A nice ride for refineries - but will it last?

Q:    Why is Shell selling off a refinery near Los Angeles in which it has a 100% holding and at the same time discussing a substantial expansion of the Port Arthur (Texas) refinery in which Shell has a 50% share?
 
A:    We see so much new refining capacity being built all over the world that the margins are bound to go down. The best time to sell a refinery is when the margins are high. Then you must try to find someone who has a different view of future developments.

Q:    So the refining sector is still cyclical despite the good results of the past few years?
 
A:     Yes. As late as 2002 the opposite was true and refinery margins were very low. That was the situation in the USA when we bought Texaco out of two joint ventures. Now we have been able to sell parts of this for a much higher price, thereby earning a good return on our capital investment.

Q:    But why sell Wilmington in California? Refining margins on the American West Coast are traditionally among the highest in the world.
 
A:     Wilmington came out of the Texaco deal. It was then a complex that wasn’t so good in terms of integrity, and so had a low reliability. We’ve invested a lot of time and money in improving its integrity, but with a capacity of 100,000 barrels of crude per day it was still a small refinery. In addition, another billion dollars of investment would have been needed to maintain its competitiveness.

In order to compete in a period of lower margins, you must have large and complex refineries. They simply can’t be built in California, given the present environmental legislation and the attitude of the public. An attempt by us to build an LNG (liquefied natural gas) terminal in that state has already failed for that reason.

Q:    The plan is now to expand Port Arthur to 610,000 barrels per day, making it the largest refinery in the United States. Texas clearly isn’t California.
 
A:     There you have the state behind you, and also the Port Arthur community. So we hope to grow there and almost double the capacity of the refinery, which we hold in a joint venture with Saudi Aramco. Port Arthur is already a complex refinery capable of handling many kinds of crude, including the poorest. This capability will be expanded even further.

Q:    Many new refineries are announced, but experience shows that many of these plans aren’t actually executed.

A:    Even if you assume that half of what’s been announced will ultimately not be built, refining capacity east of Suez will still grow by 22% between now and 2010. You see it happening again, there will be new overcapacity so margins will shrink.

Q:    California isn’t east of Suez.
 
A:    No, but refining has now become a world market. What’s being made by way of oil products in the Middle East and Asia can end up anywhere. New plants are even being built to what are termed California specifications. Take a company like India’s Reliance Industries. In Jamnagar they now have a relatively new, largely export-oriented refinery handling 600,000 barrels per day and they’ll be expanding the complex to 1.2 million. That will make it the largest refinery in the world. And it will be a good one, because Shell Global Solutions is supplying technical know-how.

You see similar developments in China and South Korea. And don’t forget the Middle East. Almost everywhere new capacity is being built. Those products have to go somewhere.

We’re delighted with the margins in the past few years. They’ve been better than I’ve ever experienced in my 35-year career. Until 2003 our average return on refining was 6% per year. Last year it was almost 20%.

Q:    Why is a company like Tesoro, which is willing to pay $1.8 billion for Wilmington, reasoning differently to Shell?

A:    I can’t speak for Tesoro, of course, but I can point out that the share price for an integrated oil company like Royal Dutch Shell is largely determined by oil production and the oil price. For a company that’s purely a refinery player, it depends on the refining margin and turnover growth. There you have to keep on growing to boost the total shareholder return. If margins are poor, companies like that run into difficulties, and in such a situation you sometimes see an about-turn whereby refining specialists are absorbed into integrated oil companies.

Q:     And now Shell’s three French refineries are being sold. For the same reason?
 
A:     Around 2000 you couldn’t earn a dime in refining in Europe. Here too, things have been going well in recent years due to the impact of worldwide capacity shortages. But markets have changed. In France, for instance, we’ve gone down in retail market share from about 16% to 3.5%. That’s why we no longer need three plants – which were small on average on the one hand, and insufficiently focused on diesel manufacturing on the other. They couldn’t be turned into the world-class capacity refineries we have elsewhere in Europe.

Q:    But surely there’s also the element of Shell’s group strategy giving priority to investments in exploration and production?

A:    To put it quite simply, I just don’t have the money to invest in upgrading small refineries. Shell’s strategy is More Upstream and Profitable Downstream. This means that a large proportion of the cash earned in downstream goes to the upstream. So the money I get from the Board has to be invested prudently.

Q:    For quite some time now, Shell’s refining capacity has been less than its branded sales on a day-by-day average basis. Isn’t it strategically risky to drop down even further, particularly now that Shell is profiling itself more strongly with special fuels like the V-Power grades?
 
A:    With all disinvestment decisions, our strategic supply position is, of course, considered as well. What product volumes are we making ourselves? How much are we buying in? What additives do we make ourselves? How much blending capacity do we have? And how can we continue making enough of our own differentiated products such as V-Power gasoline and diesel?

A key role in this is played by our trading department. Our traders last year traded about 11 million barrels of crude oil and oil products on a day-to-day basis, in other words far more than what we sell under our own brand. It’s a business enabling us to earn money on market volatility and storage, and we can also assure supplies to our own networks in this way.

Q:    Isn’t a large trading business a larger financial risk than having a strong refining and retail position?
 
A:    Not if you’re hardly earning anything on retail but you are on trading. The risk greatly depends on how you’ve organised your trading business. In the mid-1990s we started to separate our trading activities from the country organisations and turn them into one global business. We now have this one business, Stasco, which with 10 offices is able to trade worldwide, 24 hours per day, seven days per week. We have very good information from the markets and about physical oil flows. Consequently we’re better positioned than the banks, which only carry out oil trading in purely speculative papers. Almost every one of our positions is hedged, so positions in crude are offset by gasoline contracts, or diesel trades are offset by something else.

Q:    In a presentation to financial analysts, Shell said that its trading results between 2003 and 2006 roughly quadrupled. Without mentioning specific figures.

A:    We wanted to publicise our success in integrated oil trading. But we don’t disclose absolute figures. Nobody does, by the way. I don’t want our competitors to know what our income is from this business. There’s no need to make them wiser than they already are.

The volume of our trading business is growing, just like the day-to-day fluctuations on the markets. When oil was $20 per barrel a swing of 20 cents in a day was quite remarkable, but now there are days with jumps of about $2 on a $60 per barrel price. But due to our way of trading, with positions being hedged, our maximum risk isn’t more than about $8 to $10 million on any one day. Every day the open positions are totted up, and if for any reason they overshoot the limit allowed by the Board, Stasco must inform me at once.

Q:    The business strategy is More Upstream and Profitable Downstream. Where does the “profitable” boundary lie?

A:    In the upward direction it can’t be profitable enough. But everyone knows that the market always corrects itself. The reason there are so many plans for new refineries is that refining is now a money earner. An additional factor is that the national oil companies also want to have more refining capacity. In the Middle East they don’t just want to export crude but be in the whole value chain. High profitability is always self-correcting.

Q:    And in the downward direction?

A:    Our aim is to achieve an average return of 12-15% over a business cycle. How long is a cycle? Typically between seven and nine years.

Q:    At present downstream at Shell is a cash cow for Exploration & Production. And a good one, because last year the profits in this business segment were about $7 billion plus another billion dollars from Chemicals.

A:    At town hall meetings I’m repeatedly asked by our people, “what’s happening to ‘our money’”? Whereupon I explain that after the reserves debacle in 2004 we concluded that the group could only get out of its problems if we worked together to get the EP business back on the rails. But I can also tell them that in downstream we’re still investing more than we’re writing off.

At present we’re busy introducing global work processes for downstream with the Downstream One project. Once that work has been done, there’ll be a basis on which we can grow. I think that when I retire at the end of 2008, about 80% of Downstream One will have been implemented.

Where we’re allowed to grow, we take that opportunity. For instance in lubricants in new car-owning countries like Russia, India and China. I’d very much like to have refining capacity of our own in China, and more retail.

Q:    Shell regularly sells off whole groups of filling stations and then signs supply contracts with the new owners. Why?

A:    Part of our policy is to reduce the number of filling station operating models worldwide from about 160 to four. One of the four models is franchising. The station is then owned by an independent entrepreneur who has a supply contract with us and operates under the Shell brand and colours. In many regions, we as Shell simply don’t have the volume or the clout to get the best out of a network. Last year we sold our stations in a number of Caribbean countries to a businessman who’s also an automobile importer and has garages in those countries. One year later the sales figures at those stations had grown more than 20% on average.

Q:    Which raises another question about risk: such a dealer can simply change his whole chain over to another brand when the contract expires.

A:    That’s true, but as long as we make sure we have a cast-iron brand appeal and offer competitive terms, the dealers will be keen to stay with us. In many major countries, motorists state the highest brand preference for Shell. We underpin this with our V-Power fuels, for instance, and our technology partnership with Ferrari. In the USA we also aim to be top in brand preference, which is why we’re now taking part in the NASCAR (National Association for Stock Car Auto Racing) races. In the first race of the season, the Daytona-500, our team was the winner straightaway, although it was just with a two-foot lead.

Q:    Let’s turn to biofuels. What’s the Shell strategy here?
 
A:    Their development within Shell can’t go fast enough as far as I’m concerned. This may sound odd, because after all we live off the sales of hydrocarbons. But I see biofuels as a train that can’t be stopped. The European Union’s requirement is now a 10% biofuel blend by 2020, and the general energy target formulated by Brussels is a 20% reduction of CO2 by that same year. In the USA the government is talking about a 17% biofuel blend by 2017. So they’re on their way, and we have to make sure we’re part of this.

Q:    However, so far Shell has refused to make biofuels like ethanol and biodiesel itself by first-generation conversion technology. So will that now change?
 
A:    Three or four years ago we already saw that this technology, whereby food crops are converted, would have an impact on food supplies. You now see this happening. We do play a major role in the supply chain, particularly in the USA and Brazil – to such an extent that we’re now the world’s largest seller of biofuel blends. But it’s still the case that we don’t want to get involved in a big way in first-generation production. I’ve no wish to hear in 10 years’ time that the oil industry is the cause of hunger in the world.

Q:    But the world is calling out now for biofuels, or at least biofuel blends, while Shell is still just experimenting with second-generation technology through minority interests in Iogen (Canada) and Choren (Germany).

A:     In both cases, Shell is not only an equity holder but also technology developer. We’ve now got to the stage of building demonstration plants. At Choren [conversion of wood chippings to pure diesel fuel by gasification and Fischer-Tropsch synthesis – the biomass-to-liquids process] a demo plant will be opened soon. You will soon see an announcement on a demo plant from Iogen (for converting straw into ethanol by an enzymatic route).

Q:    But these are demonstration plants, so they’re still a lot of money and years away from the series construction of full-scale commercial units 10 times as large, for instance.

A:    We want to develop something that’s responsible and sustainable. This will probably come later, but so be it. You can’t skip the demonstration plant stage. With Choren, for instance, we know that the gasification process works, it’s proven technology. We also have a lot of experience with Fischer-Tropsch synthesis. But now we have to prove that they both work when linked up to one another.

Q:    And the cost will have to be driven down, because at present second-generation is more expensive than first-generation, which itself can’t exist without subsidies and tax breaks.

A:    You always need that support when an alternative technology is started up. This must bring you to the point where the unit costs are driven so far down by upscaling and technology improvement that you can compete with products made by traditional technology. It would greatly help if these producers could be rewarded by carbon credits – after all, this second-generation conversion will bring about CO2 emission reductions of up to 90%. For that purpose, it would be helpful if the present European system of tradeable emission rights were to be extended to other countries.

Q:    Aren’t you afraid that in such a situation the production of biofuels will end up by being just as cyclical as the refining of hydrocarbons is now?

A:    So what, it will indeed be cyclical, certainly. But what’s the alternative? Sacrificing 20% or more of your gasoline or diesel market? In that case you can carry on closing down refineries. And we don’t intend to do that.

*Rob Routs spoke to Piet de Wit

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