Economic Confidential, November, 2009

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Prospects For Domestic Petroleum Refining In Nigeria: A Note Of Caution

By Ekpen J. Omonbude, PhD

Introduction

Liberalising private petroleum refining in a market with sufficient demand and potential for growth should ideally mean well for the domestic downstream sector. There are quite a number of arguments which support this position, some of which include efficiency gains, enhanced price competition, and in the case of the Nigerian Government and people at least, security of supply.

The recent removal of the US$1 million non-refundable deposit requirement of potential private refiners demonstrates, if nothing else, the determination of the Government to attract investment into the Nigerian petroleum downstream sector. Recently, there has been an increase in media reports of private investors who have gone as far as having made (or are close to making) final investment decisions on the construction or installation of petroleum refineries in Nigeria. While these reports carry varying degrees of validity, they point at what can be argued as a potential emergence of a ‘refining boom’ (if the reader would permit the author to be so loose) which, coming at a time in Nigeria’s development when the Government-run domestic refineries have not met the country’s market consumption needs, can easily be viewed as a welcome development.

As far as the drive towards the establishment of private refineries in Nigeria is concerned, two issues emerge as obvious causes for consideration. First, there is the question of refining capacity and the implications on downstream market fundamentals. While the existent refineries currently operate far below capacity, their combined nameplate capacities at 445,000 barrels per day (b/d) are in excess of Nigeria’s domestic petroleum consumption of roughly 240,000 b/d (based on available information on total petroleum products consumption for 2008, from the NNPC). New capacity additions by way of other refineries being established could therefore heighten the chances of over-supplying the domestic market. Has the outlook for domestic and regional demand growth been thoroughly assessed?

Second, there is the question of sustainability of the smaller refineries expected to come on stream in the medium term, mainly in terms of their level of complexity and thus the make-up of petroleum products available both locally and for export. With the exception of the over 200,000 b/d refinery reportedly being considered by Oando (a project for which it is understood that a ‘bankability’ study has been completed by Wood Mackenzie and Foster Wheeler), the majority of the refinery projects which currently look more likely to go ahead are of much smaller capacity and significantly lesser complexity than typical full conversion refineries. It is widely perceived that these smaller refinery projects – with capacities ranging from 12,000 b/d to 30,000 b/d – have been able to secure funding primarily because of their lower establishment costs, and this has increased their attractiveness to investors. Given that capacity-upgrading costs are very high and rely on economies of scale for a chance of profitability, are questions being asked about the long-term prospects of such modular refineries when inevitable market dynamics would test their adaptability?

It is important therefore to ensure that the right practical questions are being asked on a continuous basis, both in terms of Government policy and private investor strategy, with regards to the feasibility and sustainability of private refineries in Nigeria. This is especially important considering how complex the business and governance of petroleum refining can be, as developments in global refining over the last decade have demonstrated. This brief discussion attempts to provoke some of such questions which are pertinent to testing the robustness of plans for the establishment of domestic private petroleum refineries in Nigeria.

Issue I: the question of refining capacity and its implications on the fundamentals

Is there sufficient demand potential?

Available data from the NNPC on the total domestic distribution of petroleum products for 2008 shows an average annual consumption of about 236,000 b/d (NNPC, Annual Statistical Bulletin, 2008). While economic growth plays a key role in oil demand growth, as is the case with most economies, Nigeria’s experience over the past decade has been one of restricted development influenced by a number of constraining factors other than movements in real GDP. Some of such constraints have included weakening demand from the manufacturing sector, problems with the importation of petroleum products, logistics issues with the distribution of the products to market, industrial action in the sector, and an apparent degree of product hoarding to raise prices in the black market. One or all of these factors would explain for example, why despite an annual average real GDP growth of about 8% between 2002 and 2007, total petroleum products consumption fell by an average of 7%.

The growth spike in petroleum products consumption between 2007 and 2008 (a significant 20.4% from the 2007 figure of about 196,000 b/d) points to – among other factors – the possibility of a degree of pent-up demand in the domestic market. Growth spurts such as this (or the 21.2% growth between 2001 and 2002) tend to lend support to the argument that significant latent demand does exist, enough to warrant significant levels of enthusiasm from investors in supply and distribution infrastructure. It has been suggested in some discussions that petroleum products demand could reach up to 400,000 b/d if issues pertaining to access are addressed. Given the structure of oil consumption in the country, access requirements which would need to be met, and the necessary demand drivers, it is difficult to fathom the practicality of an additional 100-200,000 b/d of demand in the medium term at least.

Structurally, transport fuels constitute the bulk of oil consumption in Nigeria, with motor gasoline (petrol/PMS), automotive gas oil (diesel/AGO) and aviation turbine kerosene (ATK) accounting for nearly 90% of total petroleum products use in 2008. Based on data from the NNPC and the International Energy Agency (IEA), this structure has not changed significantly over the last two decades. Any significant growth in demand is most likely to come from the transport sector; mainly from PMS use (motor gasoline alone accounts for about 70% of the petroleum products demand spectrum).

Based on this rather simplified hypothesis, the question arises as to what practical factors would influence growth in PMS demand. Some of the obvious drivers are economic growth (real GDP growth as a useful indicator), measurable and significant growth in motor vehicle acquisitions, the price of PMS, the population reaching driving age, changes in fuel efficiency levels of the motor vehicle fleet, as well as the quality and capacity of distribution infrastructure. With the exception of fuel efficiency, there would need to be noteworthy developments in these respects in order to apply significant upward pressure on demand growth. Assuming a direct impact of an increase in real GDP on the propensity to spend on motor vehicle acquisitions, the turnover rate of imported vehicles at the ports would have to increase considerably for example. If this were feasible, there would then be extensive pressure on the pace of development in distribution infrastructure (mainly transport) to keep up with such an expansion.

Will the market be oversupplied?

A useful approach to determining what refining capacity would be available and when it is expected to come on stream would be to class each reported project according to an assessment of what is firm, likely or not feasible. This would depend on a number of criteria ranging from licence acquisition, through securing project finance, to actual construction work on the site. Of the investors granted approval to construct refineries between 2004 and now, only a few have taken tangible steps towards their establishment.

It would be useful to find out if the DPR (or the relevant regulatory body) has defined long term refining capacity targets or limits, which would have an impact on the manner and frequency in the granting of licenses to potential investors. This is because of a likelihood of excess refining capacity in the medium term at least, based on a rough estimation of the potential refining capacity to come on stream using available reports.

According to a recent quote from the Energy Minister at a conference in London, serious steps are being taken towards restoring 3 of the existing domestic refineries to full capacity (Reuters, 21 October). Assuming there are no capacity utilisation improvements in NNPC's refineries in the next five years (which will allow reasonable time for the completion of the other refineries), and taking into consideration the reported refinery plans which have a likelihood of coming on stream, there is a possibility that about 410,000 b/d of refining capacity could be in place by 2014/2015. This has been calculated based on last year’s average refinery capacity utilisation for the existent refineries of 25%, and the proposed refining capacities of 3 refinery projects which appear likely to come on stream in the next 5 years. Assuming 90% capacity utilisation of the existent refineries (if the Minister’s recent comments do materialise), there is then a possibility of nearly 700,000 b/d of refining capacity which could come on stream in the mid-term. To put such a figure into context, this would imply that Nigeria's demand would have to grow nearly 3 times more than it has grown over any 5-year period since 1980, in the next 5 or so years.

This poses an excess refining capacity risk. It can however be managed through such mitigating measures as a clear policy position on strategic stockpiling on the part of the DPR (or the relevant body), and identifiable potential product export markets on the part of the refiners. Therefore a question to ask in this respect is what the position of the Government is pertaining to strategic stockpiling, which carries its own technical limitations. Another question to ask is if thorough assessments of the structure and outlook for petroleum products demand in such target international markets have been duly and diligently conducted. A cursory look at petroleum products demand and supply in the Gulf-of-Guinea region (and further along the West African coast) in the context of installed and utilised refining capacity, would suggest a likelihood of excess capacity if all of the planned projects were to materialise.

Issue II: the question of sustainability

Questions on product specification and quality

If it is established that there is a likelihood of excess domestic and regional refining capacity, a practical solution would be to consider exporting product further across the Atlantic (for the sake of argument). In addition to an available market, the success of such products on the international market will depend significantly on meeting international product specification requirements, mainly in terms of sulphur content in the transport fuels. Unless the assay of the crude oil feedstock contains comparatively remarkable properties (such as low sulphur content, and which would as such not necessarily require further processing), the obvious implication would be that the refineries would need to be complex (i.e. include cracking, flashing and possibly coking processes) not only to enhance product yield, but also to improve product quality and thus enhance competitiveness.

This has huge cost implications, and would require significant scaling-up of plant capacity in order to remain economic. Considering that nearly all of the refineries reportedly planned are skimming (or simple) plants, there are questions which would therefore need to be addressed. For example, what are the sulphur content limits on gasoline and diesel in Nigeria and potential export markets? Are they in line with international standards? Are they likely to be revised in the future? How will finance be secured for such capacity or complexity upgrades?

Assuming all the refineries use Agbami light sweet crude as their primary crude oil feedstock for example, an argument could be made for the simple refineries on the basis of the low-sulphur-content characteristic of this crude type (Note: the Agbami assay shows 0.05% sulphur content, and is produced about 70 miles offshore. The refinery will therefore have to be located at the coast in order to enhance margins, if this is its main crude oil feedstock. Also, the author acknowledges the vast array of other crudes whose assays may bear similar – or better – qualities). Depending on the extent of excess capacity as well as the extent of regulatory requirements for sulphur content in the petroleum products, there could well be no need for simple refineries to upgrade. However, the likelihood of undefined quality specification requirements for petroleum products in the wider international market is very low. This would create difficulty for such products from straight-run refineries to find markets.

Refinery profitability

Ensuring and sustaining positive refining margins throughout the life of the plant requires a great degree of fluidity in adjusting crude oil feedstock, plant processes and transportation logistics to enhance gross product worth. If the refiners are going to operate under free market conditions, the larger and more complex plants will most likely fare better than the skimming/modular refineries simply because they have the scale and flexibility to make adjustments as market or regulatory forces change over time.

The question of the extent of regulatory protection, or what market conditions under which these refineries would operate would then need to be asked. Will there be any form of protection or will refiners be exposed to free market conditions? The case with a number of Asian refineries for example is such that a number of them operate under protected conditions. The implication of this is that such operators can still enjoy healthy refining margins even while free market operators suffer losses. Will this then require the reversal (or adjustment) of Government policy with regards to deregulating the downstream sector?

Conclusion

It is important to bear in mind that this discussion has by no means exhausted what is an extensive list of fundamental and technical questions which must be addressed as a matter of course. It has also not considered other refining investments in the region which could also serve to test the competitive position of local refineries, nor has it raised questions on potential environmental issues resulting from refineries which may be forced to shut down in the long term. The aim of this exercise has simply been to provoke thought on the purpose and strategic direction of both the Government and investors with regards to Nigeria’s downstream petroleum future.

A cursory look at the state of play would seem to suggest that some of the numbers do not add up, as well as point at a need for rigorous due diligence regarding the drive to develop the petroleum downstream sector. For example, a clear plan for refining capacity targets, both in a domestic and international context, will need to be set out. This would require a medium to long-term analysis of market fundamentals, both domestically and in the global context.

From a policy stand-point, it would be unwise to consider the development of petroleum refining in isolation. A thorough understanding of the direct and indirect linkages to transport and industry for example, would serve to enhance the robustness of decision making with regards to defining the course of development in the sector.

Finally, it is important also to point out that a thorough assessment exercise could well identify clear and significant latent demand both domestically and in the regional markets, sufficient enough to accommodate any growth in domestic petroleum products supply. This could be the case, for example, considering differences in figures suggested as Nigeria’s total petroleum products consumption. While some put it at over 300,000 b/d (e.g. Nigeria Energy Intelligence, 5 October 2009 edition), the NNPC’s statistical data suggest total delivered petroleum products to be about 240,000 b/d. Whichever the numbers however, a clear definitional framework explaining what constitutes total consumption should serve to resolve such discrepancies.

Ekpen lives in London and may be reached at ekpeno@yahoo.com