Shell Closes German Refinery Despite NOC Interest in European Downstream Sector

A Tough Sell

Anglo-Dutch supermajor Royal Dutch Shell has announced it will convert its refinery at Harburg into a storage and handling terminal for oil products. The IOC had been searching for a buyer for over two years but, after non-exclusive negotiations with Indian oil firm Essar Oil failed, the unit will now cease operations in the second quarter of 2010.

The base oil (lubricants) section of the refinery is still up for sale and negotiations are apparently continuing, although Shell did not disclose with whom. The Harburg refinery can process 110,000 barrels a day, while the base oil plant has capacity to make 170,000 tonnes of API Group I paraffinic base oils per year and 150,000 t/y of naphthenic base oils.

Outlook and Implications

Shell's decision in 2009 to sell the Harburg refinery formed part of a well-recognised trend of IOCs seeking to divest themselves of European downstream assets as the sector continues to contract. French IOC Total confirmed in the third quarter of 2010 that it was looking to sell its U.K. retail chain, which includes the Lindsey refinery and 780 outlets. Chevron, ExxonMobil, and Murphy Oil are also pulling out of the U.K. market. Shell stands out amongst its peers for being particularly aggressive in its disposal of assets, selling all of its refineries in France and Switzerland, and offering its assets in northern Germany and Stanlow in the United Kingdom for sale.

The mass exodus reflects the poor long-term fundamentals in the European refining sector. Demand peaked back in 2005 and, after some modest recovery, is expected to continue its decline, mostly under the pressure of government greenhouse gas (GHG) emission reduction policies, biofuels or other renewables mandates, and stricter efficiency standards for new vehicles and buildings. Combined with the effects of ageing, stable populations and car ownership saturation, this will prevent petroleum-based demand from the Organisation for Economic Co-operation and Development (OECD) countries from surpassing its 2005 peak. At the same time net margins are currently very low as a result of high operating costs. These stem from high energy prices (around 7% of refinery input is for own use, hence high prices push up costs); tighter specifications (reduced sulphur content allowances increase production costs and often require more expensive forms of crude oil); and industry inflation—according to IHS CERA Downstream Capital Costs Index (DCCI), construction costs have edged down from their 2008 peak but are still 70% higher than during 2005 and are starting to rise again. The practical upshot of this is to create cut-throat competition within the refining sector, presenting opportunities for a wave of consolidation.

One interesting sub-trend to emerge from this is the penetration of the European downstream sector by emerging market energy players. Last week's announcement by PetroChina that it would team up with U.K. refining firm INEOS Group was the latest example of BRIC (economic grouping of Brazil, Russia, India, China)-based oil and gas firms making strategic acquisitions in European markets (see United Kingdom - China: 11 January 2010: PetroChina Taps Into European Refining Business with U.K. and French Interest Acquisitions). India's Essar is also keen to expand into Europe, while Russian firms have begun to make modest inroads into buying assets in Eastern European downstream markets (see Russia: 5 November 2010: Russian Companies Aim for Continued Success in Targeting Refinery Acquisitions in Northern Europe). Although the deal has not yet been confirmed, Brazil's Petrobras is also said to be interested in acquiring a controlling stake in Portuguese Galp which, amongst other assets, would provide access to the latter's downstream network on the Iberian Peninsula (see Portugal: 6 January 2011: Petrobras Eyes Eni's Galp Stake).

These moves suggest a trend towards NOCs and emerging-market energy groups with close government ties expanding into mature European markets' downstream sectors in order to develop an integrated network of processing, storage, and trading facilities. This contrasts with the major IOCs, which are gradually reducing exposure to low-margin downstream operations in mature OECD markets. Shell, for example, is hoping to reduce its net refining capacity by 15%. The IOC's moves are driven by financial considerations: return on capital from refining for the world's top seven oil companies was just 4% in 2009, compared with 17% from exploration and production, according to Deutsche Bank.

This scenario ought to precipitate a surge in mergers and acquisitions, but this has not been the case (so far) for three key reasons. First, determining the precise value of a refinery is an art as much as a science: data from IHS Herold show public refinery deals since 2009 saw asset prices ranging from US$1,320 to US$9,357 per barrel per day of refining crude processing capacity. This variance can make for difficult negotiations. Second, there remains some political discomfort associated with foreign (particularly state-owned) energy companies acquiring downstream assets. This may stem from quasi-nationalistic tendencies but equally from labour union concerns over resultant cost-cutting measures. Finally, NOCs looking for European assets may well seek to retain the original owner in a joint venture rather than buy out the entire operation. Retaining the original owner as a partner brings local knowledge, a good understanding of the assets' technical details (which can be especially useful in the refining sector given the variety of specifications), and political links. This preference is reflected in PetroChina's formation of a joint venture with INEOS as opposed to a 100% acquisition and may explain why Shell has struggled to find a buyer for the Harburg unit: the IOC is looking to divest the refinery completely.