Question Mark Looms Over Proposed Refineries

BMI View : Iran's offer to fund the construction of two new oil refineries would significantly ease Indonesia's growing dependence on refined product imports. However, with an ever-tightening global downstream market, we question the project's long-term economic viability.

Iran is proposing to invest US$3bn to build two new oil refineries in Banten and West Java, following a bilateral deal signed at the Indonesia-Iran Business Forum, according to local news sources. Under the terms of the deal, Iran would supply crude feedstock for the refineries, which would sell their products onto international markets. The refineries would be built by Indonesia's Kreasindo Resources and Iranian company Nakhle Barani Pardis. According to Kreasindo's president, both companies are in the process of conducting feasibility studies, and are looking to start construction by 2015.

The project would provide a major boost for both countries, particularly Indonesia. Indonesia is facing a growing import burden, as its stagnant downstream sector fails to keep pace with soaring domestic consumption. In 2013, we estimate that net imports of refined products reached 444,700 barrels per day (b/d); we forecast that by 2023, this figure will have risen to 693,810b/d. Heavy government fuel subsidies are partly responsible for the rise in consumption, and render the country's import dependency a serious financial drain. Indonesia is in the process of modernising its existing refining capacity, but the country's downstream regulator, BPH Migas, has said that, in addition, it needs to build at least three new refineries, with a capacity of 250,000b/d each, to ease its long-term dependence on fuel imports. Several projects have been mooted, but have struggled to find investors, due largely to the unattractive tax package on offer from the government. State-owned Pertamina will likely be unable to develop these projects alone, given weak revenue prospects from falling production in its upstream sector.

Too Much Demand, Too Little Supply
Indonesia Refined Products Production, Consumption and Trade, 2000-2022

Despite the potential benefits of the Indonesian-Iranian project, we highlight several major obstacles to its completion. Iran's capability both to finance the refineries and to supply them with crude feedstock is highly uncertain, given that it depends completely on international sanctions being lifted. Although US-Iranian talks appear to be making progress, pinning the future refined product demand needs of Indonesia on a successful outcome of sanction negotiations remains somewhat of a gamble.

Of perhaps greater concern isthe changing dynamics we are seeing in the global refining market. After a decade of aggressive ramp-up, downstream expansion in Asia may be about to slow. China, which has almost doubled its refining capacity in the last ten years, is finding foreign oil companies increasingly disinterested in investing in its downstream sector. In October 2013, Royal Dutch Shell pulled out of a joint venture with PetroChina to develop a 400,00b/d refinery at Taizhou. In January 2014, BP also dropped plans to acquire a stake in PetroChina's 200,000b/d Qinzhou refinery, which had been earmarked for upgrade ( see 'Downstream Slowdown Imminent', January 31 2014).

In part, this may be a response to slower Chinese consumption growth. However, it is also indication of broader challenges facing refiners in an increasingly competitive global oil products market. The American shale revolution has seen American refiners benefit from cheaper crude feedstock, and cheap US oil products are increasing their share of the Atlantic and West African markets. Russia has also expanded its refining capacity and is crowding beleaguered European refiners, hit by high oil prices, low efficiency and slackening European demand, out of the Eastern European and Mediterranean markets.

Saudi Arabia is also beginning to make its presence felt downstream, and we can expect this to add further pressure to the global market in the coming years. In September 2013, the first of Saudi Aramco's three mega-refineries, the 400,000b/d Jubail refinery, began commercial production. The second, Yanbu, is due to come online by Q414, with the third refinery, Jazan, slated for completion in 2016. In total, they will add 1.2mn b/d to the global refined products supply. In light of the refineries' size, their sophistication, ability to process cheaper Arab Heavy crude and easy access to abundant crude feedstock, we also anticipate Aramco will hold a significant price advantage over its competitors in the global oil products market ( see 'Aramco's Advance Could Shake Up Downstream Market', October 25 2014). It is in this context that Indonesia's downstream ambitions must be placed.

In our view, it is doubtful as to whether the proposed Indonesian refineries will prove an attractive investment prospect for Iran. We also note Iran's own limited refining capacity; development of the country's downstream sector has been undercut both by international sanctions and financial constraints. The country currently has plans to increase refining capacity from an estimated 1.5mn b/d in 2012, to 3.15mn b/d in 2015. Although we believe this timeframe to be highly unrealistic, it illustrates the government's intention to expand the downstream sector. With limited capital to dispose of, in the case that the sanctions are lifted we would expect Iran to prioritise domestic, and not international, downstream expansion. The only upside to Iran's plans, if the Indonesian refineries were built, would be to secure long term market for its crude; we recognise that Iran may struggle to find crude markets once the sanctions are lifted.

Above-Ground Conditions Unappealing To Investors
Selected Asian Countries Downstrem Risk Reward Rating

In order to meet long-term domestic refined product demand, Indonesia may have to look to other sources. This being said, under current conditions their options are somewhat limited. As reflected in our Downstream Risk Rewards Ratings, above-ground conditions in Indonesia are relatively poor; despite its large market, Indonesia ranks amongst the lowest in the region. This is largely due to its poor Country Reward Rating, reflecting the heavy burden of its fuel subsidies policy, alongside a high level of state involvement in the industry. In the absence of a more relaxed regulatory and fiscal environment, we believe that it is unlikely that Indonesia will be successful in attracting significant investment in its downstream sector.

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Related sectors of this article: Oil & Gas, Refining/Marketing, Energy Policy
Geography: Indonesia

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