Russia pushes harder for refining rationalisation
Tax changes might force smaller, simpler facilities to the wall
One of the central aims of Russian oil policy over the past decade has been to bring the country’s refining industry up to modern standards. And, as the country’s refiners grapple with weak prices and reduced tax benefits, authorities have closed a loophole that allows certain plants to export low-value heavy fuel oil (HFO) without paying duties—a move that will hurt simpler plants.
Russia is the world’s largest exporter of HFO, the ‘dregs’ of the refining process produced through the most basic techniques. This is an inheritance from its Soviet past, when HFO was used intensively in power generation and heavy industry. Demand for the product—both in Russia and overseas—has been under downward pressure for decades.
Over recent years, Russia has strived to better match its refining slate with global product demand—aiming to encourage refiners to upgrade plants to produce less HFO and other heavy distillates and more high-value light fuels such as gasoline. And its policies have had some success, with fuel oil output dropping from 77.7mn t in 2014 to 47.3mn t last year.
Russia’s refining depth, used to measure refineries’ efficiency and complexity, reached 83.1pc in 2019 after remaining flat at 70pc between 2000 and 2014. But the amount of fuel oil that Russian refineries produce is still considerable, dragging down the mean value of Russian fuel exports.
Russia kickstarted a series a tax reforms in 2011—the so-called ‘tax manoeuvre’—aimed at modernising and rationalising the country’s bloated and outmoded refining industry.
“The goal was to squeeze out refineries that do not add any economic value to the barrel of oil but live purely on that cross-subsidy in the tax regime” Smith, BCS Global Markets
The sector had undergone a rapid expansion in the 2000s, despite its lack of sophistication, low yields and mismatch between product supply and demand. State policies that supported the downstream sector over the upstream were the main driver. The tax manoeuvre sought to eliminate this cross-subsidy.
Changes to fuel export duty were a key part of these reforms. In 2017, albeit several years later than planned, the government raised export duty on fuel oil and vacuum gasoil to the same level as crude oil. Duty on more valuable gasoline, diesel and jet fuel was meanwhile set at 30pc of that for crude.
“The goal was to squeeze out refineries that do not add any economic value to the barrel of oil but live purely on that cross-subsidy in the tax regime,” says Ron Smith, analyst at brokerage BCS Global Markets (GM).
But some simpler refineries continued to produce large amounts of heavy distillates despite a greater tax burden by exploiting a customs rule loophole. Fuel oil containing more than 50pc aromatic hydrocarbons can be booked under a separate customs code, enabling companies to skirt duty.
The federal customs service has now closed this loophole. As of mid-September, aromatic hydrocarbons are subject to the same duty as fuel oil.
“This change could potentially worsen the economics of less complex refineries,” according to bank VTB Capital. “We believe it will be particularly felt by smaller and independent refineries, rather than those belonging to vertically integrated oil companies.” Small, independent refiners accounted for 16pc of overall throughput volumes in Russia in the first eight months of the year, VTB estimates.
Independent refineries have generally struggled to thrive in Russia, in part because smaller players find it more difficult to navigate ever-changing tax conditions. And the possibility of further tax treatment changes will only make it harder for refiners to commit to new investments, such as investing in upgraded capacity at simpler refineries to replace fuel oil production with more valuable products.
"Unfortunately, at any given moment of time, there are always politicians suggesting major changes to the tax regime,” says BCS GM’s Smith. “So, if you are an oil company executive and you are trying to make decisions on multibillion dollar projects that have payback periods of years, if not decades, then how do you do that when you don’t know what the tax regime is going to be in 12 months?”
Last year saw the downfall of Russia’s biggest independent refiner, New Stream Group, which formerly controlled 320,000bl/d of processing capacity at three plants in the regions of Tyumen, Krasnodar and Mari El. But New Stream’s problems were largely case-specific—it took on significant debt before the 2014 oil price crash and Russia’s subsequent recession and struggled to service its loans during the downturn. New Stream’s plants have been transferred to larger players or foreclosed on by creditors.
Russian refiners are already facing challenging financials, with the core downstream earnings of leading players Rosneft, Lukoil and Gazprom Neft almost halving year-on-year in the second quarter, according to the estimates of Fitch Ratings analyst Slava Demchenko.
83.1pc – Russia’s refining depth
While weaker demand due to Covid-19 is one factor, a larger one is low crude prices, says Demchenko. While cheap feedstock is usually welcome for refiners, for Russian players it means the benefit of reduced export duty on lighter fuels is eroded.
“When oil prices are higher, this saving on export duty is very significant, and this drives margins of downstream companies higher,” says Demchenko. “When oil prices are lower this benefit starts to disappear.”
Refiners producing large amounts of fuel oil have come under additional pressure as a result of the IMO 2020 rules on marine fuel sulphur content that came into force at the start of the year. The tougher regulations have weakened global demand for high-sulphur fuel oil dramatically, making it harder for simpler refiners to find a market for their production. Marine bunkering had been among the few remaining areas with robust demand for fuel oil.
The EU is now looking to apply its emissions trading system (ETS) to marine transport, further limiting the space for dirtier fuels—which ships can still burn if they fit scrubbers to their vessels. In mid-September, the European Parliament voted in favour of including ships of over 5,000t, travelling within the EU and to and from its ports, within the ETS.
The tax manoeuvre’s final stage began last year and aims to phase out export duty on oil and refined products entirely, while compensating for the drop in budget receipts with higher mineral extraction tax. This will drive up the cost of domestic oil supplies while negating the benefit refiners get from the lower duty on light fuels.
But Russia has sought to offset the impact of this reform by introducing a so-called reverse excise duty on certain petroleum products. This tax refund or subsidy is available to refineries that have sufficiently modernised and produce high-quality fuels. Others have secured the refund by committing to future investments. The hope is that this will also spur the sector’s further rationalisation.
“Some of the smaller refineries will exit the market, but this should not be a significant amount of refining volumes,” says Demchenko, who views acquisitions by larger players as less likely than capacity shut-ins.
“In terms of bigger companies wanting to acquire more refining, in general this has not been very desirable; often upstream projects are prioritised over refining,” he says.