Refining and Petrochems in Russia - Overview of recent developments

Publication | February 2013

Introduction

Russia is without a doubt, one of the leading countries in oil and gas production. However, this cannot be said for its refinery and petrochemicals industry. This is now changing as recent developments indicate that Russia is moving to take advantage of its vast oil and gas resources by using the full value chain. The revival of Russia’s downstream sectors through upgrades to existing capacity and construction of new refining and petrochemical facilities has clearly started.

Refining sector overview

In refining, Russia is a top five producer in terms of volume with a capacity of 275 million tons in 2011, however in refining more is not necessarily better. Applying the Nelson complexity index, Russia is a mere 67th in terms of refining quality1 (with an average Nelson complexity index of about 5 when Europe’s average is about 6.5 and the US average 9.6).

Two decades after the collapse of the Soviet Union, the need to modernise the refining sector and increase both output capacity and refining quality is clear. Demand within Russia for higher quality oil products is increasing (for example car ownership has increased dramatically, especially of foreign made or designed cars). The Government has also recognised the need to address air quality issues. A decade ago the smell of ‘benzin’ on the streets of Russia’s major cities was a distinctive feature.

In 2009 the Russian government set targets in the “Russian Energy Strategy to 2030” (the Strategy)2. The global financial crisis has slowed aspects of the implementation of the Strategy. Nevertheless the Government’s targets are high. The Strategy calls for refining output to increase from 237 million tons in 2008 to 311 million tons by 2030, and for refining depth to increase from an average of 72 per cent in 2008 to up to 90 per cent by 2030.

In addition to the Strategy the Government has introduced a number of technical regulations requiring the modernisation of the sector by requiring the phasing out of low quality refined products and the introduction of the higher Euro-5 standards by 2015.

The Government has also created incentives for a value added approach to refining and petrochemical production in the form of amendments to the tax regime. In October 2011, the 66 per cent rule was introduced on the export of fuels. Fuel oil export tax was increased from 46.7 per cent to 66 per cent, while the export tax on diesel was reduced to 66 per cent of the level of the crude export tax. The export tax on gasoline was kept at 90 per cent of the crude export tax. The intended outcome of these tax amendments is to discourage the export of fuel oil by making such export significantly more expensive and to encourage the production of lighter oil products and other value added products. In July 2012 the Government made further changes to the tax regime by reducing the excise duty on the domestic sale of lighter oil products. The combination of these tax amendments should encourage the modernisation and upgrade of existing refining facilities and the establishment of new petrochemicals facilities.


Footnotes

  1. http://www.oilandgaseurasia.com/articles/p/105/article/996/
  2. http://www.energystrategy.ru/projects/docs/ES-2030_(Eng).pdf

Petrochemical sector overview

Similarly, the petrochemical industry is under transformation after many years of minimum investment.

The Strategy linked the promotion of the development of oil refineries and petrochemical plants as part of its aim to diversify energy exports by increasing the export of value added products rather than raw crude or low complexity refined products (such as fuel oil).

In February 2012, the Government approved a policy to support the domestic petrochemical industry. The policy calls for a development plan that focuses on the construction of six petrochemical production clusters across Russia. These clusters are expected to be concentrated in Western Siberia, the Volga region, the Caspian region, North West, Eastern Siberia and Far Eastern regions.

Between 2010 and 2030 the policy anticipates a tripling of demand for petrochemical products from the industrial, residential and road construction sectors. Although the global economic crisis has affected the Russian economy, the infrastructure needs are still exorbitant with an estimate of $1 trillion in investment required by 2030 to meet the increased demands in infrastructure. Clearly, such infrastructure development will require the consumption of high-end petrochemical products.

Financing the Upgrades and Expansion

The Strategy, combined with the various tax and regulatory changes, has helped to create an environment as well as the incentives to encourage investment in the refining and petrochemicals sector. So how have and will the upgrades and new capacity be built and financed. Limited recourse financing would seem to be one of the simplest ways to bring these projects on stream quickly and effectively. The Russian legal framework contains a number of structural impediments true limited recourse financing. However, in the last three years, and in a financial world where western banks have less to lend and higher barriers imposed on them by credit committees, a number of new structures have appeared in the Russian market.

We will look at two structures that have been utilised since the implementation of the Strategy.

In August 2010, Alliance Oil Company Limited (Alliance Oil) entered into a number of direct long-term financing loans totalling US$ 760 million with Vnesheconombank (VEB) (the Russian state development bank) for the upgrade of its Khabarovsk refinery. In line with the Strategy, the upgrade, expected to be completed by 2013, will result in enhanced refining yields and higher quality petroleum products. The refinery’s Nelson complexity index will increase from the current level of 3.4 to 9.9, and the depth of refining will improve from 61 per cent to 93 per cent. The production capacity will expand from 70,000 to 90,000 barrels per day.

Alliance Oil contracted the Spanish construction group Tecnicas Reunidas to complete the upgrade. As part of this process VEB and the Spanish Export Credit Agency (CESCE) supported the financing through an ECA structure that involved a syndicate of Spanish and French banks providing VEB with the majority of the US$ 760 million through three tranches backed by CESCE.

VEB used a very similar structure again in 2011 for the greenfield Tobolsk Polypropylene project for Sibur. Again VEB was the lender to the project company with a back to back ECA covered loan from a syndicate of western banks this time with coverage from Hermes (the German ECA).

Financing structures developed further with the financing of RusVinyl’s (a joint venture between Sibur and SolVin) €1.5bn greenfield PVC production plant project. This structure moved a step further to full limited recourse financing, with direct lending from EBRD and Sberbank and a club of commercial banks comprising ING, BNP Paribas/Fortis and HSBC with ECA cover from Coface (the French ECA) and the Belgian Export Credit Agency Office National Du Ducroire Nationale Delcrederedienst (ONDD). The RusVinyl deal utilises a unique combination of traditional limited recourse structures and some innovative Russian law structures to produce a workable and successful limited recourse financing.

Recently (17 September 2012), further enhancements to the options for financing of large infrastructure such as refining and petrochemicals plants have been proposed by the deputy Minister for Economic Development, Sergey Belyakov. The deputy Minister has suggested the financing of some major infrastructure projects could be supported by the state buying project bonds issued by the project companies. The deputy Minister spoke of up to US$46 billion being available for acquiring bonds. The deputy Minister’s proposal is consistent with the statements set out in the Strategy. The Strategy states that “…under conditions of sharp decrease in world oil prices and (or) crisis situations on financial markets the state will provide for necessary support for oil business by means of state guarantees provision for investments into the oil complex development, re-financing of oil companies liabilities, taxation optimization…”. Such bond buying would provide support to the projects and make them more bankable while at the same time ensuring the state is repaid for its support of commercial projects.

The combination of the VEB back to back structure, the tools used in the RusVinyl project and the proposed bond acquisitions provides further incentives for the refining and petrochemicals industry to upgrade and expand.

A legal framework to facilitate financing

While the VEB structure and the RusVinyl structure provide options to attract further funding, fiscal incentives and bond buying will not be enough. The demand for funding for the refining and petrochemicals sectors is going to be competing with LNG plants, high speed rail, new power capacity, roads and airports for funding. Changes to the legal framework will be needed to facilitate the financing of these projects to protect the rights of both investors and financiers.

Russian law has been viewed for a long period of time as inconvenient or even unsuitable for large-scale financing transactions, mainly due to the various ambiguities of legislation and the Russian Courts (either lack of court practice or the conservative and restrictive approach which is often taken). The need for change, especially during the global financial crisis has become more and more pressing. The demand for new infrastructure has made this a key issue for Russia’s future development.

A number of legislative changes have been made in the last 24 months and further amendments are now being discussed to provide greater legal certainty and a legal framework that supports the development and funding of these major infrastructure projects.

The most current amendments being proposed are the massive amendments to the Civil Code that are expected to become law in late 2012 or early 2013. These amendments are expected to make Russian law generally more flexible and provide sponsors and financiers alike with better tools for large infrastructure development and funding. An example of the types of changes suggested to the Civil Code is the possibility of taking security over a bank account. Such security is currently technically possible but practically ineffective due to the manner in which the Civil Code protects the right of account holders to withdraw funds.

Changes that have been made since the financial crisis include those to Russian law on taking security. Under Russian law, the most commonly used forms of security are pledges and suretyships. A pledge can be taken over shares, participatory interest, other movable assets as well as immovables (the latter pledge would be called mortgage). Since 2008 the law on pledges has been heavily amended to provide for both in-court and out-of-court enforcement (previously in-court enforcement was the only choice). Most importantly, recent amendments allow for enforcement options which are a sine qua non in project finance types of transaction such as the repossession of the assets by the pledgee in addition to public auction, sale by a commissioner or sale by the pledgor. This effectively gives lenders step-in rights, which is something that was previously practically impossible under Russian law. Further recent amendments have introduced detailed procedures for each of these options.

Another area where significant amendments have been made is in respect of suretyship arrangements: a civil-law concept analogous to a common law guarantee. Until recently, such an instrument provided for a rather vulnerable security arrangement as it was considered that any amendment made to the secured obligation would automatically terminate the security created under the suretyship agreement. A recent clarification issued by the Supreme Court provides that the suretyship survives such amendments. Most significantly however, the scope of transactions where suretyship could be used has also been broadened. Suretyship can now be used to secure non-monetary, future, conditional and even defaulted obligations.

Finally, in respect of loan agreements, recent court practice has taken a pro-creditor approach eliminating one of the risks that made covenants (especially negative covenants) impossible to enforce. Recent practice suggests a lender would be able to enforce such covenants (including a negative pledge) but would also be able to accelerate a loan where the borrower is in breach of such covenants. Recent court practice, therefore, has confirmed in many recent cases the validity of the terms of a loan agreement that reasonably restrict the operations of the borrower or the third party who has granted security.

Conclusion

The incentives for project sponsors to move forward with their upgrade/expansion programmes have been clearly set out by the Government. Upgrades and expansion projects are in progress despite the global financial crisis. Viable and workable funding structures do exist and have been successfully applied to real projects such as Khabarovsk and RusVinyl. Amendments are starting to be made to the legal framework to further improve the funding options and legal certainty. These amendments will help to align Russia with the international legal concepts and funding options which are necessary for long-term limited recourse financing.

Ongoing global economic instability and/or a significant decrease in the price of oil may still hinder such investment plans. However, concepts such as the State’s bond buying proposal and VEB’s ongoing ability to enter into back to back ECA funding structures will support continued development of the refining and petrochemicals sector.


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