“I Walk the Line” – Global Refining Industry Attempts to Keep From Over Building

By John Auers

The profitability of all manufacturing businesses is highly correlated with capacity utilization and certainly this applies to the refining industry. Utilization, in turn, is driven by both demand and supply factors.  While refiners can’t control demand; they can, to a certain extent, control supply.  Decisions to expand or rationalize capacity and the rates at which they operate the capacity already in place are made by refiners based on expected and actual levels of product demand and growth.  One of my favorite Johnny Cash songs, “I Walk the Line,” comes to mind when I think about the “tightrope” refiners have to walk in order to provide enough product supply to meet market demand, but not too much as to overwhelm it.  Walking this line is particularly difficult in making capital investment decisions on adding new capacity considering uncertainties about all of the following: 1) demand growth, 2) investment/capacity decisions by other refiners, 3) regulations, and 4) other market factors.  The impacts of these uncertainties are magnified by the relatively high capital cost and time it takes to complete capacity additions.  Miscalculations can result in an “overbuilt” environment, where too much capacity is chasing too little demand, leading to low refinery utilization, low margins, and the ultimate need to shut down some refining capacity.  On the other hand if not enough capacity is added to keep up with demand growth, shortages can lead to very high prices.  We have seen both of these situations in the past, with refiners experiencing both “Golden Ages” and “Dark Ages” over just the past 10 to 15 years.

In last week’s blog, we mentioned three studies that Turner, Mason & Company has recently conducted and is releasing on a subscription basis.  In all of these studies, expectations for refinery capacity additions and modifications play a key part in our overall market forecasts of prices, supply and demand for both crude and refined products.  One of these, the Worldwide Refinery Construction Outlook (WRCO), is particularly focused on refining projects and their potential impacts on petroleum markets.  In this product, we analyze virtually all of the refinery projects currently being considered around the world and consider all of the factors impacting the success of these projects (regional product supply and demand, crude supply dynamics and capabilities, project sponsors, construction costs, etc.).  Based on this analysis, we determine which projects we believe have the greatest probability of moving from dream to reality.  We also forecast start-up dates, the ultimate cost of the project and its impact on product and crude S&D by product type and crude quality.  In today’s blog, we highlight some of the results from our 2018 WRCO, (due to be released this week) and attempt to determine if refiners will be able to “Walk the Line” and maintain a favorable refining environment over the next few years.

The Global Picture

In many ways, things are looking pretty good for refiners right now.  Global demand has been strong since crude prices dropped in 2014, averaging annual increases of over 1.6 million BPD.  Refining capacity increases have also been quite low, running well below the level of demand increases, with 2017 additions particularly low at only 800 MBPD.  This has resulted in global capacity utilization rising by almost 3% over the last three years.

We expect robust global economic growth and relatively low petroleum prices to continue the recent trend of strong product demand growth over the next two years and then slowing a bit beginning in 2020.  Over the next five years (through 2022) our forecast calls for world hydrocarbon demand to increase by 7.2 million BPD, an annual average of over 1.4 million BPD.   Inspired by the strong demand growth and the current tight refining environment, global refiners have announced new refinery additions or expansions to existing refineries which would add 25.5 million BPD of capacity over the same time period.  This is almost 2 million BPD higher than our 5-year forecast last year, but well below levels seen several years ago.  This potential imbalance is made even worse by the reality that alternate fuels (ethanol, biodiesel, CNG, LNG, etc.) are expected to grow by over 700 MBPD through 2022.  This means that if all announced refining additions were to be successfully completed, the potential supply for refined products would grow at a rate nearly five times as fast as global petroleum demand.  Clearly, not all of these projects can be economically built and undoubtedly the majority will be cancelled or postponed.

Our current list of announced new refineries and expansions encompass 244 projects (our Announced list).  Not all of these projects include crude-processing additions, as many involve the addition of downstream units, focused on either upgrading/modifying product slates or desulfurizing products to respond to increasingly stringent regulations.  An even 100 (41%) of these projects are new, grassroots refineries, while the remaining are expansions or modifications to existing sites.

Regional Developments

Asia Pacific has the largest number (72) of projects on our Announced list, which represent 30% of the total, while the Middle East is second at 42.  By capacity, the Asia Pacific projects represent an even greater proportion of the total, 10.6 million BPD or 42%.  Together with the Middle East projects, which propose adding another 5.8 million BPD of capacity, account for almost two-thirds of the 25.5 million BPD on the Announced list.  If all of the world’s proposed projects were completed, the total cost would be over $850 billion.  This would equate to an annual construction expense of over $170 billion.

While the U.S. has 31 announced projects, the crude capacity increases of these projects add up to less than one million BPD.  Coming out of the “Golden Age” (2005 to 2007) and incentivized by advantaged crude costs resulting from rapidly growing production out of Canada and in domestic tight oil basins, a number of projects, some quite large in scope such as the Motiva Port Arthur and Marathon Garyville expansions, were completed over the past ten years.  The ability of the U.S. to tap product export markets, particularly in Latin America, also was instrumental in these expansions. With the removal of the crude export ban and a slowing of Canadian crude production growth, the crude cost advantages have declined and along with potential saturation of product export markets, refinery expansions have slowed and this trend should continue. A similar trend has also been seen in Canada, while Latin American projects have been impacted by a lack of capital and a reputation for overruns and delays.

What Determines Project Success

Many projects are announced without sufficient financial backing and face significant regulatory obstacles or simply represent a concept rather than a well-defined construction venture.  In many parts of the world, announcements of new projects are more of a political “want to” rather than an actual project with realistic economics.

At TM&C, we use multiple criteria to assess the likelihood of construction for each of these 244 projects.  In order to sort out the winners and losers, we have established a Probability Index with a scale of one to five.   A one would represent a project with the lowest likelihood of completion, while a five would be the highest.  Projects with a five are generally those well into construction.  The criteria which set the Probability Index for each project are the funding capabilities of the principals, the level of detail in the announcements, the historical track record of the principals in completion of other projects, regional crude and product balances, and perceived environmental and strategic obstacles.  The amount of crude-capacity additions for each ranking is shown in Figure 1.

Projects, with a ranking of three or higher (in our Probable list), are deemed likely to be constructed and are included in our biannual Crude and Refined Products Outlook (C&RPO), the 2018 edition of which was just released last week.

Summing Up the Current Forecast

Of the total 244 projects on our Announced list, we have determined (based on the criteria outlined above) that 113 of these projects are likely to be completed by 2022 and are included in our Probable list.  Of these, 24 are grassroots refineries, with the rest involving expansions or modifications to existing refineries.  Total crude-capacity additions for these Probable projects total 8.1 million BPD.  With a utilization rate of 90%, this would increase global crude runs by 7.3 million BPD or roughly equivalent to our forecasted global demand increase.  The growth in alternate fuels will likely be absorbed by refinery closures or utilization rates of less than 90%.

As with the Announced list, the bulk of the Probable projects will be constructed in the Asia Pacific and Middle East regions.  Asia Pacific has 34% of the new project, and these comprise 53% of the additional global crude-processing capacity.  The 19 projects in the Middle East, which we expect to be completed by 2022, provide another 31%, giving these two regions almost 85% (over 6.7 million BPD) of the global total.  The average project in these two regions is also fairly large, adding about 114 MBPD of capacity.  By contrast, the 16 projects we expect to be completed in the U.S. add only 165 MBPD of capacity in total, an average of only 10 MBPD per project.  Figure 2 is a regional comparison for the two construction lists.

Expected Future Drivers

A variety of factors will drive refinery capital investments over the next few years.  Certainly, the expectation of strong product demand over the near term is a main reason for the current, very robust Project List.  But other factors are and will also be important, including those related to changes in the regulatory, economic, and crude market environments.  One to particularly keep an eye on is the IMO LS Bunker Fuel regulations which go into effect in January 2020.  We’ve written a lot about the major impacts these rules will have on both product demand and crude markets,   So far, few major projects have made it into our Project Lists despite these anticipated impacts.  That is largely due to the significant uncertainties associated with how various players will respond – how many scrubbers will ship owners install, how strictly will the rules be enforced by regulators, and how other refiners will react.  However, we can expect, because of the very strong economic drivers (higher diesel prices/lower fuel oil prices/larger heavy versus light discount) resulting from these regulations, that significant new projects incentivized by those drivers will eventually be conceived and announced over the coming years.

TM&C will be publishing an updated and comprehensive Project List as part of our 2018 WRCO, due to be released in the next week. This product provides the opportunity to see our complete refinery project listing, instead of just the most probable projects which we include in our just released C&RPO.  As in our previous editions of the WRCO, each project we track is listed by region and ranked based on its probability of success.  In addition, a detailed discussion of the regional factors and trends that are affecting refinery construction projects is provided.  If you would like more information on this or our other products, or for any specific consulting engagements with which we may be able to assist, please go to our website, send us an email or give us a call.