KARACHI, Oct 9: As New York's main crude oil contracts closed at $53.31 a barrel on Friday, after hitting record $53.40, the one sector in Pakistan that possibly had reason to rejoice was the oil refineries.

Without the previously applied 'guaranteed returns' formula, profit of oil refineries are directly related to oil prices and their ability to pass on crude oil price increases to Oil Marketing Companies (OMCs).

"The foremost threat to refinery profits is the possibility of a drop in oil prices," say Taurus Securities in their Quarterly Report (July-Sept 2004).

Declining oil prices would hit the Oil Refineries in a series of manner. They would lower the absolute value of gross profits (assuming gross margin percentage is unchanged); lower the gross margin if the refinery purchases oil at a higher price and prices drop by the time its products are sold and it could lead to inventory losses.

The report mentions that there is constantly a gap between the purchase price of crude oil by refineries and the price prevailing at the time OMCs purchase oil from the refineries. The longer the time between fuel price adjustments, the greater the exposure of refineries to an unfavourable movement of prices.

However, the introduction of fortnightly price adjustments in September 2002, greatly reduces that exposure and thus, reduced volatility in earnings. "Generally, refineries gain from rising prices (when the pricing lag works in their favour) and suffer when prices fall.

Previously, National Refinery Limited (NRL), Pakistan Refinery Limited (PRL) and Attock Refinery Limited (ARL) operated under a fixed return formula for fuel refinery operations (excluding lubricants) with the government guaranteeing a minimum return of 10 per cent and maximum return of 40 per cent of paid-up capital. Thus, shortfalls were reimbursed whereas profits in excess of the cap were siphoned off through taxes. Pak-Arab Refinery (Parco) was an exception to such a framework as it was guaranteed a 25 per cent minimum return with no ceiling on returns for a period of eight years after commissioning till 2009.

In the federal budget 2002-03, the Government abolished fixed return structure for refineries (except for parco). The refineries now compete in the market without government intervention. However, at the request of the refineries, the government has provided tariff protection from imported products in the form of a 10 per cent import duty.

With the removal of ceilings and floors on the return formula, refineries are exposed to fluctuations in international oil prices. However, method for pricing refinery output has been rationalized. Since oil refinery earnings are vulnerable to large swings, refineries are required to divert net profit after tax in excess of 50 per cent of their paid-up capital into a reserve fund to offset future losses or invest in refinery expansion and upgradation.

There are five major oil refineries in the country, PARCO, NRL, PRL, ARL and Bosicor Refinery, the last having started commercial production from July 1, this year.