BP Plc. (NYSE:BP) recently announced that it would be shutting down refining operations at its Bulwer Island refinery in Brisbane, Australia, by mid-next year. The company plans to convert it into an import terminal for refined products. This could be seen as an attempt by BP to improve the profitability of its downstream operations, as the Bulwer refinery is one of the least profitable ones in its downstream portfolio due to higher operating costs. According to our estimates, the company’s adjusted downstream EBITDA margins declined by ~80 basis points last year, primarily due to industry overcapacity. 
We currently have a $50 price estimate for BP, which is almost in line with its current market price.
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Thinner Margins Due To Industry Overcapacity
Petroleum demand in the developed world, which declined with the sluggish economy, continues to remain weak as more hybrids and electric vehicles enter the market, and biofuels become more competitive. Under these circumstances, the developing world is slowly becoming the center of demand for the refining industry. However, demand growth from the developing nations, especially China has slowed down considerably over the last couple of years due to slower economic growth. 
At the same time, governments in different parts of the world continue to expand their existing refining capacity just in order to sustain employment and reduce their reliance on imported fuels. As a result, a lot more refining capacity has been recently added globally than what has been retired. This has put a downward pressure on the profitability of refining business at a time when high crude oil prices and environmental costs are already weighing on margins. 
Most of the recent refining capacity addition has taken place in Asia and the Middle East. In Asia, China has led the growth in refining capacity. At 12 million barrels per day, the country’s refining capacity already surpasses its domestic demand. It turned into a net exporter of refined products last year and continues to make progress on capacity expansions due to be completed this year and the next.
In the Middle East, Saudi Aramco Total Refinery & Petrochemicals Co. (SATORP), a joint venture between Saudi Aramco and Total, started shipments from the 400,000 barrels per day Jubail refinery in September last year. This is just one of the three such massive facilities planned by the Kingdom. Other Middle Eastern oil producing countries are also adding refining capacities, including the United Arab Emirates, Kuwait and Oman. 
Higher Costs In Australia Due To Scale, Currency
The addition of low-cost refineries in Asia and the Middle East has made the process of distilling crude oil into lighter refined products uneconomical in Australia. This is because operating costs in Australia are much higher due to the smaller size of refining units and a relatively stronger domestic currency. BP’s Bulwer refinery is a relatively small-scale unit with a capacity of just 102,000 barrels per day. This compares to an average capacity of more than 200,000 barrels per day of the refineries that have come up in China over the past few years. Since the profitability of a refining unit improves significantly with scale because of higher fixed costs associated with the initial setup, BP’s Bulwer refinery could not compete with the recent capacity additions in China and the Middle East. 
Apart from scale capacity, stronger domestic currency has also impacted the economic viability of refining business in Australia. The Australian dollar (AUD) has appreciated more than 30% against the U.S. dollar (USD) over the past five years. This compares to just 10% appreciation in the Chinese Yuan (CNY) and a decline of 17% in the Indian Rupee (INR) against the USD over the same period. Appreciation in domestic currency makes imports cheaper and reduces the incentive for manufacturers to produce goods domestically. This has led multinational oil companies to take a harder look at their downstream operations in Australia. BP is not the only company to shut down its refinery in the country. In 2012, Shell closed its Clyde refinery and around the same time Caltex decided to close its Kurnell refinery by the end of this year. It is expected that Australia would be relying on imports for around half of its refined products demand by the end of 2014. 
We believe that the closure of Bulwer refinery would help improve BP’s downstream margins by reducing the average per unit refining costs. The company has also taken some other actions to improve its refining margins. These include the modernization of its Whiting refinery in Indiana, and upgrades to the Cherry Point refinery in Washington and Toledo refinery in Ohio. BP expects to generate incremental cash flows of ~$1 billion annually from the Whiting refinery modernization project completed last year. (See: BP Set To Start Processing More Of Cheaper Canadian Crude At Its Whiting Refinery)Notes:
- BP To Close Australian Refinery As Mega-Plant Competition Mounts, reuters.com [↩]
- China’s 2013 Oil Demand Sees Slowest Rise In At Least 22 Years, reuters.com [↩]
- Global Overcapacity To Squeeze Oil Refining Margins, reuters.com [↩]
- Satorp ships first products from Jubail refinery complex, ogj.com [↩]
- China Leads Expansion of Asian Refinery Capacity, wiley.com [↩]
- BP Refinery Closure leaves Australia More Reliant On Fuel Imports, smh.com.au [↩]