London, 4 May 2011

IHS Europe energy: Saudi Aramco's interest in ConocoPhillips' German Wilhelmshaven refinery follows a pattern of state-controlled companies with energy interests seeking to balance their portfolios by acquiring downstream European assets.

Saudi Aramco Joins European Downstream Fray – A consortium comprising Saudi Arabian state-owned petroleum company Saudi Aramco and Berolina Handelskontor Beteiligungsgesellschaft MbH, a German investment holding company, are seeking to acquire a refinery owned by ConocoPhillips at Wilhelmshaven in northern Germany. Thomas Reiter, the consortium's public-relations representative, told Dow Jones that the plan to acquire the refinery has already garnered support from regional and local politicians, a trade union and labor representatives of refinery workers.

ConocoPhillips acquired the refinery in 2006 and planned to upgrade the asset but a string of accidents and shutdowns as a result of poor economic conditions delayed the investment programme. The US supermajor finally decided to convert the refinery into a fuel depot in 2010. Reiter added that an offer had been submitted two months ago but ConocoPhillips has not yet responded.

IHS World Markets Energy Perspective

Significance: A consortium led by Saudi Aramco is seeking to buy ConocoPhillips's Wilhelmshaven refinery, in Germany and has already garnered support from local politicians and unions for the acquisitions.

Implications: ConocoPhillips planned to shut the refinery, having finally scrapped long-delayed plans for an upgrade last year, and seems likely to sell, although the US IOC has not yet responded to the proposals. The move by Saudi Aramco follows a pattern of emerging market players acquiring downstream assets in mature markets as a means to balance their portfolio.

Outlook: As high oil prices and supply disruptions continue to weigh on European downstream margins, so IOCs will seek to reorient their operations into more profitable activities but state controlled players are happy to accept smaller but steadier revenues as national strategy plays a greater role in their objectives

Outlook and Implications

Tight refining margins and generally poor fundamentals in the European downstream sector have driven IOCs to pull out of the market in search of higher returns elsewhere. Demand for petroleum products peaked in 2005 and is expected to continue its decline, mostly under the pressure of government environmental standards, biofuels or other renewables mandates, and stricter efficiency standards for new vehicles and buildings. Combined with the effects of ageing, stable populations and saturation in Western Europe's car markets, petroleum product demand is set to fall further. At the same time net refining margins are currently very low as a result of high operating costs. These stem from high energy prices (around 7% of refinery input is used 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, construction costs have edged down from their 2008 peak but are still 70% higher than in 2005 and are starting to rise again. Declining crude volumes from the North Sea are also a factor in pushing IOCs out; as the fields have matured so the supermajors have gradually reduced their North Sea upstream holdings so it makes less sense to dispose of local refineries. Finally, in terms of competition, the wave of new plants being constructed in Asia has also helped to push margins lower; India's Jamnagar refinery is sending products east and west since it was built 18 months ago.

The practical upshot of this is to create cut-throat competition within the refining sector, prompting a mass exodus of IOCs from European refining. French IOC Total confirmed in the third quarter of 2010 that it was looking to sell its UK retail chain, which includes the Lindsey refinery and 780 outlets. Chevron, ExxonMobil and Murphy Oil are also pulling out of the UK 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 UK for sale.

This trend is well recognised. Nonetheless, the fact that state-owned energy firms and emerging market sovereign wealth funds are showing significant interest in these assets has received less attention. The last six months alone have seen a string of such acquisitions and proposals: PetroChina's take-over of the Grangemouth refinery and French Lavéra facility; Total's decision to sell its stake in Spanish downstream player CEPSA to the Abu Dhabi sovereign wealth fund, International Petroleum Investment Company; and Russian energy corporations Rosneft and Gazprom both reportedly seeking to acquire refining assets in France and Italy. All these deals, successful or otherwise, fit a broad pattern of state-owned institutions from emerging markets acquiring downstream European assets from IOCs. Admittedly private investors have also shown some interest—notably Indian firm Essar and UK fund Klesch & Co.—but there is clearly a tilt towards government-owned players. Saudi Aramco's interest in the German refinery reinforces the position.

This pattern reflects two drivers. First, NOCs from resource-rich states are seeking to balance their portfolio and ensure they have access to refining assets and distribution outlets in relatively stable regions (that is, locations in which the price of gasoline (petrol) is not determined by central authorities but by markets, such as in Western Europe). This vertical integration becomes especially attractive during periods of economic uncertainty when upstream prices can be volatile, as it provides a "cushion" at either end of the supply chain. A diverse geography also allows such firms to arbitrage between markets; following the earthquake, demand in Japan is set to be laid low for some time, hence Europe becomes more attractive.

Second, NOCs' objectives differ from those of IOCs in that the rate of return on investments is not as important as simply acquiring market share and ensuring a channel for domestically produced crude oil. Under pressure from shareholders, returns of around 5% are not acceptable to the IOCs—particularly given the effort required to upgrade many of the ageing assets—but such rates are viable for state-owned entities. The fact that valuations of European refining assets are at a low point thanks to low utilisation rates is also catalytic.

Having noted this trend, there are still many European refineries that are beyond salvation. These instances usually reflect a lack of complexity at the plant or an inability to handle the types of crude becoming more prevalent (especially high sulphur content), hence even the state-owned players are not interested. Equally the political ramifications of such firms acquiring energy assets, such as refineries, remain anathema to some European governments. As such, one might expect to see NOCs teaming up with European partners to sweeten the deal, as is the case in the current instance, in which Saudi Aramco has teamed up with a German investment fund.

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IHS Europe energy analyst Kash Burchett’s note on the European refinery sector.

IHS Global Insight  www.ihsglobalinsight.com