Oil security can be high-cost folly

Why is Reliance’s Jamnagar refinery the most profitable in the world? How does it keep achieving a refining margin of $ 9-10/barrel, one and a half times as much as most global refineries (and Indian public sector refineries)? Singapore’s famed refineries today get a margin of just $ 3/barrel. How does Reliance beat all others? There are several reasons, including Reliance’s ability to build large projects cheaply (37% less than in the USA). But arguably the most important reason is that Reliance has discarded the conventional wisdom about ensuring security of supply for crude oil. Instead, it has proved that short-term opportunism in contracting oil supplies can be far more profitable than long-term security. Most refining companies sign long-term contracts covering all their crude needs, and tailor their refinery’s technology capacity to the contracted crude varieties, to optimize output. Long-term contracts provide supply security (fixed quantities per year), but no price security (the price for each consignment depends on the current market quotation). Still, security of supply has, traditionally, been viewed as an important consideration. Why? Mainly because of the Arab embargo on crude supplies to the US and its allies in 1973-74, a dramatic use of oil as a strategic weapon. However, the Arab embargo did not actually work. The US got all the crude it needed, for two reasons. First, when Arab countries switched oil supply to non-embargoed countries, those countries stopped buying from other sources, which were then free to supply the US. Second, some of the crude originally sold to other countries was diverted to the US. In 1973, Japan had the highest import-dependence of any country on oil, and was really worried about security of supply. It wanted to create giant oil companies that would buy big oilfields for security of supply. But it failed: no big fields were available for purchase. Happily, this proved irrelevant. Oil was always available at a price. Japan ended up with as much oil security as the USA despite its lack of oil giants like Exxon or Chevron. However, talk of oil security remained high fashion among diplomats and politicians everywhere. Unenterprising public sector managers found it simpler and safer to contract long-term supplies than seek bargains in short-term markets. When Reliance entered the scene, Dhirubhai Ambani asked his managers to explore all possible refinery configurations. They considered 2,300 different configurations. Eventually, Reliance opted for a highly complex refinery, because of two potential two advantages. One, a complex refinery could crack all low-value fractions (such as fuel oil) into higher value products in a fluid catalytic cracker. Two, a complex refinery could refine a wide variety of crudes. However, this flexibility came at a price: a complex refinery cost much more than a standard one. How did Reliance justify an expensive, complex refinery of the sort that Singapore and other traditional refining centres had avoided? First, it took a huge bet on the composition of future oil supplies in the world. It bet that the availability of low-quality crudes would outstrip that of high-quality crudes, creating a widening price discount for low-quality varieties. This would make it profitable to buy low-quality crudes that could not be processed efficiently in a simple refinery, but could be cracked in a complex refinery. Second, Reliance bet that profit opportunities would constantly arise because of volatile price changes for crude and refined products (such as petrol, diesel and kerosene). Every crude variety yielded a different mixture of refined products. By tracking the prices of different crudes and products, Reliance could constantly spot opportunities to buy a crude variety that was cheap relative to the products it could yield. A simple refinery lacked the flexibility to switch from one crude to another. But a complex refinery could switch not only from one crude to another but from one product-mix to another. For instance, Jamnagar could increase petrol output at the expense of diesel and vice versa, depending on which was most profitable at the time. Reliance bet that this flexibility would more than justify the high cost of a complex refinery. It has been vindicated in spades. However, its emphasis on flexibility has a corollary. Its strategy is based on opportunism in selecting the most profitable crude to import at any point of time. This means it does not emphasise security in supply. Reliance has firm contracts for only half its capacity. For the rest, it trawls the markets in search of short-term bargains. Diplomats and politicians would regard this as insecurity of supply. But Reliance has proved that such insecurity of supply can translate into security of high profits! This holds a major lesson for diplomats and politicians. Oil security can be high-cost folly. Opportunism in supply can beat security of supply hands down

One thought on “Oil security can be high-cost folly

  • 2012.Dec.01 at 15:27
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    While Reliance refinery is one of the largest and most sophisticated in the world, its profitability comes from not selling its product in India? This is the paradox of India!

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