The future of refining

By: Simon Flowers, Chief Analyst, Wood Mackenzie

Refining was rejuvenated in the early years of this century. Overcapacity and depressed margins forced refiners to focus on costs and managing for margin. Proof of success was the resilience of refining profitability after the oil price crash of 2014, and the elevation of downstream leaders to the very top of Big Oil.

The current downturn is tougher than any experienced before, and may even be providing a glimpse into refining’s long-term challenges when oil demand eventually enters decline. I asked Alan Gelder, Head of Downstream Oil, and Gerrit Venter, Corporate Analysis, how the industry will respond this time.

How has the crisis affected refining profitability? 

It’s been brutal – our global composite gross refining margin averaged a paltry US$0.20/bbl in May and June. The US$1.40/bbl we forecast as an average for 2020 is down from U$3.70/bbl last year and is the lowest this century. These depressed numbers reflect the devastating economic impact caused by COVID-19. Oil demand fell by more than 20 million b/d in the two months to April, temporarily wiping out 20 years of demand growth.

When will market conditions get better?

We are already seeing oil demand bouncing as lockdowns start to ease, led by gasoline but with jet fuel lagging. It’s not going to get back to the pre-crisis growth trend for some years – our latest Macro Oils global oil demand forecast for 2021 is 3 million b/d below our pre-crisis forecasts. There was over-capacity in refining before the crisis; lower demand just makes it worse. Compounding that is the excess product (and crude) inventory built up during Q2 2020. Inventories won’t fall back to normal levels until well into 2021.

Margins should begin to recover as the oil market rebalances over the next 18 months but will stay at modest levels. We expect the global composite margin to average US$1.40/bbl in 2020, then US$2 to US$3/bbl through 2025 – 20 per cent down from our pre-crisis forecast. That’s little more than half the US$4.40/bbl average of the last decade.

What can refiners do to get through the downturn? 

The severity of the downturn has caught everyone out. Short term, liquidity is critical for survival – the high working capital needs of refining are a real challenge for smaller independents. Higher cost players are going to struggle. The industry already runs a tight ship and managing for margin is still the mantra. Investment is already being slashed, and more efficiencies will no doubt be eked out. Any opportunity to use slack in the market to bring forward planned maintenance will be seized.

Global utilisation rates dipped as low as 65 per cent in Q2 and are set to average around 70 per cent in 2020 – the lowest in living memory. As demand recovers, refiners need to be operationally adept. This downturn is different to any experienced before – market conditions are fragile and vary from location to location while product demand is skewed. Getting utilisation rates back to profitable levels – the global average of just under 80 per cent this last decade – will take time and a delicate touch. Over-exuberance risks flooding the market with product and undermining margins.

Could we see refiners aggressively rationalise portfolios? 

Yes, there’s a high probability the crisis will accelerate a process that was unfolding gradually as integrated oil positions for the energy transition. Shell has just cut its mid-cycle refining margin estimate by 30 per cent. Some refineries will close – we reckon almost 10 per cent of high-cost refineries in Europe, 1.4 million b/d of capacity, is in serious threat of closure in Europe alone over the next three years.

The Majors will sell more downstream assets – including refineries – to strengthen balance sheets weakened in the downturn and to boost portfolio resilience. Portfolios in future need to be focused around advantaged assets: positioned close to the growth markets in Asia and the developing world; large scale, modern, low cost and low carbon-intensity; and closely integrated with crude feedstock and petrochemicals.

BP sold its petrochemicals business for US$5 billion this week, because it wasn’t advantaged – there was limited scope for deep integration with the rest of its business.

Who will buy the unwanted assets?

NOCs and niche players. A number of Middle East and Asian NOCs are long crude production/short refining and want to strengthen downstream exposure. Niche players, perhaps privately owned with lower ESG thresholds than IOCs, will also be sensing a value proposition at the low point of the cycle. 

This column first appeared in the August issue of Pipeline Magazine