| YAROSLAVL, Russia
YAROSLAVL, Russia A tax policy misfire is discouraging Russian oil companies from upgrading their refineries, and ensuring instead that they continue to export cheap fuel oil as feedstock for struggling European plants, the head of a major export refinery said.
Last year the government tried to slash an effective subsidy on exports of fuel oil, a cheap residue of primary refining which can be converted to gasoline and diesel at sophisticated refineries, by partly closing a gap between crude and fuel oil export duties.
But fuel oil exports have risen in the year since the duty change came into force, in part because crude prices above $100 makes it more profitable to export fuel oil than crude oil.
"It is holding up development of the refining industry," Alexander Knyazkov, the director of the 300,000 barrels per day Yaroslavl refinery, located about 300 kilometres from Moscow, told Reuters in an interview.
At 5.2 million bpd, Russia has one of the world's largest refining complexes and processes half of the top world crude producer's daily output, but produces little gasoline and diesel relative to yields at modern European plants.
Russia's Prime Minister Dmitry Medvedev has ordered the government to review last year's changes to duty rates, often the single largest tax item for oil exporters, and some tweaks are possible next year, regulators say.
With pressure from the Finance Ministry to ensure Russia's budget, 50 percent dependent on energy for revenue, does not suffer in oil tax reform, radical changes are not expected.
The regime becomes tougher in 2015, when the duty on fuel oil exports rises to 90 percent of the levy on crude oil.
Knyazko said the industry was already too far behind on upgrades to meet 2015 with enough new gasoline and diesel capacity in place, and was looking at exporting fuel oil at a loss once the higher duty was in place.
"No one will manage," Knyazkov said. "Not one plant. You could hand them $5 billion (to upgrade), but they would have to be physically invested. Equipment has to be ordered, and it takes two or three years to manufacture."
"There are physical limitations that can't be overcome," he added. "So we will continue to support the European economy. Is that what we need?"
Russia's fuel oil exports are a boon to the sagging economics of European refineries, which run the heavy product through gasoline and diesel-making units instead of feedstock refined from costlier crude at their own plants.
Merrill Lynch estimated earlier this year that Russia's refinery upgrade programme, if it was carried out by 2015, would reduce its fuel oil exports by nearly half or about 610,000 bpd.
In a double blow to European refinery margins, it would also increase ultra-low sulphur diesel supply by about 410,000 bpd, most of which would end up in northwest Europe.
The alternative to loss making exports, Knyazkov said, is to cut refinery runs after 2015, potentially leaving more crude oil available for export.
Russia's government has struggled for years to force oil firms into multi-billion dollar upgrades, needed to increase their yield of gasoline to meet rising demand as Russia overtakes Germany as Europe's largest car market.
In part as a result of oil company lobbying against tighter emissions standards, Russia falls far short of European restrictions on harmful substances such as sulphur in motor fuels, a cause of lung disease and acid rain.
Russia currently allows sales of Euro II motor fuels, with sulphur content of 500 parts per million for both gasoline and diesel, phased out in Europe in the mid-1990s. If it stays on schedule, the limit will fall to 10ppm in 2016, more than a decade after Europe imposed the Euro V standard.
Yaroslavl, owned by Slavneft, a joint venture of TNK-BP TNBP.MM and Gazprom's oil arm (GAZP.MM)(SIBN.MM) was quicker than many plants to upgrade, and produces only Euro V fuels since the latest upgrades were completed.
"Our two shareholders have not infrequently noted with surprise that their own plants are falling behind on capital construction, or they can't make the right quality, and where it's half and half, everything is fine," he said.
At the beginning of 2013, four years later than initially planned, Russia will move to Euro III, which allows maximum sulphur content of 150ppm for gasoline and 350ppm for diesel.
Russian media have been speculating on the potential for shortages and import needs, but regulators say the specification change will go ahead.
"The ban on Euro II has already been delayed twice," Energy Minister Alexander Novak said in an interview with Vedomosti newspaper published on Wednesday. "If we move the deadline again, there will be no motivation to meet it."
"And it is not fair to the companies who are modernising on schedule."
(Editing by James Jukwey)