Refiners weigh their options as energy transition gains pace

This article first appeared on Forbes.com on July 19, 2019.

The energy transition is, in some ways, an old story for the oil major's downstream units. For many years, the majors have been high grading their refining portfolios, cutting back on refining capacity that was merely “average”. These assets dragged on their financials. High grading has involved selling weaker sites while investing selectively at key locations to strengthen their competitive position.

The refining sector’s commercial performance returned to its traditional low levels in the last quarter of 2018. The boost the sector got with the 2015 oil price collapse has dissipated, and the fundamentals of over-capacity have returned. The US is an outlier, as it has the advantage of a growing supply of domestic crude.

While IMO 2020 is likely to provide a short-term lift to refining margins, the industry is over-building, which will cause margins to weaken. This adds to the dilemma for the oil majors as they address the energy transition. As electrification of the vehicle fleet gains pace, there is less need for their products.

So, when do the majors divest their existing assets and for what price? 

Shell decided it was best to act swiftly. It has exited refining in California, selling its Martinez refinery to PBF. The transaction was reported to be US$1 billion plus inventories, with some reports noting a potential earn-out if the financial performance was stronger than expected over the next few years. This appears to be a significant sum for a refinery with a capacity of 158,000 barrels per day(b/d). However, in our proprietary assessment of the earnings of each of the world’s major refineries, it transpires that the transaction was equivalent to only one year’s cash flow. PBF appears to have secured a bargain, as its investment is likely to be repaid quickly. The question for Shell is whether it acted with too much haste – surely it would have been better to stay at the party and leave later on, enjoying strong cash flow for another few years.

The recent events on the other coast of the US could well signal that a tipping point in any diversification strategy has been reached – the potential lack of credible buyers. The fire and explosion at the Philadelphia Energy Solutions (PES) refinery has resulted in its closure – the reason is not profitability (as our analysis indicated that the asset was cash positive and one of the more competitive assets on the US East Coast), but its balance sheet. Private equity ownership had burdened the site with debt. This meant that finding the investment to restore its operations was difficult, and so closure became inevitable.

Could this signal the end of private equity’s interest in refining as a source of value?

If so, who will buy the refining assets that the majors want to sell? Potential candidates are the major trading houses and distribution companies, but the latter are only really an option in emerging markets where volumes are growing and the security of domestic supply has value as import infrastructure is under-developed.

Without credible buyers, the majors are left with the challenge of operating the site until its closure and potential conversion to a terminal/distribution site. Shell has already experienced this once, as it thought it had sold its relatively simple refinery in Denmark to the local management, but the deal fell through.

Will staying at the party longer result in a painful hangover?

After all, stranded refining assets are costly to close. Shell has chosen to act with a clear head and demonstrate its commitment to adapting to the energy transition by potentially leaving the party early.

Watching the approach the oil majors take with their refining assets over the next year or so will provide clear evidence as to whether they are willing to make difficult choices as they adapt to a changing world.