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Why Rosneft Abandoned The Eastern Petrochemical Company Project

Last spring, Rosneft excluded the Eastern Petrochemical Company (VNKhK) project from its investment program. In a press release, Rosneft linked this decision with changes to the Russian Tax Code, which negatively affected the profitability of oil refining and petrochemicals. The latter forced the company to suspend financing of VNKhK.

The Grip of Tax Maneuver

Tax maneuver in the oil industry has become one of these changes. In the initial configuration, the project was supposed to include oil refining and petrochemical capacities of 24 million tons and 6.8 million tons per year, respectively. Rosneft was to bring them into operation in three stages from 2020 to 2028. However, a year ago, the petrochemical block was cut to 5 million tons, and oil refining - to 1 million tons in total. The reason was the government’s gradual refusal to support the export of petroleum products, most of which are still subject to lower export customs duties than oil. Fuel oil was the first to lose such a subsidy. Since 2017, its duty has been equalized with the duty on oil. As a result, its exports decreased by a quarter - from 42 million tons in 2016 to 32 million tons in 2018, according to the Russian Ministry of Energy. By 2024, the subsidy will also be nullified for gasoline and diesel, since by that time the Government will eliminate duties on oil exports, which in the mid-2010s were reduced from 59% to 30%.

This will inevitably reduce the profitability of oil refining, which will lose another indirect subsidy - low oil prices, which are calculated in the domestic market from the difference between the export benchmark and the cost of duties and transportation. Another problem is the low capacity of the Russian Far Eastern petroleum market: according to Rosstat, in 2017, the Far Eastern Federal District amounted to 4.3% and 7.4% of Russia’s gasoline and diesel consumption, respectively. Because of this, the project would be almost entirely dependent on demand in East Asia, where Rosneft would have to compete with Chinese manufacturers: according to the International Energy Agency (IEA), in the next five years China will account for 40% of the global increase in oil refining capacities (3.6 million out of 9.1 million barrels per day). The competition will also be fierce among petrochemical producers: until 2024, the existing petrochemical capacities will increase in Russia by 3.5 million tons per year, as forecast by the IEA, while in the USA - by 14 million tons, and in China - by 21.3 million tons.

The Sheer Cost Burden

Due to high competition, the project’s ultimate success would depend on the ability of its shareholders to minimize costs, which was clearly not a strength of VNKhK. To construct the complex, Rosneft would have to build infrastructure from scratch, even if supported by natural monopolies, such as Transneft, Gazprom and Russian Railways. In December 2015, the Government approved the VNKhK roadmap, which obliged these companies to include the project’s infrastructure facilities in their investment programs. However, they had disagreements with Rosneft on this issue. Thus, in 2014, Russian Railways provided Rosneft with options for adjoining the VNKhK access road to public railways, but was not ready to finance its construction. A similar position was taken by Transneft, which agreed to increase the annual capacity of ESPO-2 by 2020 from the current 44 million tons to 50 million tons, but did not intend to single-handedly lay a branch towards VNKhK. However, Gazprom turned out to be the most unyielding. In 2017, the monopoly agreed in principle to supply gas to VNKhK and buy gas from the Sakhalin-1 fields in order to supply the third phase of the Sakhalin-2 LNG plant in the future. But the companies did not conclude a final agreement. As a result, Rosneft decided to supply VNKhK with its own gas, as Deputy Prime Minister Yury Trutnev said at the 2018 St. Petersburg International Economic Forum (SPIEF).

Related: Global Renewables Investment To Hit $13.3 Trillion By 2050

At the same time, Rosneft came under sanctions, almost losing the opportunity to attract Western investment, although in 2013 it signed a memorandum with Japanese Mitsui to design the Complex jointly. In 2016, Rosneft agreed with ChemChina to finance VNKhK by a proportion of 60/40, which could save the project. However, over the past three years, both companies have not taken real action. The reason could be the weak project’s economy, which could hardly be supported by tax benefits. Like the Gazprom Amur Gas Processing Plant, the Complex should have become a resident of one of the Far Eastern territories of rapid development: This would allow VNKhK to pay social contributions at a rate of 7.6% instead of 30%, as well as receive a five-year exemption from taxes on income, land and property. But intense market competition coupled with the declining refinery profitability and unavailability of Western financing forced Rosneft to abandon the project, which was announced 10 years ago, but remained on paper.

Profitability vs Diversification

Better an end with horror than a horror without end, as a German proverb says. And that is exactly the case. Instead of commissioning new oil refining capacities, Rosneft is now better off focusing on upstream projects to overcome the decline in oil production among its West Siberian subsidiaries. According to Rosneft’s IFRS statements, from 2015 to 2018, Samotlorneftegaz reduced oil and liquid hydrocarbon production by 7.3%, and Purneftegaz and Orenburgneft - by 11.9% and 17.6%, respectively. Tax benefits should help solve this problem, given that last year Rosneft’s mineral extraction tax for each ton of oil produced (10.44 thousand rubles) was more than 15% lower than the industry average level (12.47 thousand rubles, as follows from the same IFRS statements).

Unlike petroleum products, crude oil will have an assured demand - both in the EU (where sanctions against Iran threatened with a shortage of high-sulfur oil), and in Asia, where Rosneft exported more oil in the second half of 2018 than to Europe. Therefore, investments in oil production will definitely ensure profitability, while in oil refining and petrochemicals it is easier to ensure it by acquiring existing assets instead of establishing new ones. An example is Ufaorgsintez, a producer of polymers and organic chemistry, owned by Bashneft and continuing to generate net profit after it came under Rosneft's control (5.4 billion and 2.5 billion rubles in 2017 and 2018, respectively, compared with 5.8 billion rubles in 2016, according to Refinitiv). It would be easier for Rosneft to diversify its oil business through such purchases, rather than through expensive projects, heavily dependent on government benefits.


By Kirill Rodionov for Oilprice.com

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