Regulatory clouds darken a bright outlook for refining

This article first appeared on Forbes.com on July 25, 2018. 

The spotlight fell on the refining sector in 2015 as the oil price collapse and the associated surge in oil demand resulted in a record year for global refining margins. For integrated majors, refining exposure mitigated the impact of the oil price collapse on their corporate finances.

Since then, refining margins have remained strong, but at lower levels. The days of structural over-capacity and the associated threat of site closure for weak refining assets are now a distant memory.

How long can this picture of rude health be sustained?

Refining is the sector that transforms crude oil into the finished products that consumers buy - such as gasoline and diesel for road fuels - or as feedstocks for petrochemicals, products that are a key part of our everyday lives.

Refining is a capital-intensive sector, with the following features:

• Unlike the upstream sector with its ongoing production decline, refineries tend to improve with age, as capacity tends to creep up and costs to decline, as efficiency improves;
• Capacity rationalisation through refinery closure is a slow and difficult process, particularly in Europe, due to the high social costs for the direct employees and wider community, along with the high costs of site remediation; 
• Investments in developing economies, such as the Middle East and Asia, are typically made for reasons beyond a commercial return, such as self sufficiency and national security, industrialisation and job creation, value addition to domestic resources; 
• The return on capital employed for grassroots refining projects hence tends to be below the threshold of Western companies.

As shown in Figure 1, since 2015, the growth in demand for refined products (excluding liquefied petroleum gases, LPGs) has outpaced refinery crude distillation capacity additions and this is expected to remain for 2018 and 2019. Global annual oil demand growth (excluding LPGs) has been robust over recent years, well over 1 million bpd. Wood Mackenzie’s monitoring of refining projects suggests that post 2020, annual refinery capacity additions will return to their historical levels of around 1 million barrels per day (b/d), so the refining outlook looks balanced into the medium term. However, this demand outlook is where the regulatory clouds are darkening what could otherwise be a bright future for refining.

Post 2020, the refining sector must grapple with the demand side regulatory changes that affect vehicle fuel efficiency, urban air quality and the broader moves towards decarbonisation.

Fuel efficiency and urban air quality

Ever more stringent passenger car fuel efficiency requirements are mandated for countries and regions that account for more than 75% of global gasoline demand. 

There are also fuel efficiency standards for commercial trucking in both the United States and China, with the EU considering its own proposals. These standards decouple demand for refined products from economic activity.

However, this is mitigated by consumer preference, as they typically buy larger, more comfortable, less fuel efficient vehicles if they are affordable.

Urban air quality is an issue in many European and Asian cities, due to high levels of harmful nitrogen oxides. A key uncertainty here centres on local politics and whether enough city mayors ban diesel cars to improve local air quality. Such bans promote a switch to fuel-efficient hybrid gasoline engines or to all-electric vehicles (EVs). This would be detrimental to the global refining sector as the diesel passenger car currently accounts for one-third of European road diesel demand and European diesel imports are a key target market for export refiners located in the United States Gulf Coast, Russia and the Middle East.

Decarbonisation

Decarbonisation of the transport sector is key to achievement of the global COP 21 agreement. However, significant improvements in battery technology and electric vehicle manufacturing costs and capabilities are required for the average consumer to switch to an EV over a vehicle powered by a conventional internal combustion engine.

There is also the need for major developments in recharging infrastructure. In spite of all of these uncertainties, the political pathway is clear, as many governments are adopting policies to promote EV development and deployment. The consequences to oil demand of “transport as a service” fully deployed in urban centres using autonomous electric vehicles are clear

A silver lining?

Not all regulations are detrimental to the refining sector. The requirement by the International Maritime Organisation for the marine sector to reduce their airborne sulphur emissions whilst in international water from 1 January 2020 onwards is likely to be supportive to refiners. The marine sector has a number of options to comply with this regulation, but many ship owners are expected to comply by using lower sulphur fuels, which will increase the demand (and price) of these cleaner products, so improving refining margins. There are, however, many uncertainties associated with this legislative change, so it is worthy of a separate, future, blog.

Conclusions

The key question for the refining industry over the medium term is the pace of technology change in key demand sectors, as this will determine the time it takes to shift the pattern of demand from one of strong growth (and a bright outlook) to one of gloomy decline.