Poor capital discipline will drive difficult decisions for refiners
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The problem facing the refining sector is simple
Over the next five years, crude processing capacity is set to expand by about 5 million barrels per day (bpd), while non-refinery sources of supply will add a further 1 million bpd. At the same time, demand is expected to grow by about 4 million bpd, which leaves a surplus of about 2 million bpd.
This situation – which has a number of causes, one of which could be apparent poor capital discipline – means existing refiners, many of whom have smaller assets, will face some difficult decisions.
Global oil demand growth continues to grow at more than 1 million bpd per year
We witnessed global oil demand achieve the threshold of 100 million bpd during the fourth quarter of 2018 and Wood Mackenzie’s outlook is that annual oil demand growth will remain at current levels for the next few years.
This sustained growth provides an opportunity for the refining sector, as it converts crude oil into the products consumers buy. It is a very straightforward investment opportunity because it represents absolute growth. However, the refining sector is being overly optimistic about the scale of the opportunity and is over-investing in total crude capacity.
The refining sector will add about 5 million bpd of crude capacity between now and 2023. This is over 1 million bpd more than the traditional annual average demand growth. On its own it does not seem too excessive, but the volume of biofuels and liquefied petroleum gas available to the market is expected to grow by almost 1 million bpd over the same period. This effectively means that within five years, a 2 million bpd surplus of refining capacity is to emerge. This will weaken refining margins and undermine the attractiveness of the investments being made.
So why are these investment decisions being made?
Each investment is made on its own merits, but there are three broad themes:
1. Satisfying local demand growth by investing to substitute imports with local supply
For example, Nigeria is one of the world’s largest gasoline import markets, as there is large and growing population and the national oil company, NNPC, has proved unable to operate its refineries. Nigerian entrepreneur Aliko Dangote, reportedly Africa’s richest man, is developing a very large – 650,000 bpd - refinery near Lagos. Once operational, this should displace the majority of the current gasoline imports to Nigeria, with the project’s commercial viability based on processing local crudes to substitute for imports typically supplied from Europe;
2. Back integration
There are a number of large independent petrochemical players in China that are expanding production and, as they do, are building refineries to supply the petrochemical feedstocks they require. This has seen them build very large refineries (of around 400,000 bpd), which will have a significant impact on the refined product markets as petrochemicals are only about 50% of the product supply. These sites are commercially viable, as they have low costs of construction and financial support has been provided by the local/state governments
3. Forward integration
This is typical of Middle East national oil companies, which have been investing in the refining sector both domestically and internationally. The domestic projects aim to provide security of refined product supply, a platform for industrialisation and support the local economy, while international projects will secure the long-term market for crude exports. These projects tend not to deliver a commercial rate of return, but are undertaken for the wider socio-economic benefits.
Overall, the sector is over-investing, but each of the individual projects, taken on its own, has merit.
Another challenge for the refining sector is that these new facilities are getting larger. This means that they won't only account for a significant portion of typical global demand growth, but they are also much bigger and far more competitive than refineries currently in operation.
So what does this mean?
It suggests the global refining system is returning to over-supply, which will increase competition between refiners. It may also see smaller, less sophisticated refiners in the OECD markets take a hit. Demand in the local markets these refiners serve is declining and they rely upon exports to boost their balance sheets. But, as new projects come on line? Capturing a slice of the export market will become more difficult.
In this situation, there are options. Refiners need to focus on improving their competitiveness and long-term commercial viability. They can do this in a number of ways.
Some could turn to trading, making the most of the opportunities that the growth in US crude exports and forthcoming IMO regulation changes are likely to introduce.
All can focus on both cost discipline, exploiting the opportunities digitalisation present, and on capital discipline, by investing cautiously to retain a strong balance sheet. Asset high-grading as part of a portfolio review is another option. This enables refiners to define and develop globally competitive super-sites, while they divest or close weaker assets.
While the introduction of new IMO regulations next year offer a short-term glimmer of hope for refiners, there is a real risk that the energy transition may accelerate. If this happens, refining margins will erode, leaving only difficult choices ahead.
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