrated model dead, on life support or neither? As part state-owned oil companies or NOCs increasingly turn into leading sponsors, buyers and builders of refinery infrastructure and IOCs look to divest, the troubling question which always triggers a fierce debate among market commentators is whether the integrated model of owning R&M along with exploration and production (E&P) infrastructural assets is dead as far as oil majors are concerned. There is no consensus on this one from analysts, financiers and advisers alike. The only clear trend is that IOCs with hubs in Western markets are looking to divest refining assets and are hardly lending their sponsorship to new projects based on the current economics of the refining business in correlation to developed markets. That said they have not held back from part participation in refining projects beyond North America and EU. For instance Shell, Statoil, Eni, ExxonMobil have all sought partnerships for refineries in nonOECD jurisdictions. The largest refining project by valuation in recent memory Saudi Arabias 400,000 bpd Jubail Refinery Project sees a 38 per cent stake from Total with Saudi

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Aramco as the majority stakeholder. Yet with so many refineries mothballed, near negligible evidence of new construction and many assets put up for sale by IOCs many raise valid questions about the integrated models demise. The debate has been further fanned by the decision of Marathon Oil and ConocoPhillips to create separate R&M and E&P companies last year. Of the two, ConocoPhillips' announcement, in July 2011, that it will be pursuing the separation of its E&P and R&M businesses into two separate publicly traded corporations via a tax-free spin-off R&M company created more ripples in the industry given the companys bigger international brand equity and profile. While it is too early to gauge how things will pan out for the split companies and what its wider implications would be for the refinery projects market, Wicik of Fitch Ratings notes that these two cases should not be interpreted as the way forward for the general market, especially in a European context. The strategy of European oil majors like Shell, BP and Total appears to hinge on rebalancing whereby some of their underperforming assets have been put up for sale or sold. This is an exercise in portfolio optimisation not for or against holding refining assets on the balance sheet. Admittedly, there have been two cases in the US (Marathon Oil and ConocoPhillips) where companies have announced creation of separate R&M entities. However, so far in Europe, despite the tough operating conditions, we have not seen a complete withdrawal from refining business, he adds. Baker & McKenzies Donoghue agrees with Wicik. I doubt if the integrated model is dead (or on life support for that matter). Some IOCs want to lose refining capacity as it provides them with a level of flexibility. Ultimately, if you look at the IOCs and their reduced access to reserves for them to become pure upstream players would put them at a disadvantage to the NOCs which are increasingly going into the refining business and looking at downstream projects, he says. Some companies have indicated that they would like to re-spin their R&M businesses following Marathon and ConocoPhillips move but at the same time some IOCs are also looking for good quality refining assets. Yet others are divesting some refining assets but not getting rid of their entire R&M portfolio. So while there has been interest in what ConocoPhillips' move, oil majors arent queuing up to adopt the model en masse; at least not yet, Donoghue adds. Hughes of Deloitte thinks the question is likely to evoke different answers if contextualised against the backdrop of different markets with different fortunes. We see substantial investments in the Gulf in the downstream end of the business including refining which sits happily alongside upstream activity. So if anything, a number of Middle Eastern companies are becoming more integrated. On the other hand if we were to look at the more traditional

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European IOCs they are reviewing the refining businesses along with their retail operations, he concludes. Furthermore, in a ratings-influenced world of project finance, Wicik of Fitch Ratings points to an important fact. We believe that from a credit ratings standpoint, an integrated oil & gas company would generally be rated higher than a R&M (only) company assuming a similar financial profile of both entities. So there are advantages in being integrated, he says. Contrasting the attitudes of different companies headquartered in different jurisdictions, Hughes notes that in Europe BP, for instance, is become more and more focussed on upstream but if focus is switched to Asian markets private sector oil & gas project sponsors like Reliance and Essar have significant investments in refining at no visible detriment to upstream activity. Crystal ball gazing: The crude road ahead to 2015 As explained earlier in this report, the connection between the price of crude oil and investment in refinery infrastructure does not have a linear connection, but it does have a subconscious impact on financiers mindset in what is a cut-throat business. For much of 2011 and the first few months of 2012, the ICE Brent forward month futures contract has been above the US$100 per barrel level. Most market analysts have revised their 2012 price forecasts between US$117 and US$121 per barrel, with predictions of a US$122 to US$126 per barrel price in 2013. IJ analysts believe this is a realistic price circa but no guarantor of an investment uptick in refinery infrastructure in OECD markets where refiners margins, while not abysmal, are not that healthy either and overcapacity persists. In fact, a very high a oil price raises the prospect of it affecting the cash flow of a refining facility as oil is its raw material and yet at the same erode demand for refined products as consumers curtail their spending. Conversely, an oil price around US$80 per barrel is deemed workable by IOC and NOC refiners alike, but alarms will ring for project sponsors were the price to hover around the US$60 mark. Past experience suggests that while NOCs can simply put the projects on ice, IOCs take a much dimmer medium term view. Conditions are likely to remain tough in European and North American refining markets for much of 2012, with no dramatic turnaround in fortunes expected for a few years yet, if not more. As a consequence, this will in all likelihood result in some single digit corporate financed asset acquisitions in refining business and the occasional refinancing deal in these markets but little else. Delays associated with Keystone XL pipeline project aimed at connecting Hardisty, Alberta, Canada to Port Arthur, Texas, USA are likely to stunt expectations of refinery upgrading projects in the US Midwest originally envisaged for handling Canadas bituminous exports. President Barack Obamas decision, in January, to deny a permit to Keystone XL project

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complicates matters for an already much delayed project. It has now been suggested that the project sponsor TransCanada will re-apply for a permit. Additionally, a change in political landscape in favour of the Republican Party might alter the dynamic. The Republican Speaker of the US House of Representatives, John Boehner, criticised the Obama administration for its failure over a project that would have created "hundreds of thousands of jobs" while the President responded by starting an online petition so that the general population can express its opposition to the Keystone XL pipeline. Whichever way the issue is examined, the situation would not be any clearer before the US Presidential election in November and as such does not bode well for any proposed US Gulfcoast export oriented refinery upgrading projects in the Midwest over the medium term. Concurrently, Canada which is grappling with its own domestic overcapacity issues is not likely to see new refineries either. New York-based Thomas S. Coleman, Senior Vice President at Moodys notes, that R&M companies will be pressured by overcapacity that will swamp current demand. He warns that some US refineries may be idled or closed, and that the worldwide balance in refining capacity can be difficult to predict. In Europe, Turkeys Izmit Oil Refinery Upgrade project is likely to provide a short term market boost as Tupras recently signed a US$2.1 billion long term financing for its fuel oil conversion project with 10 international banks. The majority of the funding will be insured by export credit agencies. Another new refinery project in Turkey is being planned by Azerbaijans SOCAR and Turkeys Turcas. Polands PKN refinanced most of its debt in April 2011 by signing a 2.6 billion long term credit agreement with a syndicate of 14 banks. The refinancing allows PKN to cover its funding needs for the next few years. Given that Poland needs to actively invest in downstream infrastructure; the market may yet see some movement over the next five years. However, as the majority of European refining capacity is controlled by integrated oil & gas companies, the structural weakness in European refining has caused many integrated players to increase their strategic focus on the oil & gas upstream segment through a reduction in capex for the downstream segment and refining asset disposals. In the longer term, Fitch Ratings anticipates that only a considerable capacity reduction can materially improve utilisation rates and cash flow in European refining given weak demand prospects for refined products. This can be achieved by the closure of less efficient or persistently unprofitable refineries, or the conversion of idle capacity into storage depots. Hence, IJ analysts are not positive on any new refinery infrastructure being commissioned in the EU. Wicik of Fitch Ratings believes Europeans could head overseas with their expertise. If persistent market challenges continue in the European refining business as expected over the

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short to medium term, then one of the options for some large international refiners may be to expand in fast-growing Asia which could range from acquisitions to technical advice to part sponsorship contingent upon local legislation, he says. Some oil majors such as Shell and Total have actively demonstrated this while anecdotal evidence suggests many others are in tow. Most market commentators and those in the project finance community are looking at India and Asia Pacific as investment destinations for new refinery projects, especially as Russian and Chinese markets may well be off-limits for foreign financiers. On the whole, NOCs appetite for adopting IOCs as junior project partners is growing as well. Saudi Aramcos Jubail project grabbed quite a few headlines over 2010 and could well be a harbinger of refinery projects to come for non-OECD countries. While caution is warranted, Baker & McKenzies Donoghue believes a lot of NOCs are looking to change the dynamic of their countries from being net importers of refined petroleum to actual exporters and this can make a substantial difference to the country's balance of payments. Indias attractiveness as destination for refinery project finance is evidenced in IJs data of top ranking projects. Furthermore, the recent willingness of Qatar Petroleum, Saudi Aramco and the Indian NOCs to seek private finance as well as project sponsorship tie-ups with IOCs bolsters the belief that the attitude of NOCs is changing and that foreign direct investment in downstream projects including refineries would be more welcome than before. Market feedback suggests that international commercial banks are more relevant to NOCs in cases where they wish to use limited recourse finance. Traditionally, NOCs are able to borrow with the usual lending facilities on both a limited recourse and full recourse basis. However, the banking crisis and the scarcity of capital increased the cost of this access to finance which has come down for upstream initiatives but not for refinery projects deemed challenging if not high risk by some in the market. In December 2011, at its last ministerial meeting, OPEC member nations said they are only committed to a reference case scenario, wherein using a guide price of US$85 to US$95 per barrel, an estimated US$1.2 trillion of investment would be needed between 2011 and 2035 for downstream projects including refineries[7]. This would be split as US$210 billion for existing projects, US$300 billion for required additions and US$700 billion for maintenance and replacement. The cartel is less forthcoming on refinery investment especially in light of the challenges faced by the business. Saudi Arabia, Qatar and Kuwait are likely to be the main movers and shakers but the speed and employment of investment capital and debt procurement is likely to differ across the OPEC board. Anecdotal evidence suggests some Algerian initiatives might also involve debt finance.

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Upgrading of refineries is likely take-off in Russia on the back of a taxation regime change, but only a quarter of these projects maybe debt financed. Upgrading projects in the US, especially the US Midwest, are tied-in to the prospects of the Keystone XL project. A call on which way the project is likely to go is a hard one to make at the moment even though it is likely to be approved with caveats attached. In summation, bulk of new project financed refinery build between now and 2020 is likely to come from non-OECD jurisdictions in general and India, MENA and Asia Pacific in particular. Indeed, the medium term future of refinery project finance clearly rests in the East.

- Ends With additional reporting and research work by the author from the 20th World Petroleum Congress in Doha, Qatar (December 4 to 8, 2011), 160th OPEC Conference, Vienna, Austria (December 14, 2011) and Delhi, India (January 31 to February 3, 2012). Publishing note: The author gratefully acknowledges the cooperation of the World Petroleum Congress, Government of India and the off-record and on-record insight of several industry professionals who spared their valuable time to discuss his findings. Publishing disclaimer: Please note that the commentary and opinion of individuals from third party institutions contained in this report are solely theirs and not those of the institutions they represent or work for. This report is a data and trends based assessment of the industry. It does not explicitly or implicitly constitute investment advice or an endorsement either by the individuals and institutions quoted or by Infrastructure Journal.
NOTES: *1 Metric ton = 7.148 barrels (1 oil barrel = 158.987 litres, 42 US gallons, 34.97 imperial gallons) [1] BPs Statistical Review of World Energy 2011, BP Plc, June 2011. [2] US EIA [3] US EIA, BP, World Petroleum Congress [4] Oil Refinery Infrastructure Outlook 2011: An Unloved Energy Asset?, By Gaurav Sharma, November 10, 2010. Available here. [5] India to raise FDI cap on O&G Infrastructure, By Gaurav Sharma, December 8, 2011. Available here. [6] US EIA [7] OPEC to embark US$300bn infra spending drive, By Gaurav Sharma, December 15, 2011. Available here.

This report was published by Infrastructure Journal on February 29th, 2012.

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