Essar seeks to hedge oil risks with Russian crude

Even though it is costlier to import crude oil from Russia than from West Asia, for Essar Oil it makes sense to have more suppliers

India and Russia may have been close allies in the energy sector for some time now but Russian crude oil and petroleum products have found a negligible market in India. So, when Essar Oil tied up with Rosneft, the Russian state-owned oil company, for crude oil sales last month, many were surprised. For Russia, reeling under sanctions from the West after its military interventions in Ukraine, the deal provides a long-term customer for 10 years, and an assured source of earning.

For the Indian company, this offers the opportunity to hedge its crude oil risks. Essar Oil runs a refinery at Vadinar in Gujarat with an annual capacity of 20 million tonnes, and owns Stanlow Refinery, with a capacity of 296,000 barrels per day, near Liverpool in northwest England. The deal with Rosneft will help the company add one more source for its crude oil supply. "The strategic potential of the agreement between Rosneft and Essar (Oil) can hardly be overestimated. For our Indian partners, the signing of this agreement represents a vital element of basic supplies diversification," Rosneft Chairman & Vice-chairman Igor Sechin said in a statement issued after the signing of the deal during the visit of Russian President Valdmir Putin in December. The company also secured a $1-billion credit line from the Russian government-controlled VTB Bank during the visit.

At the moment, 35-40 per cent of Essar Oil's crude oil requirement at Vadinar comes from West Asia and another 15-20 per cent from domestic suppliers, while the rest is transported all the way from South America. Essar Oil wasn't buying any Russian crude oil, says a company spokesperson. However, he did not give details about the deal.

Cost factor
India, which has an overall refining capacity of 217 million tonnes, bought just about 270,000 tonnes of Russian crude oil last year. Rosneft's crude oil capacity at 104 million tonnes per annum is huge, but for Indian companies, it is costlier to import crude from Russia than from West Asia.

Whenever refineries buy crude oil, besides logistics or the proximity of the source country, the configuration of the refinery to process a particular grade becomes important. Heavy and ultra-heavy crude oil, normally available at a discount to benchmark grades, constituted 93 per cent of the crude oil processed at the Vadinar refinery last year, up from 86 per cent in the previous year. "In spite of processing such a high proportion of tough (grades of) crude oil, we produced 84 per cent higher-margin light and middle distillates," Essar Oil Chairman Prashant Ruia told the company's shareholders recently. The Vadinar refinery has processed more than 75 varieties of crude from across the world, including some of the "toughest crudes".

Clearly, the fact that Essar Oil entered into the deal under which supplies begin this year means the refinery is capable of handling the Russian crude oil variety and the cost benefit of this far outweighs the logistical concerns. Besides, Essar Oil had payment problems with Iran when the United States and the European Union imposed sanctions on the West Asian country. "With this (the Russian deal), our crude oil basket will get more diverse, thereby reducing regional supply risks," says Ruia. Though Russia too faces the threat of sanctions, an Essar Oil spokesperson says there are no sanctions on Russian crude oil at the moment. "Going forward too, we would be in complete compliance with the government of India's guidelines related to Russian imports," he adds.

In spite of adding a new crude oil supplier, Essar Oil, like other Indian refiners, is not planning to add more capacity at Vadinar in the near future. According to Ruia, India's annual refining capacity is fairly balanced compared to actual demand. "At the expected (annual) growth rate of 4-5 per cent, our surplus capacity will get absorbed in the next three to five years. Future expansion, unless it is brownfield, is going to be extremely challenging, given the issues related to land acquisition." Essar Oil is, therefore, planning to meet incremental demand through strategic investment in large-scale and low-cost refinery assets with long lifespans. This could mean acquisition as well.

DEBT RESTRUCTURING: A DOLLAR AFFAIR

A big challenge for Essar Oil lies in restructuring its debt. “Being a fully dollar-driven company, it makes immense sense for us to de-risk our business from currency fluctuations by converting our long term liabilities into dollars,” says Chairman Shashi Ruia. This will lower interest cost and also extend the debt tenure. Till date, the company has dollarised about $1 billion of rupee debt and it plans to dollarise another $1 billion debt by March 2015. Though the Gujarat government tax arrears impacted the company’s profitability last year, and not much has been flowing out of Essar Oil lately in terms of investment plans, the company seems to be on track in setting its house in order. ( As Essar Oil is in the process of delisting from the market, its debt figures are not available.)

MORE RESERVES: Essar’s Vadinar refinery in Gujarat

Fraught with problems
Ruia sees the global refining industry facing several challenges in the days ahead: weak demand, new capacity addition, and dominating role of governments in both exporting and importing countries. "Over the next seven years, we expect about 5.7 million barrels of net refinery capacity to be added. While Asia and West Asia will account for about three-fourths of the fresh capacity, the region is expected to be balanced in terms of capacity growth and demand."

At Vadinar, Essar Oil is undertaking a series of low-investment and short-gestation projects, under the banner of Optima Plus, which upon completion would provide a gross refinery margin uplift of about $1-1.5 a barrel over a period of two years. The company's gross refinery margin was $7 barrel for the quarter ended September 2014. These projects include setting up one more hydrogen manufacturing unit and the conversion of the existing vacuum gas oil into more valuable distillates. In 2012, the Vadinar refinery's capacity was expanded to 20 million tonnes, with an increase in its complexity from 6.1 to 11.8 on the Nelson index, making it India's second largest single-location refinery after Reliance Industries' Jamnagar complex. The higher a refinery is on the index, the better equipped it is to refine low quality crude oil.