Kemp: Lindsey Refinery Victim of UK Policy, Shale

French oil major Total has announced plans to halve capacity at its Lindsey refinery on Britain's North Sea coast as part of an overhaul of downstream activities intended to address overcapacity in the European refining sector.

Total's decision comes as no surprise. Of the six refineries still operating in Britain, Lindsey was most at risk of closure or capacity reduction, as shown in a report prepared by consultants Purvin & Gertz for the UK Petroleum Industry Association in 2013.

Purvin & Gertz was commissioned by the refiners themselves to report on competitive challenges faced by their industry as a result of government regulations and explain the sector's value to the UK economy, so the report tries to be optimistic about the future.

But Purvin & Gertz considered various scenarios and concluded the most probable outcome was the closure of one or two refineries to eliminate the country's excess production of gasoline and improve profit margins for the refineries that remain open.

When the report was published, Britain had seven operational refineries.

Since then, the smallest and least technically sophisticated refinery, at Milford Haven in Wales, has closed and there are plans to turn it into a tank farm to handle imported fuel.

And in 2014, the owners of Stanlow refinery mothballed one of its crude units and cut throughput capacity by around one-third, blaming overcapacity in the European refining sector.

But this does not seem to have been enough to save Lindsey. It is much larger than Milford Haven but among the six remaining refineries it is the least sophisticated so it was always going to be next on the list for closure or capacity reduction.

TOO MUCH GASOLINE

Lindsey's problems are a microcosm of the difficulties besetting the UK refining sector. Britain's refineries are old, too small, need major investment, and have fallen victim to government policy encouraging motorists to buy diesel cars. The U.S. shale revolution has now dealt them the final blow.

Most of Britain's refineries were built between the 1950s and 1970s when they were designed to produce lots of gasoline to meet booming demand from motorists.

They are optimised to process the light low sulphur crudes produced from the North Sea and similar areas with a relatively small amount of medium crudes blended in. The problem is that those crudes are among the most expensive in the world precisely because they are so easy to refine.

U.S. refineries have invested heavily to process poorer quality and therefore cheaper crude oils. And the new mega refineries built in India in the Middle East over the last decade are also designed to process poorer and cheaper crudes. Meanwhile, Britain's refineries are stuck processing the most expensive feedstock in the market.

At the same time, the demand for fuel has shifted. Cars and trucks have become much more efficient and government policy has encouraged a shift from using gasoline to diesel.

The result is that Britain's refineries produce far too much gasoline but not enough diesel or jet fuel to supply the country's large hub airports at Heathrow and Gatwick.

Britain is forced to export gasoline while importing diesel and jet. Britain imports almost half of its diesel and jet fuel, according to Purvin & Gertz, but exports as much as a quarter of its gasoline.

The strategy of exporting gasoline and importing diesel was viable when the United States was importing large quantities of gasoline in the 1990s and early 2000s. But the shale revolution has cut U.S. demand for imported gasoline close to zero.

U.S. gasoline imports from Britain's refineries fell to less than 25,000 barrels per day in November 2014 from around 100,000 barrels per day in 2010.

Britain's refiners have struggled to find profitable alternative markets.

But if Total reduces Lindsey's capacity by around half, it would move the UK domestic gasoline market back to balance or even into a deficit.

In turn, that would allow British refiners to raise their prices because the marginal gallon in the domestic market would come from an overseas refinery and have to pay freight costs.

Britain's motorists will have to pay a bit more at the pump but it would put what's left of the UK refining industry on a sustainable basis.

In a bitter irony, just as the industry is finally dealing with its gasoline surplus, government policy appears to be poised to change again.

Diesel engines are now blamed for serious air pollution in London and other cities.

After three decades of encouraging motorists to buy diesel cars because they are more efficient and contribute less to global warming, government policy is set to switch to encouraging them to buy gasoline powered vehicles to cut pollution.

But the possible reversal of dieselisation policy has come too late to save Lindsey.

NELSON COMPLEXITY

The full Purvin & Gertz report on "The Role and Future of the UK Refining Sector in the Supply of Petroleum Products and its Value to the UK Economy" is available on the UK Petroleum Industry Association's website and the relevant analysis is contained on page 112 (http://www.ukpia.com/docs/default-source/publication-files/therolefutureoftheukrefiningsector.pdf).

The most important factors affecting refinery profitability are capacity and complexity.

Size matters because there are substantial economies of scale in petroleum refining so larger refineries tend to be more profitable than smaller ones provided they can run close to full capacity.

Complexity, on the other hand, is important because it determines how far a refinery can upgrade poor quality and therefore cheap crude into high quality fuels and earn a big margin for doing so.

The industry uses the Nelson Complexity Index as a rough indicator of a refinery's upgrading capability. Different units in a refinery are each assigned a number of index points for their cost and contribution to upgrading crude into quality fuels and then weighted for their share of refinery throughput.

Lindsey has a weighted average Nelson Complexity of just over 6, which is low for a modern oil refinery, and about the same as the closed refinery at Milford Haven.

Lindsey is much less sophisticated than Grangemouth in Scotland (which has an index of around 8), Pembroke in Wales (9), Stanlow in Cheshire (10), Fawley on the south coast (12) and South Killingholme (12), which is also on the North Sea next to Lindsey.

For context, the two massive modern refineries operated by Reliance Industries at Jamnagar in India can process a combined 1.25 million barrels per day of crude and have Nelson Complexity Indices of 11.3 and 14.0 respectively, according to the company.

Milford Haven's closure was inevitable given that it was processing less than 150,000 barrels per day and had a Nelson Index of just over 6 (http://link.reuters.com/tuv93w).

But because the refinery was so small, its closure was not enough to rebalance the UK fuel market. It was always the case that one more refinery would need to close, or have its capacity reduced.

Stanlow reduced capacity by one third last year. But Lindsey was always especially vulnerable because it was barely more sophisticated than Milford Haven (http://link.reuters.com/wuv93w).

Lindsey, in North Killingholme, is also located right next to the much more advanced refinery at South Killingholme, which is almost twice as complex.

And Britain's central government helped bail out Grangemouth in Scotland in 2013 to avoid embarrassing job losses in the run up to Scotland's independence referendum.

With Milford Haven closed, and Grangemouth saved, Lindsey has been living on borrowed time.

Now Total wants to reduce the refinery's throughput by half, cut jobs, and invest in new equipment to increase its complexity and sophistication to give it a future, albeit in reduced form.

By John Kemp