India's growing refining might -- Too much of a good thing?

Whether this will again swing the pendulum to too much capacity in the coming decade remains to be seen. But for now, it is fast becoming a tale of two cities.

Refiners in India's public and private sector are working on projects that will add some 1.18 million b/d of new capacity and 1.62 million b/d in expansion at existing refineries by the end of fiscal 2011-2012, far ahead of the projected increase in domestic demand over the same period. The new plants will use the latest available technology to take in the trashiest of crudes -- sour, acidic and heavy -- and churn out the cleanest of products, complying with Euro III and Euro IV emission norms.

One would have thought the persistent negative margins of the state-owned Indian refiners from paying rocketing crude costs and selling subsidized fuel at the government's behest would have emptied out their pockets, broken their backs, and brought the massive juggernaut of refining sector upgrades and expansions to a grinding halt by now. Far from it.

The companies are sinking in billions of dollars in downstream investment, counting on strong margins from shipping products to the US, Europe, Africa and the Middle East from ports on the country's west coast.

Little wonder then that the South Asian giant is making refiners in Japan and South Korea, traditionally the region's leaders in refining technology, extremely nervous. It could soon be the worst of times for them.

Japanese refiners, with a collective 4.9 million b/d of capacity, are standing at a crossroads, scratching their heads over a persistent downslide in domestic demand, almost a freak phenomenon, looking at the exploding demand for commodities in most of the rest of Asia. Their Indian rivals are much closer to the customers in the Middle East, Europe, Africa and the US east coast. Japan has relative proximity to the US west coast, but is unable to match the strict gasoline specifications of California.

The smaller refineries might wait to be rescued. Like the 100,000 b/d Okinawa refinery of TonenGeneral, which earlier this year got picked up by Brazil's Petrobras, a foreigner in Japan. Or the other minnow Kyushu Oil, with a 160,000 b/d refinery in Oita, which is to be swallowed up by the country's top refiner Nippon Oil by October.

But the bigger ones must feel the ground slipping from under their feet. Even if they consolidate through mergers and acquisitions, not only are they far from the world's choicest export markets, but will also need to reach deep into their pockets to set up export infrastructure.

South Korea, which exports about 30% of its refined products output of 2.6 million b/d, is in the same boat. And what a contrast it draws with India. S-Oil, the country's second largest refiner and the only one planning a new refinery, just took a one-two punch.

A 480,000 b/d grassroots refinery planned by S-Oil was last July derailed by land owners demanding high prices to make way. The project was put back on its feet, but now it has been knocked down by soaring construction costs and uncertainty dogging the appetite of the country's top three export markets -- Japan, the US and China.

If the US slips into a prolonged recession and its import demand for Chinese goods wanes, the argument goes, China's industrial growth and consumption of raw materials, including oil, is bound to slide. The South Korean refiners could be in hot water.

The Indian refining community is not only adding capacity, but boosting export capability. Private oil and petrochemicals giant Reliance Industries, which already exports 60% of its output from the 660,000 b/d Jamnagar refinery on the west coast, now has Essar Oil for company, which began commissioning its 210,000 b/d export-oriented refinery in nearby Vadinar in late 2006 and is on the cusp of bringing it online full steam.

Reliance itself will be starting up a second 580,000 b/d refinery at Jamnagar before the end of this year, which will export everything it produces.

Other major new refinery projects in the state-owned sector have been declared as export-oriented.

Are the Indian refiners simply at the right place at the right time? So far, they don't seem to be having any problems steadily increasing their exports. Yes, the state-owned players are still obliged to meet domestic demand first, but they are gradually shipping overseas more and more of their surplus, adding to the barrels flowing out from Reliance and Essar.

India first became a net exporter of refined products in fiscal 2001-02. Its product exports more than doubled to 32.4 million mt or about 648,000 b/d in fiscal 2006-07 from 14.6 million mt in 2003-04. Volumes for the current fiscal year, ending March 31, are bound to surpass, given that the total exports until January alone were 31.20 million mt.

So it probably should not come as a surprise that a small fiscal measure by New Delhi recently -- of imposing a 5% tax on naphtha imports by polymer producers starting April 1 -- attracted more attention than it would have, say, four years ago.

What would the tax do? Would India's naphtha imports go down as the country's polymer producers turn to domestic barrels? More importantly, if the refiners sell more at home, will their naphtha exports slide? India exported some 8 million mt of naphtha in the first 10 months of the current fiscal year, and imported 5.33 million mt.

For now, industry players expect no major changes in naphtha flows into and out of the country. The bigger importers are expected to either renegotiate with their overseas suppliers for better terms, or pass on their increased feedstock costs to their product prices as result of the 5% tax, or do both.

In other words, the naphtha import tax is not seen capable of substantially altering the export and import decisions of the country's refiners and petrochemical producers or eroding their profits.

But is there a bigger danger here that we are missing? The government stepped in with the naphtha import tax to correct what it saw as "price distortions" and "revenue losses," to quote Finance Minister P. Chidambaram in his budget speech. Refiners were exporting naphtha, while petrochemical producers were importing it, taking advantage of the export benefits and duty exemptions, and that seemed like a situation that needed to be corrected.

This is a government used to dictating to the oil sector. After fully deregulating the domestic oil market as planned in 2002, it brought back price controls through the back door in 2004.

Assuming that the government would not grudge the state refiners small profits from exports in view of their mounting losses from ballooning fuel subsidies and their dependence on the government to bail them out with oil bonds, the motive spotlight falls on Reliance, which both exports and imports naphtha. Ironically, that company is expected to be the least affected by the new tax, or to make any changes in its naphtha import and export volumes. The integrated producer could easily pass any rise in costs down the chain of petrochemical products.

As India's refiners take the country to its target of becoming an oil products export hub, likely faster than envisaged, will the government be able to change its mindset in time to let the market forces do their job? A "regulated" export hub is kind of hard to imagine.