While the oil upstream segment involves the exploration and production of crude oil, the midstream segment focuses primarily on the refining of the crude oil. In this article, we will explore how refineries operate, the regulatory environment, factors influencing their profitability, the role of non-energy products, and an analysis of the competitive environment.
The Role of Oil Refineries
Oil refineries play a critical role in transforming crude oil into refined products used in daily life, such as petrol, diesel, furnace oil, and kerosene. In Pakistan, petrol and diesel are the most consumed products, with furnace oil contributing to electricity generation primarily.
Other refined products include jet fuel for aviation, naphtha for petrochemicals, asphalt for road construction, etc. This oil refining industry in Pakistan is also strictly regulated by the government; prices are set/revised on a fortnightly basis.
Government Regulation and Pricing Mechanism
Pakistan’s oil refining industry operates under stringent pricing policies established by the government. Refineries can sell their refined products, particularly petrol and diesel, at ex-refinery prices set by the regulators. Ex-refinery price is the actual import price of Pakistan State Oil (PSO), which can also be considered as the import parity price.
Import parity price considers the landed cost — the total cost of importing a product, which includes freight, insurance, customs duties, and other associated costs.
While one might assume that rising product prices lead to higher profitability, the reality in refining is different. Profitability is driven by product spreads (the difference between the price of crude oil and refined products), not just the absolute price levels.
For instance, if petrol is priced at $100 per barrel and crude oil at $80, the spread is $20. However, if petrol rises to $120 while crude oil jumps to $110, the spread narrows to $10, reducing profitability despite the higher prices. These product spreads, when combined in a weighted average according to output slate of the refinery, translate into Gross Refinery Margins (GRMs).
Gross Refining Margin (GRM) and Profitability Trends
Refineries, not just in Pakistan but also globally, rely heavily on Gross Refining Margins (GRM) for their profitability. GRMs measure the spread between the price of crude oil and refined products and fluctuate with international prices. When GRMs are high, refineries experience strong profits; however, when they fall, so do profits. An analysis of the historical GRM trends reveals that they are highly volatile in nature, while averaging around a certain mean. This volatility eventually translates into refineries profitability as well.
Custom/Deemed Duties
Another key factor influencing refinery profits is the customs duty on high-speed diesel, currently set at 7.5%. This duty is incorporated into the final price, allowing refineries to benefit from an incremental price that contributes directly to their profits. Estimates suggest that this deemed duty provides approximately PKR 9 billion annually to Pakistan’s three main refineries listed on Pakistan Stock Exchange — Attock Refinery, National Refinery, and Pakistan Refinery.
The Impact of Furnace Oil on Refinery Operations
A significant challenge for Pakistan’s refineries is managing the production of furnace oil, a low-value byproduct. In recent years, demand for furnace oil has plummeted due to the rise of more efficient and cheaper electricity generation sources like LNG and hydropower. With furnace oil-based power plants having been phased out, refineries are left with excess production. Unfortunately, furnace oil is an extremely low-value product and hence carries negative product spread. Exporting furnace oil compounds the problem due to added inland and sea freight costs.
Lubricants: A Profitable Segment
Unlike the volatile fuel segment, the lubricants sector remains highly profitable, particularly for National Refinery, the sole local producer of base oil in Pakistan. Lubricants, including engine oils and machinery oils, are essential products that provide strong profit margins due to their deregulated nature.
National Refinery’s lube segment consistently delivers profits in the range of PKR 8–10 billion annually. This stable income contrasts with the fluctuating fortunes of the fuel segment, where profits are heavily influenced by international market trends.
Porter’s Five Forces Analysis of the Oil Refining Sector
To better understand the competitive landscape of the oil refining sector, we can apply Porter’s Five Forces analysis:
- Competition: The industry has low competition due to a high demand for petrol and diesel, with local refineries supplying less than 50% of the national demand.
- Bargaining Power of Suppliers: Supplier power is low as government-regulated pricing limits the ability to charge any premium.
- Bargaining Power of Buyers: Buyers also have low power due to a reliance on locally refined products, especially given Pakistan’s foreign exchange constraints limiting imports.
- Threat of Substitutes: There are no significant substitutes for petrol and diesel, especially with the decline of CNG as an alternative fuel source.
- Threat of New Entrants: The sector has high barriers to entry, with new refineries requiring massive capital investments.
The Future Outlook for Pakistan’s Oil Refining Sector
The future of Pakistan’s oil refining sector hinges on two key elements: GRMs and upgradation projects. The government’s National Refinery Policy 2023 encourages refineries to upgrade their technology to meet advanced euro fuel standards and refine more crude oil locally.
Upgradation projects are being incentivized through increased customs duties on petrol and diesel. These improvements are expected to boost profitability; however, timing and financing details remain unclear. More details about capital costs and financing structures will provide clearer insights into the potential value of these projects.
Conclusion
The midstream oil refining sector in Pakistan faces both challenges and opportunities. While refineries shall benefit from customs duties, they shall continue to grapple with the volatility of GRMs. Understanding these complexities is vital for making informed investment decisions in this industry.