Last week, I attended the 39th Annual Oil & Money Conference in London, a major energy event which is co-hosted by Energy Intelligence and The New York Times. This year, the conference again played host to leaders from around the world representing all segments of the oil and gas industry. As always, the event featured lively discussion about developments shaping the markets and the challenges and opportunities these will provide companies throughout the supply chain. It was my privilege to be a panelist for the refining session which was held last Thursday morning (October 11). It was especially an honor to share the stage with two of the most distinguished executives in the global refining industry – Joe Gorder, CEO of Valero and Abdulaziz Abdulla Alhajri, Director of Downstream Operations for Abu Dhabi National Oil Co. (ADNOC). These leaders provided great insight in how their companies, both of which are cutting-edge players in the industry, are addressing market trends and regulatory challenges. For my part, I focused on identifying and provided some high level observations on which developments will be the most impactful for the refining sector over the coming years and will share those thoughts in today’s blog.
The refining industry certainly operates in a very complex environment and is impacted by forces both within and without the industry itself. While this is certainly not a comprehensive list, we feel the most important drivers which will influence refiners’ prospects can be grouped into four broad areas – product demand, changes in refinery capacity and utilization, crude supply and government regulations.
As in any industry, product demand growth is critical to the refining industry. Refined product demand growth in turn is dependent on a number of factors including prices, economic growth, demographics and competition from alternatives or substitutes. All of these have and will continue to play major roles in demand patterns. Certainly a lower price environment in recent years, together with strong global economic growth has led to very strong demand growth throughout the world. In fact, product demand over the last four years (on an absolute basis) has been almost equal to the levels seen in the run up to the “Golden Age” in the early/mid 2000’s, and higher than any other period since the 1970’s. The higher prices we are seeing now are likely to slow this pace, but to what level is yet to be seen.
Demographics have also played a major role in demand growth and will continue to do so. This has been particularly evident over the last decade plus as growth has shifted dramatically from developed economies to developing ones, with China leading the way. This trend will continue, with more shifts to come as less developed countries in the Indian sub-continent, Southeast Asia and even Africa take the growth baton from China.
Alternatives and substitutes are playing an increasing role in meeting product demand as the world moves to curb climate change by moving away from petroleum. The phrase “Peak Demand” has been thrown around a lot lately, and it certainly is something for refiners to fear. However, while we might be hitting “Peak Demand Growth” and perhaps even have hit Peak Demand in Europe, Japan and are close in the U.S., Global Peak Demand for petroleum is not in our forecast through at least 2035. In fact, while we see demand growth slowing and generally shifting away from transportation and more toward petrochemicals, we have total petroleum demand in 2035 over 12 million BPD above current levels.
The refinery capacity side of the supply/demand equation is also very important to consider when forecasting refining prospects and margins. Over the last few years, global capacity additions have lagged significantly behind strong demand growth, and this has increased average global utilization rates by 3% (on an absolute basis) and provided significant support to refiners’ bottom lines. Poor operations at refineries in some parts of the world, notably Latin America, have also been beneficial to those refiners who could reliably operate their facilities. U.S. Gulf Coast refineries have particularly benefitted, with product exports playing a major and growing role in their business plans.
In the short term, we see global refinery capacity additions exceeding demand growth over the next three years by about 1 million BPD. This will put pressure on some of the weaker refineries, particularly the least complex facilities, and these will be negatively impacted by the 2020 IMO LS Bunker rules. Further out, we feel the fears of Peak Demand will actually benefit refiners by limiting expansions and lessen the likelihood of overcapacity.
Changing crude supply dynamics will also be very important to refiners. Over the last few years, U.S. refiners have benefitted from the Light Tight Oil boom, investing in the ability to run more of the very light barrels. With growth continuing, refiners around the world will find these sweet crudes to be very valuable in the post-2020 IMO world. Deep conversion refineries in the U.S. and other parts of the world will benefit from their ability to run cheaper heavy sour crudes in that same post-2020 world. In the short term, there has actually been a bit of a supply crunch on those heavy barrels, as production in Venezuela and Mexico has fallen and Canadian heavies are hitting pipeline constraints. Eventually we expect a rebound in heavy crude production, and this will further benefit heavy capable refiners, although the timing of that rebound is uncertain.
Government involvement in refining is certainly not going away and new regulations will continue to play a major role in refiner’s prospects. The IMO rules will certainly be a major industry-wide event. It makes the first time we’ve seen a global-wide fuel specification enacted, and it comes on a stream which is particularly difficult for refiners to desulfurize. Crude differentials will widen, diesel margins will grow and high sulfur fuel oil prices will tank. The more complex refiners with the best access to heavy crudes will come out as winners, along with refiners capable of producing significant volumes of diesel; while, as noted earlier, we can expect some additional shutdowns of uncompetitive plants. Significant uncertainties involving enforcement and ship-owner investments in scrubbers make it difficult to forecast the level and duration of the market impacts of the IMO rules.
Other regulations, most enacted on a regional basis, will also result in winners and losers, with those refiners best positioned either geographically or configurationally coming out on top. Of course regulations penalizing petroleum as a whole and mandating nonpetroleum alternatives without considering economics would harm not only all refiners, but also consumers.
It’s important to add one final point with regard to regulations – uncertainty is perhaps the biggest enemy for refiners. Refiners have proven to be able to respond to reasonable regulations, but investments take time and conflicting signals limit the ability of refiners to make those investments in a timely and efficient manner. Unfortunately, policymakers seem to thrive on uncertainty and the only thing we, perhaps, can be certain of is regulatory uncertainty.
TM&C constantly monitors all of the areas we discussed at Oil and Money which impact refining industry prospects. We include our independent analyses of these impacts in our semiannual Crude and Refined Products Outlook, the most recent edition of which was released mid-August. For more information on this report or on any of our other analyses or our consulting capabilities, please send us an email or give us a call at 214-754-0898.