Future of Australian refining

Key messages

Australian liquid fuels demand and supply

The Australian refining industry is a small player in the international liquid fuels market. The ongoing viability of the Australian industry will be determined largely by international factors. In particular, competition in the Asian fuels market arising from changing demand for liquid fuels, and increased supply from new Asian refineries.

Since 2000, demand for Australian petroleum products has grown by 2 per cent per annum. Gasoline and LPG demand grew for several years at around 1 per cent per annum, but since 2005 demand has been contracting, in part due to rising international petroleum product prices. Middle distillates such as diesel and jet fuel have grown at rates above 5 per cent. Domestic sales decreased by 3.2 per cent in 2006 (by 1600 ML) to 48 800 ML. These changes in liquid fuel demand are expected to continue with increasing use of diesel in commercial and industrial applications and continued expansion of diesel use in the passenger vehicle market. Alternative fuels are also expected to capture a small but increasing portion of the liquid fuel market. For example, LPG currently accounts for almost 10 per cent of total liquid fuel demand and biofuels are growing rapidly. Domestic production fell by 6.7 per cent in 2006 to 38 100 ML. The lower level of domestic production was, in part, due to delays in construction work on some cleaner fuels projects. Total domestic production is expected to grow only marginally with de-bottlenecking of refinery operations in future years. Since 2000 there has been a major structural shift in the Australian fuels market with imports increasing from around 10 per cent of total demand in 2000 to nearly 22 per cent in 2006. Total imports increased to 10 500 ML in 2006. Import levels were much larger for some key fuels (e.g. over 30 per cent of diesel was imported in 2006). Australia is expected to continue to import an increasing proportion of liquid fuel demand. The actual level of imports will depend on growth in demand and the ability of the Australian refining industry to compete with Asian refineries.

Asset value

At the end of 2006 the assets of the downstream petroleum industry were $16.6 billion across the refining and marketing sectors. Asset values increased by $2.2 billion from 2005.

The growth of assets was driven by the large investment since 2004 in the Cleaner Fuels Program. There has also been significant investment in the distribution sector and retail service stations to improve supply reliability and meet competitive retailing challenges.

Debt position

In 2006, total industry borrowings fell to $5.65 billion which is above the average 1997–2006 net borrowings for the industry of $4.9 billion. Strong cash flows from improved refinery margins provided a sound basis for the large investment program undertaken in 2006.

Investment and profits

Due to its capital intensive nature, the downstream petroleum industry routinely requires large and ongoing investment in plant and equipment to continue safe and reliable operations. Major milestones in the Australian Government Cleaner Fuels Program meant a significant increase in capital expenditure in 2005 and 2006. Investment in plant and equipment doubled in 2005 to $1.3 billion and continued in 2006 with a further $1.45 billion in new investment. As a proportion of net profits on a statutory basis, investment increased from 63 per cent in 2005 to 96 per cent in 2006. On an underlying profitability basis, the proportion of investment to net profits increased from 86 per cent in 2005 to 99 per cent in 2006. These figures highlight the large and ongoing investments required to maintain the downstream petroleum industry. From 1997 to 2006 the industry invested over $6.7 billion. In comparison, net profits over the same period were $6.5 billion on a statutory basis and $5.8 billion on an underlying basis.

Profitability measures

The improvements in Australian industry profits in recent years reflect the impacts of historically high crude oil prices and tight refining capacity. These factors are illustrative of the large and cyclical fluctuations which are a feature of the downstream petroleum industry. The average returns over the period 1997–2006 indicate that on a longer term basis the returns for the industry remain low.

The overall picture for returns has improved significantly with increases in refiner margins and large stock gains driving profit increases over the last few years. This increase in profits and cash-flow has been accompanied by commensurate increases in investment.

In comparison to the years prior to 2003, where industry returns marginally exceeded the long term bond rate, returns since 2004 have been well above 10 per cent for both statutory and underlying profits. However, the downstream petroleum sector is a cyclical and volatile industry and future returns will largely depend on developments in the Asia–Pacific refinery industry, international crude oil markets and the course of the Australian economy.

For statutory returns, the major feature of profitability over the last couple of years was the large rise in crude oil prices in 2005 which led to stock gains of $673 million. This raised the statutory return to 19.6 per cent in 2005. Stock gains were more modest in 2006 at $69 million and the statutory return fell to 13.7 per cent.

Increases in international refining margins have driven an improvement in profitability, with the underlying return increasing to 14.8 per cent in 2005. The performance was not matched in 2006, with returns easing to 13.3 per cent. The fall in returns could be attributed to lower demand, higher costs and delays in the construction program for cleaner fuels, and the increased asset base.

In 2006, the profit per litre of fuel sales on an underlying basis increased marginally to just over 3 cents per litre. The statutory net profit per litre decreased to 3 cents per litre in 2006 from a profit of above 4 cents per litre in 2005. Longer term, over the period 1997–2006, average returns are around 1.2 cents per litre.

A continuation of low average returns will challenge the affordability and attractiveness of future investments.

Return on assets

Measures of profitability are presented as earnings before interest and tax (EBIT) on total assets for both statutory and underlying returns. The statutory return is reported in company accounts and complies with reporting requirements under relevant legislation. The underlying return removes the impact of stock gains and losses to derive a profit result not affected by the impact of movements in international crude oil prices. Removing the stock valuation effects from profitability measures provides a clearer picture of the fundamental economic performance of the industry.

Competitiveness of Australian refineries

The significant competitive pressures faced by Australian refineries is illustrated by the high level of products imported into northern Australia from nearby Asian refineries with direct and efficient access to this market.

Compared to refineries across Asia, Australian refineries suffer from substantial disadvantages in operating and capital costs that virtually preclude Australia from consideration for new refinery investment. The relatively small Australian refineries offer no economies of scale benefits and as an industrialised nation, Australia offers none of the capital or operating cost benefits available in many developing countries.

In addition, the taxation and investment regimes applying in Asia are highly attractive for new investment with the provision of taxation holidays, substantial investment allowances and investment facilitation. General government regulations in Australia are increasingly complex and involve higher compliance costs, together with lengthy delays in gaining development approvals.

The significant disadvantages faced by Australian refineries present major challenges for governments. For example, fuel pricing, taxation and fuel standards are regulated by federal and state governments. Many environmental policies are regulated by state governments and in some cases by local governments. These policies increase the complexity of operations and raise the costs of doing business in Australia. Regional competitors do not face many of these issues.

In order to compete, the existing Australian refineries must operate extremely efficiently and reliably, and make the most of their geographic location and advanced fuel standards.

Australian government policy

The downstream petroleum industry faces a complex policy environment with interactive and in some cases overlapping regulation by federal, state and local governments.

Government policies will have significant impacts on future refinery operating requirements and hence will impact critically on commercial viability. Government policies will also impact on investor perceptions of the longer term prospects for Australian refineries.

The key policy influences on the Australian refining industry are:

• the Cleaner Fuels Program
• liquid fuel supply reliability
• energy security
• alternative fuel mandates
• fuel and corporation taxation
• skilled labour training
• climate change policy
• environmental regulation.

In each of these areas, AIP and its member companies advocate policies which apply equally to all participants in the industry and which are based on sound science and supported by comprehensive economic analysis.

Actions in each of these policy areas will have the potential to affect the competitiveness of the Australian refining sector. Policy makers will need to consider all possible options if the competitive position of the refining industry is to be maintained. It should not be assumed that refiner margins arising from regional refining industry conditions will always enable Australian refineries to manage increasing policy constraints and the associated costs.