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Policy Options and Prospects for Egypt’s Downstream Sector

Research & Analysis

By Emad El-Din Aysha, PhD

Egypt’s refining industry suffers from a series of mismatches in the downstream sector. Refineries are not designed to process certain grades of crude that nonetheless are supplied to them. Business sources explain that the same holds true of petrochemicals. The end result of this has been excess capacity, underperformance, underinvestment, and technological backlog.

This results in an underperforming sector that suffers from financial and technological deficits and a lack of backward linkages from petroleum to the rest of the economy. In petrochemicals, the prices of plastic articles in the Egyptian marketplace – even small shopping bags – have been going up. Yet the prices of the feedstock of plastics, the basic chemicals derived from oil and gas, have been going down globally in tandem with crude prices. A problem that highlights the negative effects Egypt is facing as a net importer of plastics.

Refining and petrochemicals, needless to say, are the backbone of downstream or post-production. The classical textbook definition separates refining and petrochemicals from midstream – transportation through pipelines, tankers, trucks, and from marketing – sales and distribution of finished petroleum products. In industry-speak, however, these three stages are increasingly being lumped together.

The byword for ameliorating inconsistencies in the downstream sector is therefore ‘integration,’ explains a petroleum expert who prefers not to be quoted by name. Oil majors like BP and Chevron and national oil companies (NOCs) like Saudi Aramco and Malaysian Petronas are fully integrated, upstream, midstream and downstream, enjoying their own refining and petrochemicals, sales departments, subsidiaries and investments. The very nature of downstream is then changing as a consequence of the integration, the expert adds.

Egypt needs to develop its downstream sector more than ever before given the mounting fuel import bills and the severe strain it places on the whole economy by depleting the hard currency reserves. The issue at hand now is to identify, in detail, the full range of problems afflicting Egypt’s downstream sector in all its stages and look into policy options for resolving them – keeping country and company comparisons in mind.

Currency Feedbacks and Planning Challenges

The current dollar crisis has revealed just how susceptible the petroleum sector is to global currency fluctuations and domestic inflation, if only because international oil companies (IOCs) operating in Egypt insist on being paid in US dollars. When Egypt’s hard currency intake is hit by a shortage of exports due to stalled factories, high volumes of much needed import paid for in foreign currencies and terrorism scaring off tourists then petroleum entities like the Egyptian General Petroleum Holding Company (EGPC), even if operating at optimum capacity, cannot pay back what they owe to foreign operators like BP and ENI.

What is less well known, explains the anonymous expert, is that the downstream sector is hit even harder by the dollar crisis for several additional reasons. One is that when IOCs do not get paid they insist on being given a larger share of their crude output, which they keep to themselves, depriving Egyptian refineries of their feedstock. A second problem is that with delayed payments the operators, in turn, delay their deliveries to local vendors, forcing Egyptian companies to seek energy from other sources to meet their contractual commitments, putting additional strain on hard currency reserves, since oil transactions internationally are denominated in dollars. A final problem is that downstream, much like most manufacturing industries in Egypt is heavily dependent on imports paid for in dollars.

The pipelines constructed here in Egypt, whether to connect drill rigs or export oil and gas, are made out of component parts from abroad that are first purchased for hard currency, imported and then welded together here. There is no shame in this as most developing nations have to import materials and technologies, but it is an issues that needs to be resolved over the long run.

The key is planning, says the anonymous expert. All petroleum projects are long-term. Development projects in oil take four to five years on average. For natural gas this can stretch to ten years, since the back-time needed to build liquefaction facilities has to be incorporated into planning and from early on; it is cheaper to export gas in LNG form than through pipelines. Much the same holds true of petrochemicals. As profit margins in downstream are much smaller, by comparison with upstream, the planning stage is essential, the expert adds. Even large integrated oil firms make between 80% and 90% of their money from upstream, leaving downstream struggling to compete for attention and finances – a gap that can only be filled through deliberate national policies.

Downstream Economics and Strategic Input

Need for strategies are important everywhere in the developing world, even hydrocarbon-rich countries like Iran, to cite an Iranian expert, Ali Mirmohammad, Senior Consultant and Business Development Manager with Frost & Sullivan. The country repeatedly failed to translate its ample oil and gas reserves into a thriving petrochemical industry over a long period of time. Even when downstream became a priority for the Iranian regime, over the past 20 years, the industry still did not take off. It was not only sanctions that held back progress, he explained, but also inexperience, poor management, among other issues.

The economics of downstream may not be as profitable as upstream but the benefits in terms of value-added, job creation, and moving away from a dependency on oil are insurmountable, Mirmohammad insists. The longer you go along the value-chain the more capital costs go down, while profits go up, he says. Producing methanol, for instance, demands an investment of over $900,000 to generate a single job. Producing polypropylene (PP) packaging bags derived from methanol, however, demands less than $20,000 per job. Iran has finally woken up to this potential and has plans to build more than 30 industrial cities to develop oil and gas downstream projects with an emphasis on methanol downstream products, which include PP consumer goods such as plastics.

Egypt seems to have recognized this potential, and has undertaken similar measures. The Egyptian Petrochemicals Holding Co. (ECHEM) was set up in 2002 specifically to execute a 20-year long National Petrochemicals Plan, according to Oil & Gas Journal (OGJ). In addition, given that the cost of petrochemical feedstock is highly volatile, tied to other factors such as economic circumstances and population trends, flexibility is another key ingredient of strategic planning for downstream, OGJ explains.

Improvements in Integration and Regulation

In the context of slimming currency reserves and downstream economics, planning deficiencies can be resolved through integration. The petroleum expert added that integration across the downstream chain revealed another seldom recognized problem with the oil and gas sector in Egypt, namely, the sheer number of firms in the petroleum sector, especially over the past 10-15 years. There were many separate refinery companies managing their own affairs without coordinating with other firms of their own kind or the upstream companies that supply them with crude. It would be better, he argues, to have a smaller number of larger firms integrated across the different facets of the downstream supply chain.

In Egypt refineries are increasingly beginning to integrate their operations with petrochemicals, according to OGJ, via grassroots projects where a refinery is co-located with a major petrochemical complex. EGPC is also brought in as a partner to insure feedstock supplies with Egyptian banks pitching in for stable local financing. A business source in petroleum adds that while this is the right approach to take, the problem is that upstream entities like EGPC, EGAS and GANOPE are tasked with managing the downstream sector too, multiplying their functions from being production partners in joint ventures to becoming government representatives busily enforcing rules and regulations.

The petroleum expert says that holding companies like EGPC and EGAS could do with a dose of integration themselves, doing an even better job of overseeing their subsidiaries if they owned and operated them directly. His advice is that these additional downstream oversight functions be parceled off to a specialized regulatory body, allowing the two companies to focus more on upstream E&P activities than on distribution and managing local markets. Integrating gives a body a larger asset base but also more responsibilities for managing those larger assets, so it is better to remove other functions served by that company in tandem, he explains.

Indonesia has taken this path, with two separate regulatory bodies dealing with up and downstream – BP MIGAS (later SKK MIGAS) and BHP MIGAS, respectively. Indonesia’s NOC, Pertamina, is a fully integrated upstream-downstream firm. Nonetheless it had to relinquish its powers over production sharing contracts (PSCs) to SKK MIGAS and its original monopoly power over the price of oil, gas and fuel products to BHP MIGAS. Indonesia still subsidizes many of its local fuel products, but BHP MIGAS has made sure that these fuels only go to deserving customers – keeping a watchful eye over Petramina and its branches – while introducing competition between distributors through tenders. Indonesia, like Egypt, is a net importer of crude oil with many exhausted oilfields. But with the right upstream incentives put in place over the years, compensating investors for bringing in the right kinds of technologies, production rates have gone up and Indonesia has finally been able to rejoin OPEC in October 2015.

The petroleum business source adds that Egyptian downstream companies have been able to avoid merging for a long time because of subsidies on their feedstock, a circumstance that may change as energy subsidies are phased out. Consolidation through mergers and strategic partnerships are certainly advisable during economic downturns, says John McCreery, Head of Bain & Company’s Asia Pacific Oil & Gas practice, but such decisions should always depend on the strategic context. A supply chain expert and freelance managerial consultant, Riyad Nour, also cautions against too much integration, especially when it comes to petrochemicals and the plastics industries.

The key to sound economic management is competition, not monopoly. Merging a petrochemicals plant with plastic manufacturers would create a powerful entity but would deprive the consumer of choice in the marketplace, and with that come inefficiencies that eat away at quality considerations. Further, the OGJ article also reminds us that the Egyptian market is too small to absorb any surge in petrochemicals products; therefore, any growth in the sector will have to be financed by exports, a prerequisite of which is high quality products. In Europe all existing and new petrochemical substances, local or imported, must be registered by the industry in question with the European Chemicals Agency that oversees commodities required standards. If Egyptian products are to compete successfully abroad, they must meet the regulatory requirements of those foreign markets and be able to offer demanded scope and quality of products.

Up the Downstream Learning Curve

Egypt’s downstream sector must replicate other successful models, such as Iran mentioned above. It needs to build production facilities, produce its own pipes and create access to professional engineering companies and engineering, purchasing and construction (EPC) contractors. Once it is able to reduce imports of construction parts from abroad, it will insulate itself from currency shocks. There are positive signs in the offing. Egyptian engineering companies like Petrojet and Enppi have already made major contributions to the Egyptian pipeline market; dealing with design and commissioning respectively. Local engineering consultancy firms and pipeline inspection firms are pound for pound as good as global firms, says Ramy Magdy, a Senior Drilling Engineer at SUCO.

Riyad Nour adds that refining, even in its current dispersed state, was going up the learning curve at the level of skills training. He explains that in the past foreign partners in refining were not concerned with training refinery staff but that Egyptian companies were able to send their employees to study abroad or work with foreign and Gulf Arab oil companies to re-skill their workforces in line with international standards. Firms specialized in training, whether for refineries or even offshore rigs, were beginning to get licensed in Egypt, he says.

These local achievements need to be harnessed and expanded on. Measures have already been taken to ride out the currency storm, explains PICO International Petroleum’s General Manager, Shawky Abdeen, with 20%-30% of arrears owed to foreign partners being paid in Egyptian pounds. Upgrading oilfield service companies is another avenue, as many of them already rely, to varying extents, on locally manufactured materials and designs, says another petroleum engineer. Local content stipulations and stringent quality specifications are the traditional policy tools used to achieve this, as Egypt Oil & Gas has documented. The anonymous expert also adds that more downstream people needed to be included in ministerial positions, whether from sales and distribution or midstream as well as refining and petrochemicals.

Integration is a delicate balancing act between too much and too little centralization, but there are lessons learned based on experience of different companies and countries, that can help guide the way for Egypt out of its dependency on imported downstream products and finally establish Egypt as an exporter of choice in the coming years.

Special thanks to Wael El-Serag and Economist Ahmed Kamel

petrochemicals downstream refineries