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The Second Annual Conference

9-11 June 2005
Odessa Hotel, Odessa, Ukraine

Sponsored by OilMarket magazine
with official support from
Russia's State Oil and Gas Gubkin University

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The recently finished in Odessa, Ukraine, Congress on Oil Transit and Refining in the CIS and Baltic States set the key industry accents

Playing around with the concepts of refining, transit and diversification has already cost dear to Ukraine's oil products market. Generally greeted by politicians, the talk on Russian monopoly tactics on Ukrainian oil products market is being used as a key argument for promoting alternative crude supply routes. However, few question the destination of alternative crude - the mostly aged Ukraine's refineries. One could ship expensive Caspian crude to Drogobych or Nadvirna refinery - having learned that the low yield of motor fuel fractions fails short of required acquisition costs compared with "monopoly-enticed" Urals, one would begin to understand that this is a loss-making operation. As the French proverb puts it, however long you feed a cow chocolate, you won't milk cocoa from it. In other words, the high-quality Caspian crude supply to Ukraine's aged refineries won't improve oil products yield there and is therefore a sheer "money-waster". The intricate links between FSU crude transit and refining businesses were the highlight of II international Congress on Oil Transit and Refining in the CIS and Baltic States, which was organised by the OilMarket magazine and took place in Odessa on 9-11 June this year.

The drive to compare the different solutions to transit and refining challenges proved yet again right for the congress. It had a particular impact in present conditions, when in Ukraine's power ministries, including judiciary, there are plenty of those wishing to invent a "crude bicycle", so to say. Congress members were reminded that in such an intricate segment of the economy as a fuel sector, "experience is the best criterion for the facts".

Myths and reality of Russia's monopoly tactics
The presentation made by Leonas Garbenis, director of economy and strategic planning at Lithuania-based Mazeikiu Nafta, put certain parallels between the "author's vision" for Ukraine's Odessa-Brody project and Lithuanian Butinge terminal. Just as Odessa-Brody pipeline, Butinge terminal was launched to enable alternative crude supplies reaching Lithuania. However, said Garbenis, for the whole of its operation, the terminal unloaded only a couple of tankers with North Sea blend Flotta. This was enough to discover that tailor-made for processing Russia's blend Urals, Lithuania's Mazeikiai refinery gives higher returns operating on Russia's crude. Though, added Garbenis, there is always a possibility to switch the supplier if required - refinery's management simply shows no desire to do so. The company improves the supplies to domestic oil products market and expands export shipments mainly through various refinery upgrades and a good marketing. The logic is simple: enhancing efficiency of feedstock processing and seeking new export opportunities for gasoil, gasoline and other oil products boosts the refinery's profit-earning ability while improving its market position. On the other hand, the stability of the company is ensured by the state, which owns over 40% stake in Mazeikiu Nafta. However, the most important fact is that refinery's control stake is owned by the very Russians who are being demonized by Ukraine's PM Yulia Timoshenko.

Unfortunately, in Ukraine the process of "separating grain from the weeds" is in rudimental stage. It seems the authorities view the lack of alternatives to Russia's crude supplies as Pandora's box of the problems plaguing Ukraine's oil products market. As Oleg Gutsulyak, deputy head of oil department at Ukraine's ministry of fuels and energy, pointed out, official Ukraine is re-assessing the trends present in the country's oil refining and transportation segments.

Aleksandr Shevchenko, an aide to the general director of Ukraine's crude pipeline monopoly Ukrtransnafta, added in his presentation that the top managers of Ukraine's oil transportation segment understand the importance of Odessa-Brody pipeline as an instrument for diversification of the feedstock to the domestic refineries. However, his presentation echoed the statements previously heard from the company, to the point that Ukrtransnafta's priority lies in quickest restoration of Odessa-Brody direct operation [now the pipeline is used in "reverse" mode, shipping crude from Brody to Odessa - OM]. The company also insists on luring Caspian oil producers to use the pipeline for transit of their volumes to Eastern Europe - the plan has already cost Ukrainian taxpayer hundreds millions of dollars, with no end in sight.

At the same time, according to Aleksandr Grabovskiy, a project manager at TNK-BP Ukraine, which successfully lobbied reverse usage of Odessa-Brody pipeline, Urals shipments via Brody to Ukraine's Black Sea terminal Pivdenny have already earned Ukraine some $34mn in tariffs. In 2005, the company will ship 140,000 b/d through the pipeline. Shipment volumes would have been higher if Ukraine's authorities could at least match Pivdenny's tanker duty and port charge to Odessa terminal tariffs. For Russia's oil transportation professionals, economy of the shipments has long become the driving force of the business - while Ukraine, as ever, likes talking of long-term strategic priorities, which generously justify multimillion losses.

The entire spectrum of the post-soviet projects in FSU energy-related sectors is based on the profitability factor. Following this logic, Ukraine is probably better off leaving intact reverse operation of Odessa-Brody pipeline and concentrating on transit expansion projects. There some interesting ideas here, such as keenly discussed behind the congress's main stage project on construction of 52km pipeline linking Prydniprivski trunk oil pipelines with Pivdenny terminal. Present at the congress highly professional traders unanimously said that unlike with Odessa-Brody project, such a link would immediately be filled with Kazakhstan-produced crude.

The transit games abd technological booby-traps
It seems that the top managers of Ukraine's crude industry (actually, after the Orange revolution it is unclear just who they are) are yet to find out that without investing millions of dollars in refineries' upgrading - just as adjacent Belarus, Lithuania and Poland have done - the country is unable to either "beat monopolisation by Russia's crude " or secure oil products supplies to the domestic market and money for the budget from export-designated volumes. Even transit of Russian crude volumes through Pivdenny terminal is seen as "necessary evil", and finding the way to counter that "evil" is one of the top priorities of the industry.

Presently, Ukraine lags behind every other FSU country in oil refining segment. Wile many are keen to remember that Ukraine's total refining capacity reaches 1.04mn b/d, they forget the statistics presented by the breakdown of refineries' output. Ukrainian fuelling stations are quite likely to sell diesel fuel with 8,500 ppm (!!!) sulphur content - while neighbouring Belarus, Lithuania, Latvia and Estonia for several years comply with Euro-3 regulations. Starting from January 2006, Estonia will upgrade to Euro-5 regulations, limiting its diesel fuel market to the blends with less than 10ppm sulphur content. Discard for nation's health, shown by Ukraine's MPs who hand-pick various obstacles for the propositions on tightening domestic standards for motor fuels is both familiar and easy to explain.

However, the lack of legal incentives for refineries upgrade projects hits units' export potential among other things. In addition, investment programmes of Ukraine's refineries were badly hit by circulated in spring 2005 initiatives of new Ukrainian government, which decided to get some cash for socially-biased budget using "fat cats" doing business in the country's oil sector. The political factors of the decision are clear, but they have little in common with fine-tuned control over Ukraine's motor fuels market. It seems that very few officials per se studied Ukraine's oil refining segment, preferring to earn points on the TV and in the media munching the popular topic of Odessa-Brody crude flow direction.

Such blatant disregard to refining industry is bound to hit back - if Ukraine fails to redress the misbalance, April's gasoline price wars will fade in comparison.

Ekaterina Nezlina, an analyst at Purvin&Gertz consultancy, estimated in her presentation that by 2009 Russia would reach the balance between crude production and pipeline export capacity. In normal language, this means that Russia could choose the destination for its crude shipments. Ostensibly, the destinations would be governed by profit-loss equation, in which case Ukraine would have to enter much tougher competition with other export routes. And Ukraine is unprepared for this scenario, noted Vladimir Kapustin, general director of Russia's R&D centre VNIPINeft. According to Kapustin, Ukraine must invest immense sums in its refining sector if it wants to compete with the refineries located in the EU, USA and Japan, or even in the neighbouring Belarus. Even today, there are reasons for an alarm, as gasoline prices growth outpaces the growth of crude cost - the refineries in the US run on full capacity but still the country has to export motor fuels from Europe. Kapustin said that the tendency will remain, while the volume would expand, as Europe boosts diesel fuel usage while the US doesn't.

Russia's oil industry isn't ideal either, said Kapustin, but there are some positive changes. The most evident is a $300mn hydrocracking unit project at Lukoil's Perm refinery, which enabled the company to start exports of diesel fuel with 10 ppm sulphur content via Vysotsk terminal in the Gulf of Finland in March. Having no incentive to produce low-sulphur diesel fuel at the domestic market, Lukoil has found it in adjacent Finland, where the company acquired a network of fuelling stations. The company's entry to the European markets of oil products retailing coincides with persistent growth of diesel fuel demand, said Kapustin. There are also positive changes in quality of Russia-produced gasoline - over the recent years, a number of Russia's refineries have launched isomerisation units, cutting down the content of benzene and cancer-inducing aromatics in produced motor fuels.

Here also, neither Russian nor Ukrainian legislation provides incentives to gasoline producers - just as in the past, the motivation came from the EU and the USA markets, as implemented there environmental regulations were making Russian oil products unfit for consumption. This spurred construction of isomerisation units at Ryazan, Ufa, Khabarovsk, Komsomolsk and other refineries. In August, Surgutneftegaz-owned Kinef refinery (Kirishi, Leningrad region) will launch an isomerisation unit designed using technology of Krasnodar-based R&D centre Neftekhim.

That compares favourably with Ukraine, where up till 2004 no refinery owned an isomerisation unit. Lukoil-owned Odessa refinery set the trend, launching $15mn 100,000 tpa isomerisation unit designed by the US-based UOP in June 2004. TNK-BP plans to launch Neftekhim-designed isomerisation unit on its Linos refinery in July this year. To the date, any talk on other modernisation projects for Ukraine's refineries, especially those targeting boost of gasoline quality, remains a lip service. At the same time, payback period of Neftekhim-designed isomerisation units is a mere trifle at 8-10 months; compared with Western analogues; this technology also saves the companies millions of dollars on isomerisation process catalyst change, said general director of Neftekhim R&D labs Alexander Shacun. In general, with legislative support and incentives for the refineries in place, the issue could have been solved. There is no pressing need to spend hundreds of millions of dollars on hydrocracking units, but Ukraine's refineries well could boost the quality of produced gasoline, and within a short timeframe, too.

But as for now, the situation is almost Kafkaeskan. The citizens breathe the smog resulting from appalling gasoline, banned in Europe decades ago, while the government gives no incentives for refining sector development. The very same government boisterously accuses Russia of monopoly tactics in crude sector while rushing to supply its Eastern European neighbours and its own underdeveloped refineries with the crude which costs well above the Russian blend. The same government trumpets even more about the prospective of joining the European Union.

The unbiased international discussion that surfaced at the congress provided an objective look at the farce. Why do you think Ukraine's government can't see it?

P.S. The invitations to attend the Congress were sent out to Ukraine's PM, to the ministers of transport and fuel and energy, as well as to the Secretariat of the President, National Security Council, state-owned oil company Naftogaz Ukrainy and so on. However, the official Ukraine had no time to dip into close and not-so-bright future of Ukraine's petroleum segment.
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