Does Australian oil refining really matter?

"The earth... will be reliant on fossil fuels for many years. That is why carbon capture and storage is so important to climate change policy"

In a recent speech prepared for the American Chamber of Commerce, Caltex Managing Director and CEO Des King examined these and other issues.

Petroleum products like petrol, diesel and jet fuel provide 35 per cent of Australia’s energy. They are vital to many industries like transport, mining, agriculture, construction and tourism, and everyday commerce. Without them, Australia would literally stop moving.

Growing oil demand is making supply more difficult, more expensive and more risky. Given that Australia is heavily dependent on oil, we should avoid losing any of the links in the oil supply chain. Doing all we can to retain oil refining in Australia makes sense provided it remains a net positive for the economy including energy security.

World energy demand up 50 per cent by 2030

Globally, there will be a massive increase in demand for energy and all the services that energy provides – including heating and cooling, cooking, mobility and ultimately employment. The International Energy Agency (IEA) projects a 50 per cent increase in energy demand by 2030.

Developed countries, particularly the United States and the countries of Europe, have high energy demand but relatively low energy growth. Their share of demand drops from 56 per cent to 40 per cent by 2030.

China, India and many other developing countries are coming off a lower energy use base but growing much faster. Their share of demand increases to 60 per cent.

World will continue to rely on oil, coal and gas

Where will all this energy come from? The IEA projects that oil dependence will fall but oil will continue to dominate energy supply, about one third of the total. Gas and coal will continue to supply about one quarter of global energy.

Other sources will grow but still supply less than 20 per cent of energy. It will be important to develop a range of new renewable energy sources but these are generally seen as playing a minor role over the next 20 to 30 years.

Longer term, major changes will be needed in the way energy is produced and consumed. The problem is not really the endowment of resources, it’s developing the resources sustainably and delivering them to markets. That is best achieved through competitive markets for investment and trade in energy at the global, regional and domestic levels.

Conventional oil supply will fall below demand

There is a wide range of forecasts for oil supply. “Peak oil” forecasters see conventional oil production declining within 10 to 15 years but oil companies are generally more optimistic. It is likely the trend will be tighter oil supply and increasing prices, with periods of substantial price volatility.

Even if “peak oil” forecasters are correct, we would be producing about as much oil in 2030 as we do today. The real worry in that case would be growth in demand and what we could do to supplement conventional oil supply to fill the supply gap.

Oil supply will become more difficult and risky

Resources of oil are extensive but the technological, financial and political challenges of producing enough oil at an acceptable price are daunting.

By 2030, more than half of production will have to come from development of existing reserves – a massive capital requirement – and growth in production will have to come from unconventional oil resources and new discoveries.

Large conventional crude oil resources are located in areas that are subject to substantial risk such as the Middle East, Russia, the Caspian region, Venezuela and Nigeria. Other crude oil resources are in difficult environments such as ultradeep water.

Unconventional oil resources are costly and technologically challenging, such as Canadian tar sands, Venezuelan extra heavy oil and US oil shale. Biofuels face major technological challenges to make large scale production sustainable and cost-competitive.

Greenhouse gas must be reduced

Supplying oil and other energy to a growing world is a huge challenge – but an even larger challenge is climate change, which requires action to greatly reduce greenhouse gas emissions.

“Longer term, low carbon technologies may include plug-in hybrids, hydrogen internal combustion engines, hydrogen fuel cells and pure electric vehicles”

In 1980, global emissions of carbon dioxide were less than 20 billion tonnes, with the developed countries of the OECD accounting for more than half. By 2030, emissions will exceed 40 billion tonnes, with most of the growth in developing countries. However, developed countries will still have much higher emissions per head of population.

While there is no agreed target for reduction in global emissions, a reduction of 50 per cent or more in global emissions by 2050 is commonly suggested, with a greater reduction in developed countries. The changes in energy supply and demand to meet such a target will be truly radical.

The earth can’t sustain the increased carbon dioxide emissions from burning fossil fuels – yet it will be reliant on fossil fuels for many years. That is why carbon capture and storage is so important to climate change policy. While efficiency measures will reduce electricity demand, there can’t be a long term future for coal and gas unless power station emissions of carbon dioxide are captured and permanently disposed of.

For oil, action lies more on the demand side, to greatly improve the fuel efficiency of vehicles. In the medium term, diesel engines and petrol or diesel hybrids offer lower grams of carbon dioxide emissions per kilometre. Longer term, low carbon technologies may include plug-in hybrids, hydrogen internal combustion engines, hydrogen fuel cells and pure electric vehicles. Renewable fuels will help cut emissions from the supply side but are likely to play a relatively small role.

Global refining capacity will remain tight

World oil demand and supply will continue to grow strongly, even with the challenge of climate change. That means growing demand for refined petroleum products and the refineries to produce them.

New refineries and capacity additions will be constrained by increasing capital costs and tougher environmental requirements for cleaner fuels. As a result, global refining capacity is expected to remain tight. Despite this, there will be strong growth in capacity in developing regions, including the Asia Pacific.

Australian refining production is less than demand

Australia has seven major refineries in operation, as shown in the map below. In recent times, ExxonMobil closed its refinery in Adelaide and is now importing petrol and diesel mostly from its refinery in Singapore. It also scaled back its refinery in Melbourne to cut the cost of upgrading it to produce cleaner fuels.

Caltex has refineries in Sydney and in Brisbane. Caltex is an Australian company in the business of refining crude oil into petroleum products, then distributing and marketing those products at the wholesale and retail levels. In the first half of 2007 our profit was $255 million on a replacement cost basis. That’s just 2.6 cents per litre across all our sales of petroleum products. It’s a high volume, low margin business.

Australian refineries produce about 590 thousand barrels per day of petrol, diesel and jet fuel or about 34 thousand megalitres per year, mostly for local demand. This is well below Australian demand for these petroleum products, which is about 43 thousand megalitres per year.

The shortfall in refining capacity means imports are about 22 per cent of Australian demand for petrol, diesel and jet fuel.

Petroleum product imports will grow strongly

Demand for petrol is fairly flat but demand for diesel is growing strongly at four per cent a year and jet fuel at three to four per cent annually. Petrol demand growth is reduced by increased fuel efficiency and penetration of biofuels. Diesel demand is closely linked to economic growth and jet fuel to tourism.

Strong growth in demand for diesel and jet fuels means that imports will grow as no new refineries will be built in Australia and capacity increases at existing refineries will be much less than demand growth.

Imports in 2015 could equal 30 to 40 per cent of demand for petrol, diesel and jet fuel. By 2030 imports could be 50 to 70 per cent of demand.

Regional supply and demand remains tight in medium term

Economic growth, particularly in Asia, is driving global demand for petroleum products, particularly diesel, and keeping prices for diesel high. It wasn’t always like this.

There was excess capacity in Asia in the late 1990s, particularly for petrol. Financial returns were unsustainably low and oil refining in Australia was in dire straits. Since about 2003, Asian demand has been very strong, particularly in China, and refining capacity is scrambling to catch up. In Australia and globally, oil refining is now earning reasonable returns after years in the doldrums.

New Asian refineries

Higher returns induce new investment. For example, the new Reliance Petroleum oil refinery at Jamnagar in north-west India will be on stream in late 2008 making petrol, diesel and jet fuel for the export market. Its capacity of about 600 thousand barrels per day will be similar to the total capacity of Australia’s seven oil refineries. The new refinery will complement the existing Reliance Industries refinery at Jamnagar, making a total capacity of 1.2 million barrels per day.

Large modern Asian refineries have economies of scale that mean lower unit costs than Australian refineries and higher energy efficiency. Apart from India, there are large oil refineries in Singapore and other refineries throughout Asia and in the Middle East with products for export to Australia.

Shipping costs create location advantage for refineries

So how can we compete? The economics of refining are basically simple. Crude oil is imported in large ships – up to 200,000 tonnes. Petroleum products are imported in much smaller ships – up to 45,000 tonnes.

The key question for refinery viability is whether the landed cost of crude oil in Australia plus refining costs and a profit margin is less than the landed cost of petroleum products. The higher cost of freight for product imports provides a location advantage for Australian refiners.

In the first half of 2007, the freight difference for Caltex between small product ships and large crude oil tankers was US$2.75 per barrel. (A barrel is 159 litres.) However, this natural protection is eroded by the higher cost of refining in Australia which results from smaller scale, higher capital costs, and higher wages and energy costs. So Australian refining is quite marginal and vulnerable to additional costs not faced by our international competitors.

How do we stay competitive? Not through protection – Australian oil refining has no tariff protection and we don’t propose any. Not through subsidisation – unlike many industries we don’t seek and don’t receive financial assistance. Not through regulation – we want a level playing field, not regulatory distortions in our favour.

“From time to time, various politicians, organisations and media engage in oil company bashing as a cheap way of gaining public support”

Staying competitive requires strenuous efforts to improve efficiency and cut costs. It also requires all governments to avoid imposing costs that cumulatively could kill refining in Australia.

Let me give you some examples.

Refining faces carbon pricing risks

Carbon cost.

Total Australian greenhouse gas emissions in 2005 were 559 million tonnes of carbon dioxide equivalent. Of this about eight per cent was from use of petrol, eight per cent from diesel and four per cent from jet fuel and other fuels. To manufacture these fuels, oil refineries produced about one per cent of Australia’s emissions.

Under the emission trading scheme proposed for Australia, permits to emit greenhouse gases in a particular year will be auctioned, with the revenue going to the government. Emitters must surrender permits each year equal to their emissions.

However, companies that face import competition from countries that do not impose carbon costs may be classified as “trade exposed, emissions intensive” and receive free permits. As Singapore refineries will bear no carbon costs, Caltex should receive a free allocation of permits for its refinery emissions.

Unless this occurs, up to $1 per barrel of the $2.75 per barrel freight advantage could be eroded. This level of carbon cost would probably make all of Australia’s refineries uneconomic and shift production to Singapore, India and other countries that will not bear any carbon costs.

Also under emission trading, the former government proposed that Caltex should be responsible not only for our own emissions but also our customers’ emissions. At a carbon cost of $40 per tonne of carbon dioxide, Caltex would have to purchase $1.4 billion in permits annually – then increase our prices to recover the money. This would impose a huge financial risk on Caltex far out of proportion to our earnings and financial capability.

Other regulatory issues

Biofuels

Caltex supports the development of biofuels like ethanol and biodiesel as they may play a significant role in future fuel supply and energy security if costs can be reduced and sustainability issues can be overcome. However, we are concerned at government policies and legislation to mandate the supply and use of biofuels.

Biofuels need research and development for new feedstocks and advanced technology and may warrant some additional transitional financial assistance. However, a sustainable biofuels industry can’t be built behind protective barriers – Australia learnt this lesson many years ago.

Environmental requirements.

Air pollution is still a major issue and Caltex has invested $500 million to produce cleaner fuels to cut air pollution. Over the period 2007 to 2009 we will spend about $1 billion on various capital projects to improve safety, reliability and production capability and to maintain our refineries. We support expenditure to reduce the impact of our refineries on the air, water and land but such expenditure has to be realistic and spread over a reasonable period – we just can’t afford everything or do it all over the next few years.

Fuel price regulation

From time to time, various politicians, organisations and media engage in oil company bashing as a cheap way of gaining public support. I am pleased to say that neither the Coalition nor Labor have taken this approach, which is to their credit, and the ACCC is taking a fair, rigorous and fact-based approach to its current inquiry. However, other attacks and proposals for regulation undermine confidence in the industry and ultimately call into question the desirability of investment. False perceptions of excessive profits and market power can also constrain political and regulatory ability to rationalise the industry or impose unreasonable conditions on such rationalisation.

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