A swelling ocean of cheap and dirty fuel oil pouring out of Russian refineries and onto world markets tells the story of misaligned tax policies and perverse incentives that jeopardise President Vladimir Putin's campaign to modernise industry. Despite repeated attempts to fix its tax system, export incentives that are meant to be phased out by 2015 still make it more profitable to export cheap fuel oil - the detritus of the refining process - than the crude from which it is made.
The result has been a glut of exports of the lowest-value refined oil product and very slow progress in improving Russia's creaky refining industry, which has ballooned into the world's third largest to meet domestic demand for gasoline. The policies hit Moscow's export revenues and effectively subsidise refiners everywhere in the world but Russia, who benefit from cheap Russian feed stock they can further refine into more expensive gasoline or diesel.
"These fuel oil exports undermine demand for, and the value of, Russia's own medium sour Urals crude," said Andrew Reed from US-based ESAI Energy consultancy. Fuel oil, used for heating and marine fuel, is the residue left over when refineries produce more expensive products like gasoline, diesel and jet fuel. It is the only major refinery product that is cheaper than the crude from which it is made, and demand for it has declined sharply in recent years as environmental regulations tighten around the world and power plants shift to cleaner natural gas.
A sophisticated modern refinery will usually limit fuel oil to no more than about 15 percent of output. But in Russia, where many refineries still date back to the days of supporting the heavy fuel needs of the Soviet Red Army, fuel oil accounts for more than a quarter of refinery output. Determined to encourage refining, Russia has long subsidised fuel oil by charging far lower duties to export it than crude. That meant there was little incentive for refiners to invest in upgrading their technology to reduce the proportion of fuel oil they produced.
Russia tried to improve the situation in 2011 by introducing a new tax system that raised the duty on fuel oil exports to 66 percent of the duty on crude, from 45 percent. Moscow also set a target date of 2015 to eliminate the subsidy altogether and equalise the duties on fuel oil and crude. But statistics show that so far the tax changes have yet to prod improvements to the technology of Russian refining.
Under a formula for measuring refining sophistication - which deducts fuel oil output from total processing - Russia's score has stayed virtually unchanged over the past five years, near the bottom of the international league table, among the least sophisticated big refining countries in the world.
The government had hoped that between 2011 and 2015 refiners would build equipment capable of producing a greater proportion of higher-value products, like the most advanced plants in China or India. However, modernisation, estimated by Bank of America Merrill Lynch to cost $31-$37 billion, is massively behind schedule. State major Rosneft alone has a $25 billion upgrade plan, but many projects won't be finished before 2017 at the earliest.
Big refiners warn that they won't be able to modernise by 2015. The situation is worsened by excessive technical regulations and high duties on imported equipment, issues seen as endemic in Russia and which thwart modernisation. Under pressure from an industry not yet ready for the change, officials now suggest they may abandon their 2015 target for eliminating the subsidy for fuel oil exports, letting firms continue to profit from the glut at the tax collector's expense.
Energy taxes - including oil export duties - account for half of Russia's budget revenues. In 2007, it needed oil prices of $34 a barrel to balance its budget. Now it needs $115 due to heavy social spending. For years, Russia subsidised its refining industry at the expense of oil production through lower export duties on products. Annually such subsidies amounted to up to $20 billion, according to research by Skolkovo, a Russian business school. The aim was to encourage 25 plants scattered across the world's largest nation to produce more gasoline. Putin criticised oil firms for domestic gasoline shortages in 2011.
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