Refinery Service Market in Russia

Oil and Gas 2011

Contents

Introduction Refinery market development Personnel of refinery services Financial standing of refinery services The choice of contractor and conditions of servicing Key threats and prospects of refinery service market development

3 3 4 4 5 6

Introduction Development of refining industry during 2004-2009 was accompanied by increased demand in supporting industries. In order to function properly, refineries often require access to the following: Mature infrastructure Non-stop functioning of supporting industries (access to distribution systems, uninterrupted supplies of raw materials, etc.) High quality of services (provision of modern equipment and technologies, maintenance and repairs of machinery, transport, etc.) At present, the industry is engaged in a process of technological development brought about by a gradual shift to higher environmental standards and an increase in oil processing depth. For example, in 2012, Russia is planning to adopt Euro-4 emission standards. Meanwhile, the implementation of investment programs will increase companies average Nelson index from 4.5 to 6.5 by 2017.In turn, this will lead to significant capital investments in modernization. This modernization process will affect the supporting industries as well. In particular the refinery service market will experience boost of the demand for machinery installation services and increase in requirements for service quality and personnel. Refinery market development Refinery service market has only just begun to emerge, and so is too early to define at this point. Unlike oilfield services, which have increasingly been outsourced over the last 10 years, the outsourcing of refinery services is a relatively new phenomenon. However, as refineries spend 11% of their total production costs on services, it is probably fair to say that the refining services market may currently be valued at USD 3bn.

Picture 1: Structure of the refinery service market, 2009

5% 6%

48%

Mechanical service Transport service Energy service Instrumentation & Automation

41%

Source: SPARK, Deloitte analysis

Breaking down the refinery services market, is evident that the main suppliers of services are generally affiliated entities of oil companies, which account for nearly 70% of the market. Some oil companies, such as TNK-BP, Surgutneftegaz, and LUKOIL, outsource their services within the framework of cost optimization programs. This trend has led to the creation of an independent market. Nevertheless, refineries have a number of reasons for retaining certain in-house services, primary among these being safety requirements, as industrial and environmental safety remains the direct responsibility of refineries, even when services are outsourced. For instance, industrial transport services remain in-house, as refineries are concerned about

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losing control over this area, which is vital if repairs or other work needs to be carried out at a plant. At the same time, companies retain control over passenger transportation primarily for historical, rather than economic reasons. Among integrated mechanical services, only machinery maintenance is generally kept in house, with other such services (mechanical engineering, major overhauls) being outsourced. Maintenance and technical modernization services are generally provided by independent entities because of large fluctuations in demand for these services.

at Bashneft facilities. The markets for these services remain relatively open and the majority of them have already been outsourced. However, the companies providing these services are mainly regional players that have a history of serving refineries in this area. Personnel of refinery services Nearly 72% of people employed in the refinery services industry work for service centers that are integrated into refineries, which corresponds to the 70% market share of these types of businesses. The majority of personnel provide mechanical services (approximately 57%). The high employment costs associated with staff involved in mechanical maintenance attests to the high potential of the equipment maintenance and repairs market, and the advantages of applying the outsourcing model to these services. Nevertheless, at present, the number of people working for integrated entities providing these services is almost 1.5 that employed by independent service companies. The second largest share of the market in terms of employment structure is represented by transport services (nearly 35%) that are completely integrated into the structures of refineries or affiliated companies. Meanwhile, the share of energy and instrumentation & automation system services in overall personnel structure is insignificant, as the maintenance of control systems and energy equipment does not require a large human resource base. Financial standing of refinery services To a great extent, the affiliation factor determines the financial standing of service companies. One third of affiliated services incur losses due to the pricing models set for the purpose of profit reallocation for the benefit of oil and gas companies. Transfer pricing prevents integrated services from carrying out investment

Picture 2: Services distribution between different types of companies

Instrumentation & Automation Energy Mechanical Transport 46%

81% 80% 54% 100%

19% 20%

Independent services Affiliated services Source: SPARK, Deloitte analysis

Energy and control system services require the involvement of a small number of specialists and, therefore, are a popular target for outsourcing, due to the greater efficiency offered by the independent business model. Energy services are rarely included in the structure of refineries, and are mostly seen

Picture 3: Breakdown according to the number of employees in different service companies, 2009.

5%

4%

On average the receivable turnover of independent service companies is 30% lower than that of affiliated companies. The financial standing of affiliated service companies can be adjusted by the parent/ head companies. According to statistics from 2009, the profitability of independent service companies on average was 10% whereas the profitability of affiliated companies was 1.6%. The choice of contractor and conditions of servicing Going to tender is a key tool for a contractor. Approximately 80% of Instrumentation and Automation, energy services and 45% of mechanical services are bought on the basis of a tender. Industry representatives have noted that better services are provided by independent companies in comparison to affiliated ones. The exchange of information about the quality of services provided is significantly hindered due to the closed market. For example, the creation of an O&G service provider database (which would rate companies according to price and the quality of services provided) would reduce the risks for oil refineries associated with unreliable work and would better control the cost of services provided by independent companies. Payment periods are also overly long (30120 days). Small service companies can have substantial problems meeting salary and tax payments within these timescales. These terms are especially tough for independent service companies who do not have access to cheap capital. Foreign contractors are more likely to confirm long payment periods.

35% 56%

Mechanical service Transport service Energy service Instrumentation & Automation Source: SPARK, Deloitte analysis

programs and establishing benefit funds for personnel. These issues are usually addressed by parent companies. Restrictions in the independent investment activity of integrated service companies weaken their competitive positions in comparison with foreign companies. On the other hand, affiliated service companies do not have to search for orders as this is done by the affiliated refinery or other companies in the group.

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Key threats and prospects of refinery service market development The threat of foreign competition is highly relevant to the Russian market as the prices of many foreign service companies (particularly those from China) are lower on average than those of Russian companies. In addition equipment produced abroad is often of a higher quality which enables machinery producers to win both machinery supply and maintenance tenders. Russian affiliated services also do not have the financial resources to renew machinery.

Affiliated service companies are not motivated to improve the quality of the service which they provide. Geography also plays an important role in this process as the remote location of repair facilities from the refineries can substantially increase the price of services due to increased transportation costs. However, the independent service market is not completely free from problems. Most independent service companies are small-scale which often leads to weak corporate management. Providing a refinery service requires highly-qualified personnel and on site involvement. The lack of qualified personnel is worsened by the low mobility of employees. The refinery service market is expected to experience some changes in the near future. First of all, there is significant deterioration of equipment in Russian refineries. It is estimated that 7085% of equipment need to be replaced over the next 2 to 5 years. The need to modernize production in relation to implementing the Euro-4 ecological standard in 2012 are powerful levers for increasing refinery investment and technological change. In turn the renewal of machinery will firstly lead to an increase in the demand for mechanical and instrumentation and automation services and then to the demand for energy services. Modernizing refineries can also lead to a decrease in equipment maintenance and to toughening of the personell qualification requirements. The market entry by new foreign players will enhance competition, improve service quality and decrease service prices. The similarity of oilfield and refinery services could lead to a merger of separate field-specific types of services, for example, transport services. The optimization of maintenance costs by refineries and the desire to obtain a better quality of service are vital to further shaping of independent refinery service market.

Picture 4: Future major events in the oil refinery sector of the Russian Federation

Large-scale upgrade Transfer to Euro-4 Transfer to Euro-5 of the equipment on the oil refineries Rise of the Nelson index to 6.5

2012

2013

2014

2015

2016

2017

The dependence of organizations on oil companies is a key problem with regards to expanding the market. As previously noted, transfer pricing may lead to the unstable financial health of a company. Independent companies are unable to decrease the cost of their services so their key advantage is the quality that they provide. In the future it is expected that companies will move towards outsourcing refinery services. For example, Kirishinefteorgsyntez, the largest Russian refinery, is serviced exclusively by independent mechanical energy services and instrumentation & automation companies.

Contacts

Moscow Russell Banham CIS Energy and Resources Leader +7 (495) 787 06 00, ext. 2107 rubanham@deloitte.ru Elena Lazko CIS Oil & Gas Practice Leader +7 (495) 787 06 00, ext. 1335 elazko@deloitte.ru Kelly Allin Audit +7 (495) 580 96 80 kallin@deloitte.ru Andrey Panin Tax and Legal +7 (495) 787 06 00, ext.2121 apanin@deloitte.ru Yegor Popov Financial Advisory Services +7 (495) 787 06 32 ypopov@deloitte.ru Yaroslav Gorodiskiy Corporate Finance Advisory and M&A +7 495 787 06 00, ext. 1646 ygorodiskiy@deloitte.ru Wayne Thomas Transaction Services +7 (495) 787 06 00, ext. 2325 wathomas@deloitte.ru Tatiana Kalashnikova Petroleum Services Group +7 (495) 787 06 00, ext.1300 tkalashnikova@deloitte.ru

Almaty Daulet Kuatbekov Audit +7 (727) 258 13 40, ext. 2777 dkuatbekov@deloitte.kz Michael Sturdivant Tax and Legal +7 (727) 258 13 40, ext. 2717 msturdivant@deloitte.kz Kyiv Justin Bancroft Audit +38 (044) 490 90 00, ext. 8660 jbancroft@deloitte.ua Vladimir Yumashev Tax and Legal +38 (044) 490 90 00, ext. 2648 vyumashev@deloitte.ua Artur Ohadzhanyan Financial Advisory Services +38 (044) 490 90 00, ext. 3618 aohadzhanyan@deloitte.ua Yuzhno-Sakhalinsk Andrey Goncharov Director of Yuzhno-Sakhalinsk office +7 (4242) 46 30 55, ext. 3802 agoncharov@deloitte.ru

Baku Elnur Gurbanov Audit +994 (12) 598 29 70, ext. 4318 egurbanov@deloitte.az Nuran Kerimov Tax and Legal +994 (12) 598 29 70, ext. 4339 nkerimov@deloitte.az International leaders Adi Karev Global Oil & Gas Leader + 852 2852 7509 adkarev@deloitte.com Carl Hughes Energy and Resources Leader Deloitte UK +44 20 7007 0858 cdhughes@deloitte.co.uk

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