Refinery and construction costs continue to rise

The costs for designing and constructing downstream refining and petrochemical projects rose three percent from Q1 2010 to Q3 2010, according to the latest edition of the IHS CERA Downstream Capital Costs Index (DCCI). It was the third straight increase for the index since prices bottomed out at nine percent below peak 2008 levels. Costs are now just four percent below their 2008 peak.

The DCCI is a proprietary measure of project cost inflation similar in concept to the Consumer Price Index (CPI). It provides a benchmark for comparing costs around the world and draws upon proprietary IHS and IHS CERA databases and analytical tools. The current DCCI rose from 175 to 180 over the past six months; the values are indexed to the year 2000, meaning that a project that cost US$100 in 2000 would cost US$180 today.

Higher commodity prices and a weakening US dollar continued to be the driving force behind the steady rise of costs in the downstream sector. "The momentum in the rise of costs back to prerecession levels is really a 'slowmentum' reflective of the broader global economic recovery," explains IHS CERA Chairman and author of the Pulitzer Prize-winning book The Prize, Daniel Yergin. "Activity is increasing and prices are rising, albeit with a healthy dose of caution."

Commodity prices were driven by the global economy's recovery and increased construction activity as the impact of the fiscal stimuli was felt by the wider economy. Steel prices continued to show high degrees of volatility as iron ore producers switched from adjusting prices annually to adjusting them every quarter, reflecting market-based demand-supply fundamentals.

The continued weakening of the US dollar also contributed to the rise of commodity prices while also driving up costs of equipment, labour and engineering and project management costs. The dollar's fall was driven by the US Federal Reserve's second round of quantitative easing to reinvigorate the US economy - the Fed recently announced a US$600 billion plan to purchase treasury bonds over the next eight months.

Robust downstream construction activity in China, India and the Middle East continues unabated, according to the index. Record refining and ethylene capacity additions came online in 2009 and more projects are in various stages of engineering and construction. This trend is expected to continue until 2015. Government policies encourage investment in the downstream sector in anticipation of increasing demand for transportation fuels, plastics and fibres.

China plans to increase refining capacity by 50 percent in the next five years. Similarly, the Middle East is emerging as a major hub for petrochemicals, with advantageous feedstock and government policies that incentivize diversification into other industries supported by petrochemicals. Large complex refineries with integrated petrochemicals are emerging as the 'new standard' to position the downstream sector for profitability.

The capacity additions in Asia will continue to put downward pressure on margins as excess capacity emerges in the face of tepid consumer demand. Refiners and petrochemical companies in Organization for Economic Cooperation and Development (OECD) countries - which have been rationalising refining capacity - will continue to face rising pressure to shutdown older and less efficient plants with poor economics.

"The economic outlook ahead appears to be mixed with rising prospects that the recent momentum will give way to an impending slowdown," says Farooq Sheikh, lead researcher for the IHS CERA Capital Costs Analysis Forum for Downstream. "China also appears to be slowing down as the government increasingly restrains the fiscal stimulus, and has recently increased interest rates by a quarter percent in fear of a real estate bubble."

Developing countries are showing increasing concerns about capital flows into their markets, creating an asset bubble. Capital controls and higher interest rates are being employed to temper unbridled growth. As a result, the DCCI concludes that another modest increase is expected in downstream capital costs in the near term as recovering construction activity and further increases in raw materials prices push costs closer to their pre-recession highs.