SA’s reliance on security of supply with oil products

A renewed focus on the petroleum refining business in SA has followed the announcement that Chevron is looking for a buyer for its SA business, writes Robert Stewart.

A renewed focus on the petroleum refining business in South Africa has followed the announcement that Chevron is looking for a buyer for its local business. South Africa has four oil refineries in addition to the large Secunda synthetic production and the small Mossel Bay synthetic production. Of the four oil refineries, three are at the coast, Shell/BP (Sapref) and Engen (Enref) in Durban, Chevron (Chevref) in Cape Town; and one is inland, Sasol/Total (Natref) in Sasolburg.

The local production is supplemented by imports of petroleum products, mainly into Durban, to meet the markets of the customs union. This report offers perspective on the issues affecting the viability of the oil refineries from the point of view of the refiner and of RSA Inc.

Socio-economic value

This perspective highlights the numbers of jobs associated with refining, directly and indirectly. For an appreciation of this aspect, refer to the Chevron presentation in a recent public – National Energy Regulator of SA – forum about the value of Chevref to the Western Cape economy. The perspective must also include the value of sustaining technical expertise within the country, provided by the national education institutions.

The example of the economic shutdown of refineries in Australia has been cited. These shutdowns presumably followed a conscious policy decision by the government based on an assessment of factors unique to Australia and reflecting the judgment that unfettered competition in the supply of petroleum products would be good for Australia. This does not mean the same policy will be good for South Africa.

Investment in new oil refineries is typically based more on strategy, rather than the return on investment in the refinery itself. Examples are the large export refineries of the Middle-East where oil producing nations want to diversify from total reliance on sales of crude oil, and home refineries built by economies such as China, which want to diversify from heavy reliance of their economies on the global sources of finished products.

It is in this context, among others, that Project Mthombo (the green-field refinery in Coega mooted by the national oil company, PetroSA) would have been appraised. There is much of value to be learned from the Project Mthombo story.

For South Africa the Secunda coal-to-liquids production shields the country from geopolitical upset and complete reliance on imports in the form of either crude oil or petroleum products, but the amount has diminished substantially from the figure of 50 percent of demand that Secunda originally supplied in the early 1980s. Reliance on the conventional oil refineries for security of supply is high. The only strategic storage (SS) of petroleum available to South Africa is in the form of crude oil. There is as yet no SS storage in place for finished products.

The ability to import finished products through Durban for the Durban and inland markets is constrained and in the absence of local production the nation’s security of supply would be compromised, at least in the short to medium term. Sources of crude oil are more diverse than sources of products and so a balanced dependence on both of them seems sensible.

The importance of the oil refineries in providing security of supply is justifiably reflected in the government’s Energy Security Master Plan of 2007, in terms of which the refineries’ production should be put into the market ahead of imports.

A meaningful way to appraise the local refineries is to test them in terms of their sustainability in the face of competition in the target product market (South Africa) from other refineries.

Production cost

The appropriate marker is the production from the large export refineries of the Arabian Gulf and India, against which it is supposed the RSA refineries cannot compete with regard to their superior economies of scale. It is the cost of product from these refineries landed in South Africa against which the cost of production from the local refineries at the same location must be gauged.

It is true that these export refineries have the advantage of economies of scale, but the South African refineries have offsetting advantages that are seldom highlighted. The local refineries also have disadvantages, which arguably can be viewed as opportunities.

Local refineries have a location advantage due to the difference in cost of freight of crude oil and of finished product. Local production of speciality products, such as bitumen, LPG, and solvents, enhance this location advantage. The local refineries are favourably located in terms of their South African market.

The coastal refineries have a location disadvantage in bearing the freight cost of export of heavy fuel oil. However, this disadvantage would be eliminated if the heavy residue can be profitably upgraded instead. Consideration must be given to the mooted international ban on the use of heavy residue in bunker fuel on environmental grounds.

Basic fuels pricing (BFP) is the regulated price against which the refineries actually make their margin, but it is contended that the current BFP formula for representation of the import price understates the value of the refineries’ production. This is obviously a disadvantage, which can easily be corrected. Some years ago, the Department of Energy (DOE) commissioned a study by an international firm but nothing seems to have followed. In any case, the study failed in its understanding of how to uphold the import-parity principle as a cornerstone of the current regulatory framework.

The South African oil refineries are probably more competitive than they are given credit for. The analysis must be done properly. The refiners must do business and make long-term decisions amid uncertainty about this regulated industry. Clarity on key issues has not been forthcoming from the DOE.

The major issue is the move to CF2 (the second phase of the move to the “cleaner fuels” that are marketed in Europe). There seems to be a stalemate between the DOE and the oil industry. It is well known that the refineries need to spend significant capital to meet the improved quality specifications and they have argued for compensation.

The writer thinks that such compensation is unwarranted as this investment decision ought simply to be about doing what is needed to stay in business. However, in the context of CF2 it is reasonable that in return for this investment the refineries should at least gain the following:

* Unqualified affirmation of the policy, which gives priority to local production in the market.

* A BFP formula that adequately reflects the value of the clean fuels provided to the market.

With the above two assurances the refineries will be in a fair position to take the commercial risk against the prevailing level of global refining margins. So much for the stand-alone economic viability of South African refineries.

Security benefits

If the government additionally decides that the social and supply security benefits are important then there must be specific measures of support for the refineries through a transparent mechanism for all to see and understand. The government must make a call one way or the other about this, and soon. Does South Africa go the way of Australia, letting the refineries compete for survival, or should it retain the benefits of local production that a developmental economy might value?

The government must provide an early signal in terms of the sale of Chevron’s business, particularly the consequences for the refinery. Will government stand back and watch a global trader buy the business and close the refinery simply to suit the trader’s global strategy?

Or will it take steps to incentivise the retention of the Cape Town refinery as a local producer?

* Robert Stewart is the founder of PetroLogistics, a consultancy specialising in economics of oil refining and supply operations and the development of strategy for businesses and government.

** The views expressed here do not necessarily reflect those of Independent Media.

BUSINESS REPORT