Energy and Climate Change CommitteeWritten evidence submitted by Phillips 66 Limited

Phillips 66 is a downstream energy company with Refining and Marketing (R&M), Midstream and Chemicals businesses. The company’s R&M operations include 15 refineries with a net crude oil capacity of 2.2 million barrels per day, 10,000 branded marketing outlets, and 15,000 miles of pipeline systems. In Midstream, the company primarily conducts operations through its 50% interest in DCP Midstream LLC, one of the largest natural gas gatherers and processors in the United States with 7.2 billion cubic feet per day of gross natural gas processing capacity. Phillips 66’s Chemicals business is conducted through its 50% interest in Chevron Phillips Chemical Company LLC, one of the world’s top producers of olefins and polyolefins with more than 13 million metric tonnes/year of annual chemicals processing capacity across its product lines.

Phillips 66 Limited owns and operates the Humber Refinery in the UK and markets transport fuels under the JET brand.

Response to Questions Posed by the Committee

1. What are the factors that have led to the closure of UK refineries? Why is production increasing overseas?

1.1 Refining is the link between two independent oil markets: the crude oil market and oil products market. Refineries purchase crude oil, the price of which is determined by the availability of crude oil and the demand for crude oil by refineries, and refineries sell oil products, the price of which is determined independently by the demand for energy by end users and the supply of oil products from refineries. Refining is a margin business therefore and out of the margin that is available from these two independent markets, a refinery must pay its fixed costs (for items such as labour, maintenance, rates, taxes), its variable costs (for items such as chemicals, catalysts, energy) and must generate sufficient cash to invest in maintaining safe, reliable and legally compliant operation.

1.2 Key factors that determine the competitiveness of any refinery are its location, size, complexity and operating performance as well as the legislative burden placed on it, and UK refining is disadvantaged vs competition in many of these factors: Increases in the production of shale oil in the United States, limits on infrastructure to transport the shale oil to refineries and legislated limitations on the export of crude oil from the country are leading to a surplus of crude oil within the US, which is depressing the price of crude oil locally and providing a substantially greater margin for US refineries to operate than UK refineries. In addition, rapid increases in the availability of shale gas in the US have depressed natural gas prices, reducing the cost of energy to US refining significantly compared to UK refining. With energy being the single largest cost of operating a refinery, the lower energy cost for US refineries is another significant competitive advantage for US refineries compared to UK refineries. Similarly, the availability of cheap natural gas in the Middle East provides a competitive advantage for Middle Eastern refineries compared to UK refining. Electricity is a large cost for refineries and the UK’s leadership in reducing greenhouse gas emissions is leading to substantial increase in the UK’s electricity cost. This compounds the fact that other countries have lower generation cost from low price fossil fuel.

1.3 The size of a refinery is an important factor for economy of scale; larger refineries can dilute their fixed and investment costs over a larger volume of products and thereby reduce the costs on a per barrel basis and improve the operating margin. The average size of refineries in the US and Middle East is larger than in the UK and UK refining is disadvantaged compared to these other regions by its smaller size of refinery.

1.4 The complexity of a refinery is a measure of its capability to process heavier, more contaminated feedstock (which is cheaper as a result of its poor quality) and/or produce a higher proportion of high-demand products such as jet fuel and diesel (which command higher prices as a result of the demand). US and Middle Eastern refineries have invested more heavily in equipment to process cheaper, more difficult to process crude oils and to produce a higher proportion of high value products than UK refineries have and are able to extract a higher gross margin (before costs) from the market than UK refineries can.

1.5 European Union objectives to improve air quality require European refineries to invest more heavily in equipment to reduce environmental emissions than refineries outside Europe; US refineries have a similar legislative burden to European refineries. In addition, UK specific legislation such as CRC and Carbon Floor Pricing for example, burden UK refineries even further, requiring even higher levels of cost and/or investment and making UK refineries less competitive in a global market.

1.6 The UK privatised its ports and unlike with other privatisations such as electricity and water, Government did not appoint a Ports Regulator. UK refineries such as Humber Refinery, which historically leased ports assets or land for critical infrastructure during the time of Government ownership, are now faced with privatised monopolies exploiting the fact that there is no Ports Regulator when it comes to renewing leases. The ability for privatised ports to exploit the lack of a Ports Regulator is compounded by a weakness in the Landlord & Tenant Act which allows privatised ports to seize assets from tenants and to charge those previous tenants with unregulated commercial rents for their use.

1.7 The UK climate change goals to reduce greenhouse gas emissions by 80% by 2050 are a clear message to refinery owners that the UK is committed to reduce the consumption of fossil fuels. The result of the legislation is that the UK (and European) oil consumption is falling and that refinery capacity is therefore not utilised fully by supplying products to UK/Europe. Unless UK/European refineries can compete with other refineries around the world to supply products outside of Europe, UK/European refineries will close

1.8 The afore-mentioned factors result in UK (and more generally, Europe) being a challenging region for refining and with a surplus of refining capacity globally, then some UK and European refineries have become unable to make sufficient sustained profits or attract the necessary investment to upgrade them to remain valuable businesses in their company’s portfolio of refineries.

2. What impact (if any) has UK and EU regulation had on the UK refining industry?

2.1 UK legislation which is not applicable to refineries in other countries, is not based on sound science, and/or which favours one technology vs others disadvantages UK refining by adding cost which many competitors do not have to bear or do not bear to the same degree.

2.2 IHS Purvin& Gertz estimate that UK refineries will need to invest £5.5 billion of capital to meet UK and EU legislative measures in the period 2013–30 and will incur an additional £5.9 billion of operating cost in the same period in order to operate that new equipment, to purchase EU allowances and to support the UK’s target carbon floor price. This figure excludes legislative impacts for Fuels Quality Directive and Energy Efficiency Directive which as yet are not fully defined.

2.3 This large, mandatory expenditure provides no return on investment and reduces the funds available for UK refinery owners to invest in improving the performance of UK refining businesses and to maintain or improve the viability of UK refineries. As outlined in section 1 above, the UK is a challenging country for refineries and margins are tight. Large investments in projects that do not earn a return on capital are therefore difficult to justify. Owners are therefore faced with the alternatives of making large investments in low return UK refineries or avoiding the investment by either partial or total closure.

2.4 Within the transport sector, a combination of Government-driven fiscal factors and the automotive industry’s response to targets derived from Government environmental legislation has encouraged a shift away from petrol powered vehicles towards diesel powered vehicles, as a result of which the UK has a surplus of petrol, which it is exporting and a shortfall in diesel, which it is importing to meet demand. The necessity for UK refineries to export petrol to distant markets outside of Europe (Europe has an excess of petrol for the same EU Government legislative reasons) reduces the value that UK refineries can achieve for petrol products and reduces margin consequently, although this is partially offset by an increased margin available for supplying diesel. IHS Purvin & Gertz estimate that UK refineries would have to spend approximately £1.5 to £2.3 billion over the next 20 years to keep up with changing product demand.

3. What part will refined oil products play in the UK’s energy requirements and transport in particular to 2030 and beyond? What mix of products is likely to be required and how well does this match with current UK refining capacity?

3.1 The International Energy Agency forecasts that oil will be a major source of energy to 2030 and beyond, accounting for over 80% of EU transport fuel. The projections for UK demand are similar.

3.2 The main fuels required in the UK in the future will be petrol, diesel, gas oil and kerosene, but refinery specialty products such as lubricants, solvents, carbon coke and petrochemical feedstocks will become increasingly important sources of supply for growing, downstream industries and hence uses of oil products.

3.3 Renewable fuel such as bio-ethanol and bio-diesel are likely to become an increasing proportion of fuel for transport and heating, partially replacing fossil fuel in the energy mix.

3.4 There is a mismatch between UK refinery output and UK market demand. UK refineries, which were built predominantly in the 1960s when petrol demand was a much higher proportion of total UK energy demand, currently produce an excess of petrol and insufficient diesel and jet fuel (refer to response to Questions 2 and 4), the shortfall being met by imports from countries such as the Middle East, Russia, India and the USA.

4. What is considered to be the right balance between oil products refined locally and imports and what are the current and future scenarios?

4.1 Phillips 66 refers to the International Energy Authority model for Short Term Energy Security (MOSES) and the guidance issued by the IEA that import dependence greater than or equal to 45% of market demand is high risk to a country’s energy security. The UK dependence on imports is currently at a level of 56% for jet kerosene, 48% for diesel and 44% for heating kerosene. There is a surplus of petrol to meet the demand.

4.2 Using IHS Purvin & Gertz forecast for future UK demand and assuming no further closures of UK refineries then UK dependence on imports increases to 59% for jet kerosene and 56% for diesel by 2020. The dependence on heating kerosene imports remains at 44% and the petrol surplus increases. If more refineries were to close, and two have been actively marketed recently without finding buyers, then IHS Purvin & Gertz forecast that import dependence for jet kerosene and diesel could increase to levels of 77% and 75% respectively by 2020. It is for Government to decide the right balance between oil products refined locally and imports, however Phillips 66 recommends that Government adequately model supply security both in times of stability (when oil markets operate well) and in times of dislocation such as occur during wars, hurricanes etc.

5. What are the factors, both domestic and international, that will determine the future viability of the UK refining industry?

5.1 The factors that determine the future viability of the UK refining industry are detailed in response to Question 1). UK legislators are unlikely to influence the commercial conditions affecting the refining sector (oil price, refinery size), but can and do impact the cost for UK refiners to comply with legislation and to some extent (eg electricity from renewables), the cost of energy. European specific and UK specific legislation impact the competitiveness of UK refineries compared to the global competition by increasing the level of investment required to continue to operate in the UK vs elsewhere.

5.2 IHS Purvin & Gertz forecast that average UK refining margins in the future may be approximately $2.50/barrel of oil processed. It is possible given the global surplus of refining capacity and the economic conditions for refining in Europe, that refining margins in the UK could be even lower than this, with some UK refineries being break-even rather than profitable. In the period to 2030, IHS Purvin & Gertz estimate that the cost for UK refineries to comply with European/UK legislation will be the equivalent of $1.85/barrel, not including the compliance cost for article 7a of the Fuels Quality Directive or the Energy Efficiency Directive. Estimates for the cost to comply with FQD article 7a alone range between $1.50/barrel and $7.00/barrel, which would be additional to the costs described above. In this scenario it seems unlikely that UK refineries will invest the £1.5 to £2.3 billion required to meet the changing product demand of the market and security of energy supply in the UK will increase as forecast and remain high risk.

6. What impact would the closure of UK refineries have on (a) energy supply security (b) environmental objectives and (c) the price of petroleum products in the UK??

6.1 The impact of further refinery closures on supply security is highlighted in the response to question 4 above.

6.2 The impact upon UK environmental objectives is difficult to predict but since refining crude oil is very energy intensive, it is likely that the closure of UK refineries would reduce the UK’s domestic emissions. However, demand for oil products previously produced within the UK would be met by imports from overseas refineries, thereby probably increasing overall emissions by longer supply chains.

6.3 The future cost of oil product in the UK should another refinery close is complex, with regional supply & demand balances overlaid with other factors such as logistics costs, taxation policy and duty point determination. Phillips 66 has no comment on future pricing of oil products in the UK.

7. What would be an appropriate baseline level of refining capacity in order for the UK to remain broadly self-reliant in an emergency?

7.1 IHS Purvin & Gertz report that the UK is dependent currently on imports to meet approximately 50% or more of the market demand for Jet kerosene, diesel and heating kerosene, which is a high risk to energy security using the International Energy Authority model for Short Term Energy Security. It is unlikely, given underlying global economic fundamentals for the refining industry and the cost of meeting the environmental objectives of the European Union and UK Government that further refining capacity will be added in the UK in the foreseeable future nor existing refining capacity modified extensively to increase kerosene and diesel production and as a result, it is unlikely that the UK can be broadly self-reliant in an emergency. Indeed, the economic conditions for UK refineries may result in further refinery closure.

8. What steps could the UK Government take to maintain an appropriate baseline level of refining capacity?

8.1 Despite not having a company view on what an appropriate baseline capacity is, Phillips 66 sees the following as measures that would assist preserve a UK refining industry:

8.2 Meeting the UK’s future energy needs in a secure, resilient and sustainable way that also meets environmental and air quality objectives, is a huge challenge. It requires policy that is closely aligned and balanced across these key areas and it requires UK Government to set out a long-term framework for UK refining that provides oil companies with the confidence and incentive to continue operating refineries in the UK and to continue investing to maintain a viable UK refining industry in the future.

8.3 At both the European and UK level, Government should strive to implement legislation in a way that maintains the competitiveness of UK refining vs other European refineries and vs global competition. In particular, legislation should not be European or UK specific to as large an extent as possible, legislation should be justifiable, based on sound science and achieve the agreed objectives, without gold-plating or adding “bells and whistles” and it should not favour one technology over another.

8.4 The UK Government should address elements of taxation and/or economic policy that impact UK refiners adversely compared to an importer operating in the same market. One example being that an importer importing product in to the UK pays duty as that product crosses the loading rack whereas a UK refiner pays duty on product as it leaves refinery tankage. This difference favours an importer by allowing an importer to move product to terminals in the UK without paying duty. A second example is the reduced obligation for importers to store only 58 days of oil products compared to UK refiners obligation to store 67.5 days, which increases the working capital that UK refiners must bear compared to importers.

8.5 The UK Government should appoint a Ports Regulator or put an arbitration process in place to resolve disputes between UK refiners and privatised port authorities, on whom refiners are wholly dependent for movement of feed and product by ship and who have a monopoly position. In addition, the UK Government should amend the Landlord & Tenant Act to prevent privatised ports from seizing assets from tenants and then charging the previous tenant unregulated commercial rents for their use.

8.6 UK Government should urge the European Parliament to retrospectively review the plethora of existing legislation impacting the UK refining industry to check its fitness for purpose.

8.7 UK Government should not intervene on the EU Emissions Trading Scheme. This scheme is set up to trade carbon allowances in the free market. Any retroactive amendment of the trading scheme such as withdrawing credits or raising the target for 2020 CO2 reduction goes fundamentally against the effective running of a trading scheme.

9. What is the significance and potential future impact of the changing ownership of UK refineries in recent years?

9.1 Many of the current and prior owners of UK refineries have large, diverse, international refining portfolios, have differing objectives for their refining portfolios and have competing opportunities for capital investment. In these circumstances, the portfolio value of any particular refinery can change with time and a refinery can become less valuable to an existing owner than it is to another. In a mature sector like the UK, it is likely and indeed healthy for there to be changing ownership of refineries as strategy and objectives of individual companies change with time. Changing ownership can be a positive factor since it brings in new entrants, new investment and new ideas.

9.2 One potential adverse impact of a change of ownership, especially an impact of the withdrawal of large, multinational oil companies and the introduction of smaller, less diverse companies is the risk that the asset base of some of the smaller companies is not sufficient to justify providing credit terms to those companies at a level that supports the arrangement of product exchanges and purchases and sales that occurred historically with the multi-nationals. This limitation to doing business with some owners of refineries may be particularly important during a response to an unplanned disruption to fuel supplies in country.

May 2013

Prepared 25th July 2013