Fitch Ratings expects increased merger and acquisition ("M&A") activity to continue in the European refining sector as supply-demand fundamentals continue to be favourable for refiners. The unusually long period of healthy refining margins worldwide, which started in 2004, is expected to continue in the short- to medium-term, but margins will be exposed to high volatility.

Fitch views M&A activity as a key driver for rating changes in the refining sector. "Fitch believes that likely acquirors of European refining assets include independent refining companies from western and central Europe, and oil companies from oil producing countries, such as Russia or Kazakhstan," says Arkadiusz Wicik, Associate Director in Fitch's EMEA Energy and Utilities team. The agency expects the consolidation of the central European refining sector to continue, and expects that it will be led by the largest regional players, such as Austria-based OMV AG, Hungary's MOL and Poland's PKN Orlen SA (rated 'BBB-' (BBB minus)/'F3'/Outlook Negative).

The favourable environment for refiners in the past few years has been reflected in the materially higher number of acquisitions within the European sector and the aggressive valuation of refining assets. Acquisitions in western Europe primarily included divestments of some refineries by oil majors. Fitch views these disposals as refinery portfolio optimisation rather than as majors' exiting from the refining segment. After a number of acquisitions of oil majors' refineries, Petroplus Holdings AG became the largest independent refiner in Europe.

The central European refining sector, which is viewed as attractive for investors due to its low levels of competition and high growth potential, has also seen a number of ownership changes in recent years. These changes include the privatisation of Turkey's sole refiner TUPRAS (rated Long-term local currency Issuer Default rating 'BBB-' (BBB minus)/Outlook Stable) and the acquisition of Lithuanian refinery Mazeikiu Nafta AB by PKN Orlen SA in 2006. A more recent change in ownership includes Kazakhstan-based National Company KazMunaiGaz's (rated 'BBB'/'F3'/Outlook Stable) pending acquisition of The Rompetrol Group NV (rated 'B-' (B minus)/Rating Watch Positive) with its key asset Romania's Petromidia refinery.

The favourable outlook for refining margins is supported by a tight balance of global refining capacity versus demand for refined products, regional supply-demand imbalances (most notably a shortage of gasoline in the US and diesel in Europe), and tightening environmental regulations and fuel specifications in Europe and the US. Fitch believes that a sizeable increase in global refining capacity, which was expected to come primarily from new build large refineries in Asia, the Middle East and Africa by 2010, may be lower than originally expected. Some of the currently planned new refinery projects may be scaled down or deferred, as investment decisions have to take into account sizeable construction cost inflation within the industry in the past few years, especially in view of return thresholds when assuming mid-cycle refining margins. There is also the risk of a lower than forecast demand for refined products should global economic growth significantly slow down.

Despite the current extended upturn, Fitch views the refining sector as highly cyclical and capital intensive, with high business risk. As a result, only those independent refining and marketing companies that have a strong business profile and moderate financial policy are rated by Fitch in the 'BBB' rating category. The agency rates refining companies based on normalised (mid-cycle) cash flows and financial leverage, and as a result the current boom in the refining sector itself has not led to positive rating actions.