S.Korean refiners may see lube oil lifeline slip away

* Profits from lube business plug gaping hole from refining

* Capacity increase may bite lube margins in late 2014

By Meeyoung Cho and Chris Lee

SEOUL, Sept 23 (Reuters) - Profits from robust lubricant oil sales helped offset steep refining losses at South Korea's top three oil refiners in the first half, but planned production hikes later this year threaten to erode margins and sever their earnings lifeline.

Korean refiners have focused on specialty lubricants, using heavy oil upgrading systems to feed residual oil from the refinery process into lube base oil, and have enjoyed robust sales this year to Europe and the United States.

Profits in lube base oil, the feedstock for engine oils and greases, covered nearly two-thirds of refining losses at South Korea's top three refiners despite making up only six percent of sales, helping them weather a refining industry downturn.

"Refineries are experiencing many losses when it comes to refining ... they're passably making a profit in lubricants and chemicals. The lubricant market isn't doing well like it was back in 2011 but it's still basically an oligopoly market," said Yeon-ju Park, an analyst at KDB Daewoo Securities.

SK Lubricants Co Ltd, owned by SK Innovation Co Ltd , GS Caltex Corp and S-Oil Corp reported combined profits from their lube oil and lubricant businesses of 389 billion Korean won ($374 million) over the first six months of this year, doubling year on year, according to an analysis of company filings.

Over the same period, SK Energy, also owned by SK (KSE: 003605.KS - news) Innovation, GS Caltex and S-Oil accrued a combined 623 billion won operating loss in their refining businesses, which were hit by weak oil prices and soft regional energy demand, swinging from 509 billion won profit a year earlier.

But a planned 30 percent increase in four South Korean refiners' lube oil production capacity - to 144,300 barrels per day (bpd) - before the end of the year poses a major risk to lubricant revenues, and could expose the country's energy giants to harsher operating conditions, analysts said.

South Korea has the fourth-largest refining capacity in Asia Pacific at 2.9 million bpd, but run rates and refinery sales have eased this year, although lube oil and lubricant sales jumped 17 percent in the first half to 3.4 trillion won.

ADDING CAPACITY

Lube oil has five major markets depending on quality and usages, the largest of which are 'Grade II' for industries and automobiles, and 'Group III' for premium market vehicles.

European and U.S. demand for high-end automobiles is projected to remain brisk, but premium lube production capacity is rising.

"They're all flocking at the same time because they have no other choice. This is part of the reason why lubricating oil product prices are unable to rise," said Kyu-won Hwang, an analyst at Tong Yang Securities.

South Korea's combined lube production capacity will jump 30 percent to 144,300 bpd later this year as SK Lubricants jointly with Spain's Repsol will open a 13,300 bpd plant and Hyundai Oilbank with Shell Petroleum Co, a refining unit of Royal Dutch Shell (LSE: RDSA.L - news) , will start 20,000 bpd plant.

Shell (LSE: RDSB.L - news) is also betting on lubricants along with its chemicals and retail fuel sales to help it boost the performance of its downstream division, where oil refining will remain a drag on earnings in many regions.

"The supply is out there, and lubricating oil margins are also easing, so profits will be diminished," said Young-joo Son, a senior analyst at Kyobo Investment Trust.

(1 US dollar = 1,042.5 Korean won) (Reporting by Meeyoung Cho and Chris Lee; Editing by Richard Pullin)