European refiners, on the ropes, face knockout blow from Russia

Reuters

* Russia to invest $55 billion in refinery upgrades

* Low-sulphur diesel surplus to flood European market

* Russia to cut heavy fuel oil shipments

By Vladimir Soldatkin and Olesya Astakhova

MOSCOW, Nov 22 (Reuters) - Russia will flood Europe withdiesel and starve it of heavy fuel oil when the countrycompletes a $55 billion refining overhaul, further threateningthe continent's downstream sector as it struggles to survive.

The investments, which seek to capture more value from eachbarrel of Siberian crude by refining it more deeply in Russia,would choke flows of straight-run fuel oil used as a feedstockby Europe's advanced processing units.

Russia's Soviet-built refineries, some dating to the 1940s,mainly operate simple distillation units. Straight-run fuel oil,known as mazut, is the residue left after lighter fractions areevaporated off.

The planned installation of 130 new units, such as thelong-awaited 60,000-barrels-per-day (bpd) hydrocracker atSurgut's northwestern Kirishi refinery, will enableRussia to increase yields of lighter products instead. That willcreate a huge surplus of high-quality diesel on Europe'sdoorstep.

If that isn't bad enough, the world's largest oil producerwants to triple crude exports to China. With Russian oil outputlikely to stagnate in the years ahead, Europe's refiners mayfind margins squeezed further by a dearth of Urals export crude.

"European refineries are going to be hit across the board,"said Heitham Tolba, a downstream analyst for energy consultantsWood Mackenzie.

Russia exports around 3.5 million bpd of crude to Europe.Fuel exports total 700,000 bpd - a third of Russia's overseasoil product deliveries.

The government backed the refinery overhaul in 2011 aftergasoline supplies almost ran dry due to a lack of modernrefining capacity, riling drivers not long before VladimirPutin's election to a third Kremlin term.

The upshot of ensuring that motorists have enough premiumgasoline to fuel Russia's growing fleet of Western-made carswill be a diesel surplus that could reach 65 million tonnes ayear by 2020, Moscow's Skolkovo business school estimates.

CAPACITY BOOST

Russia's primary refining capacity, which distills oil intobasic fractions such as naphtha, fuel oil and low-qualitydiesel, will expand by only 7.5 percent to around 285 milliontonnes (5.7 million bpd) by 2020, according to the plan.

Secondary refining, in which complex hydrocarbons are"cracked" into simpler ones, will grow by 90 percent over thesame period to match Russia's primary refining capacity.

This will boost output of high-quality products, includingultra-low-sulphur diesel (ULSD) with sulphur content of 10 partsper million (10 ppm). Russia will require vehicles to use ULSDfrom 2016.

In addition to the diesel glut, Skolkovo expects Russia toproduce a gasoline surplus of 10 million tonnes in 2020.

This assumes that domestic consumption of oil products willgrow at a yearly rate of 3.5 percent, even after allowing forfuel-efficiency improvements in Russia's vehicle fleet.

The European market, now experiencing diesel shortages,would be the main destination for the surplus, as most Russianrefineries are located in the west of the country.

EXPORT BOOST

Wood Mackenzie expects Russian ULSD output to top 1.1million bpd in 2016, up from 750,000 bpd now. Exports may doubleto 680,000 bpd as Russia competes with European refiners to filla growing diesel shortfall.

European refineries are already suffering from low margins,forcing around 1.8 million bpd of capacity to be mothballedsince 2009, according to Deutsche Bank. That leaves 10.7 millionbpd of operating capacity in the European Union plus Norway.

The plants most vulnerable to closures are the less complexrefineries in the Atlantic basin that rely heavily on gasolineexports.

Exporters of high-quality Russian oil products to Europehave also been encouraged by a decision to tighten environmentalrules there. These state that from 2015, the maximum sulphurcontent of shipping fuels will be cut by 90 percent to 0.1percent in Sulphur Emission Control Areas, which include some ofEurope's busiest sea lanes.

At the same time, European refineries are cutting runs asdiesel production requires a strong premium to prices forbenchmark grades such as North Sea Brent crude to be profitable.

Crack spreads (LGO-LCO1=R), measuring the premium of JanuaryEuropean gasoil futures over Brent crude, are nearly $15 perbarrel, indicating that producing diesel is slightly profitable.

Yet the overall profit on refining a barrel of Urals ExportBlend crude in the Mediterranean is just 12 U.S. cents, downfrom over $4 early in the year.

"Many of the diesel suppliers that will export more dieselto Europe, especially Russian ones, can be profitable even whendiesel spreads to Brent weaken. So even when the diesel spreadweakens, they will continue to deliver diesel to Europe," saidAndrew Reed from U.S.-based think tank ESAI Energy.

The shale energy boom is meanwhile expected to propel U.S.oil production past Russia's as soon as next year, theInternational Energy Agency estimates. That in turn will boostNorth America's own diesel surplus.

In its 2025 outlook, Russia's second-largest crude producerLukoil said net diesel exports from the United Stateswould peak at 500,000 bpd in 2015. That contrasts with netimports of 200,000 bpd back in 2005.

"The Russian refiners are close to European markets and theyhave the advantage of a local supplier. They still have tocompete against the Americans - but they have the advantage ofthe proximity," said WoodMac's Tolba. (Additional reporting by Maxim Nazarov; Editing by DouglasBusvine and Dale Hudson)

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