Maintaining Profits in Low-margin Markets
-Jamie Brunk, Manager - Lube Studies HSB Solomon Associates LLC

HSB Solomon Associates LLC (Solomon) conducted a study of base oil refineries in 2012. In this analysis, it compared the Russian plants to solvent plants and hydroprocessing plants overall. The analysis reiterated that low-cost producers will show profits in low-margin markets and survive. Additionally, it was noticed that some - not all - high-cost producers will be at risk of closure. In this article, the author presents this study.

Oversupply continues to impact base oil refineries around the world, putting at risk the futures of the highest-cost producers. In Russia, all eight base oil refineries use the older, conventional solvent technology, though this could change as some have announced plans to move toward hydroprocessing. Although their performance as a group still lags behind solvent plants overall, performance has been improving over time in many areas. Extenuating circumstances and government subsidies notwithstanding, this improvement will have to continue if these facilities are to be sustainable over the long term.

Production Cost Considerations and Trends
To establish cost of production, we employed Solomon’s Comparative Performance Analysis (CPA) methodology. We took the feedstock cost and subtracted the by-products revenue to determine the net raw material cost. To that result, we added the total cash operating expense. Dividing that figure by the base oil volume yielded the base oil production cost per unit of base oil.

It is important to note that the following factors may affect raw materials cost:
  • Feedstocks Utilised: The vacuum bottoms used to make brightstock are less expensive than the vacuum gas oil used to make neutral base oils. Both cost less than the hydrocracker unconverted oil used to make Group II and higher neutrals. Solvent plants tend to use vacuum bottoms and some vacuum gas oil, but hydroprocessors use vacuum gas oil and unconverted oil; therefore, the solvent plants have lower average price for feedstocks.
  • Yield of Base Oil: Because the analysis is based on the cost per unit of finished product, the yield of the finished product plays a significant role in the results for each refinery. Conventional units of solvent based plants have a much lower yield of high-value products than hydroprocessors do. Solvent dewaxing equipment, for example, has a lower yield than the catalytic dewaxing equipment used by the hydroprocessors. Because one extra step is involved (deasphalting), vacuum bottoms produce a lower yield of finished base oil than vacuum gas oil.
  • Value of By-products: Hydroprocessors primarily make low-sulfur diesel as their by-product, which has a very high value in today’s fuels market. Conventional units make waxes, asphaltenes, and extracts. Wax continues to be a very valuable by-product. Although asphalt is important for constructing roads, it is not worth a lot of money. The same is true of extracts. So, conventional plants are at a disadvantage in terms of the value of their by-products.
An examination of the cost of production for refineries worldwide shows that the best performers keep costs relatively low and the very worst have costs that are extremely high. But for three-quarters of the world’s refineries, the cost to produce is virtually the same. Refer to figure 1 on the next page for a graphic representation. Net Raw Materials Costs (RMC), meanwhile, tend to vary more widely. One refinery may have high raw material costs and low operating expense. A refinery with a similar cost of production may have a very low RMC and high operating expense. The total of the two components is the important value to minimise.

Operating expense and RMC are not totally independent of one another. The choice of raw materials affects what it costs to manufacture the base oil; they are tied together, as illustrated in figure 2 on the next page.

With the cost to produce so similar for the entire centre region of the curve - within a few dollars of one another - it does not take much to change the cost structure and move from the third quartile in performance to the second. Fourth-quartile performers, meanwhile, may have reason for concern. In today’s market, they could be next on the list for shutdown.

Why do all the plants on the far end of the cost curve remain and not go away? Typically, they are in business for a different reason. Governmental initiatives keep some of these refineries operating even though they are not profitable from a strictly economic standpoint.

An examination of cost to produce by plant type shows hydroprocessing plants averaging first-quartile performance and the average of the older solvent plants barely in the third quartile. The Russian plants as a group fare better than the solvent average, but remain in the third quartile as illustrated in figure 3 on the next page.

Interestingly, the average of the top 4 performing solvent plants show the best performance of all, squarely in the first quartile and ahead of the hydroprocessing average. But in general, it is the solvent plants that are at the highest risk of shutdown because their costs tend to be higher. The top 4 solvent plants show that shutdown does not have to be the answer if you operate a solvent plant efficiently.

Looking at the performance of the Russian plants over a three study period, we find them at the midpoint in 2008 and 2010 before they regressed relative to others in 2012 into the low end of the third quartile. The industry is moving all the time, so the performance of the Russian plants did not necessarily worsen. It just may not have improved as much as others did. Figure 4 on the next page illustrates this concept.

Operating Expense Impacts and Trends
Three factors tend to have more impact on operating expense:
  • The first is the technology employed to manufacture base oil, where the hydroprocessors enjoy a significant advantage.
  • The second is location of the refinery because of its relationship to energy and feedstock costs.
  • The third is utilisation. Obviously, the more you make, the lower the per-barrel cost of the fixed items of the operating expense.
In studying the components of operating expense, we find that, on average, half is devoted to energy. In Asia, energy costs jump to 65 per cent while the US and Canada devote only 21 per cent of their operating expenses toward energy. Russia, at 47 per cent, is close to the average due primarily to the price paid for energy. On a cost-per-gigajoule basis (US dollars per gigajoule or USD/GJ), the average cost is 9.06 USD/GJ. The cost in Asia is 14.98 USD/GJ. In the US and Canada, the cost is 3.39 USD/GJ. And in Russia, the cost is 5.37 USD/GJ. North American refineries are enjoying relatively low-cost energy due to the recent boom in production of shale gas.

When it comes to energy efficiency as measured by the Solomon Energy Intensity Index (EII), we see that the top 4 solvent plants are as efficient with their energy consumption as the hydroprocessors. The solvent average sits in the third quartile, but the Russian average is in the fourth quartile, a reflection of their extremely low energy efficiency. These plants have not spent the time and effort to worry about energy efficiency; that is a concern for the future.

One bright spot for the Russian refineries is in personnel costs. A few years ago, they were off the curve, saddled with directives to employ people rather than to make money. With a more profit driven perspective they are starting to pay closer attention to the numbers of people they employ. Hourly pay rates are low compared to many refineries in the world, which provides an advantage. Work hours are still high, but the refineries are continuing to show improvement.

Turning to utilisation, we see that that in 2012, the top 4 solvent plants enjoyed the best utilisation, followed closely by the hydroprocessors, both in the second quartile. The Russian average is better than the one for solvent plants overall, which shows they are better utilising their equipment, as illustrated in figure 5.

That said, in 2012 average utilisation was lower than we saw in the period between 1998 and 2006. Demand is going down and supply is going up, so everybody’s utilisation has dropped.

Another factor is economic downtime that is created because the plant cannot make a profit in the market. In the past, we have seen plants shut down as much as 5 per cent of the time because they cannot make money. In 2012, those figures were as high as 15 per cent.

Russian plant utilisation in 2008 was at the third-/fourth-quartile break point. In 2010, they jumped to first-/second-quartile performance, only to slide back to second-/third-quartile performance in 2012. Although they improved over 2008, they still lost ground, as shown in figure 6.

With the current oversupply in the base oil market expected to persist, the focus among producers will continue to be on costs. Although hydroprocessing plants enjoy a cost advantage overall, solvent plants can be low cost even though they use the older technology and employ older equipment. Still, as high-cost producers shut down, it is likely that more conventional plants than hydroprocessors will be taken out of the mix.

Not all high-cost producers are at risk. Some national oil companies have a different philosophy as to why they are in business. Some companies are integrated in their downstream operations, so, they consider security of supply and are willing to pay a little extra to ensure they have the supply that is in-house rather than purchased. Additionally, some facilities are beset by severe environmental problems and are better run at a loss than cleaned up at great expense.

We know all refiners can reduce their costs. Clearly, many have implemented operating cost reductions. But refiners also need to look to the other side of the equation. They must maximise production of their high-value products. It is short sighted to focus solely on operating expense. In base oil plants, margin is more important than operating expense. Typically operating expenses increase in the production of high-value products, but margins usually increase to a greater degree. Thus, the maximisation of high-value product is also the key to long-term viability.