Published on
Tuesday, October 27 2020
Authors :
Jonathan Leitch
In this blog post, we focus on the challenges facing the European refining industry and prospects for its future. Having recently joined the Turner, Mason & Company team covering the EMEARC markets and based in London, Jonathan offers his insights from 25 years of experience in the crude oil and refined product markets.
For the European refining industry, it may be the case that the darkest hour is just before the dawn. Excess refining capacity is a persistent issue that has been elevated to a crisis by the steep decline in oil products demand resulting from the COVID-19 pandemic inspired lockdowns. Several refiners have already announced capacity closures, and more are certain to follow as Europe encounters a second wave of infections. These closures, however painful at the time, should ultimately lead to a more balanced market environment, which in turn will result in improved margins and financials for refiners. Consequently, we do expect that the short-term pain felt by European refineries will effectively result in longer-term gain, at least for those who can survive the shakeout.
We’ve certainly seen plunging refinery margins in the wake of the COVID-19 lockdowns in the Spring as product demand declines were unprecedented in both speed and magnitude throughout the world. This prompted refinery run cuts and announcements of permanent refinery closures. European refiners have felt the negative effects more keenly than other regions due to the shocking economic downturn which came at a time where the Continent had an existing overhang of spare refining capacity.
Trying to find positives in the current situation is difficult as product stocks swell due to a contango market structure and European demand looks set to remain depressed for months to come. However, if this period of woeful refinery margins prompt a sufficient rationalisation of refining capacity, it could end the problem of surplus refining capacity in Europe and support margins for several years as demand recovers from the effects of COVID-19.
The problem of excess refining capacity in Europe has persisted due to:
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The European automotive fleet has been through decades of dieselisation, shifting demand away from gasoline. This change was driven by the assumption that diesel cars were better for the environment due to better efficiency and, therefore, lower CO2 emissions. However, problems with NOX and particulates, which prominently came to light with the Volkswagen emissions scandal, mean that this process has been reversing since 2016.
The change in demand patterns has long been a problem for refiners as they have not been able to shift their yields to match local requirements. As a result, there has been a surplus of gasoline and a deficit of diesel. While the de-dieselization trend noted above has tended to help this imbalance, other factors have combined to put additional pressure on the supply/demand balance and margins. Most prominent of these is a more challenging market for gasoline exports and increasing supplies of middle distillates, both of which have resulted from the addition of new refining capacity in Asia and the Middle East and the modernization of Russian refineries.
Investments in hydrocracking capacity to increase diesel yields have been costly but have kept many European refiners profitable during tough times while refiners with a higher ratio of catalytic cracking capacity have struggled.
As mentioned, refinery capacity has grown in other regions to either match local demand growth or to add value to their domestic crude production. These new refineries tend to have economies of scale, petrochemical integration and residue upgrading to boost yields of the more profitable products and lower operating cost structures than aging European facilities. As a result, they can push surplus diesel and jet fuel into the European market while local refiners find their run rates capped by the problem of surplus gasoline.
European refiners have also carried the burden of tougher environmental restrictions compared to their competitors in other regions. Carbon costs under the EU Emissions Trading Scheme have risen sharply since 2017 and, to some, present an unlevel playing field which does not fully take account of the “offshore” emissions that result from importing refined products.
With these challenges in mind, and extended periods of weak margins in the past, we could expect more European refiners to have closed than has been the case. In part, this is due to the high cost of exit from the business (and in many cases government intervention to prevent closures). On a national level, the redundancies that arise from closures are difficult to accept politically and can damage corporate reputation.
There is also a high cost in dismantling equipment and remediating polluted land to useable state. As a result, some refiners have kept refineries operational even while consistently operating at a loss. Others have overcome these exit hurdles by selling off refineries to buyers who believe they have the qualities needed to bring about a change in fortunes. A popular option has also been to close the oil refining capacity at a site and convert it to renewable fuels production or to operate as a storage and distribution terminal, but there is a limit to how much of this type of facility the market actually needs.
The demand impact from COVID-19 has been exceptional, and in the most recent edition of our bi-annual Crude and Refined Products Outlook (issued in August), we estimated that in Europe total products demand for 2020 will be 1.6 million barrels per day lower than in 2019. It is very possible that the decline may be even more severe than this given the recent return to some additional lockdowns in much of the region. On a global basis, we estimated a decline in demand in 2020 of over 8 million barrels per day YOY, creating the current level of inventory overhang and huge surplus of refining capacity.
The impact on refinery margins has been severe enough to push weak but surviving refiners over the threshold for closure as estimates for the cost of continuing to operate exceeds the costs of closure. More closures are inevitable and this may also be a suitable time for integrated oil companies to reduce their exposure to refining and help them along the path to lower carbon emissions.
We estimate that there could be a further 1 to 2+ million barrels per day of refinery closures in Europe on top of those already announced. This sets the European and broader Atlantic Basin refining sector up for higher margins from 2022 onwards. Margins will be stronger in the post-recovery world than would have been achieved had COVID-19 not occurred as weak refiners would have struggled on.
There may be tougher times ahead for the rest of this year and into 2021, but we feel it is likely that the dawn is approaching and refiners can look forward to healthier margins in the post-COVID world.
However, the effects of the long-term decline in European products demand will be felt eventually, and the new day for refiners may be short. We expect margins to start falling again by 2025 due to a combination of capacity additions in other regions and the transition to clean fuels which will cut fossil fuel demand in Europe and also add to the operating costs of refiners.
The Chief Executive of Italian refiner Saras stated that the third quarter was among the worst in the history of refining. Unfortunately, margins may decline further over the next six months, but better times are ahead. Not long after the statement from Saras, it was announced that Trafigura had bought a 3% stake in the company. This may well turn out to be a very shrewd and well-timed investment in a strong asset with a complex configuration and good location. However, the outlook for the European refining sector could be dimmed if cash-rich traders buy up weak assets from struggling refiners as has happened in the past.
The type of refinery that will thrive after the current crisis has a high proportion of upgrading capacity, the ability to handle a wide crude slate and produce the highest specification fuels, a good location close to local markets but with the option to export surplus product, good terminal and storage facilities, scope for renewables production and petrochemicals integration. The type of refinery that is expected to struggle is small, located in an area with easy access to imports and competing capacity and of simple configuration with a low upgrading ratio. There are some exceptions such as refineries with captive local markets, dedicated crude supply and political support. In all cases, the financial stability and strategic vision of each refinery’s ownership will also play a key role in the survival of individual facilities.
The tough situation for refiners means that big questions need to be answered and important decisions need to be made. Turner, Mason & Company is well placed to provide expert help through these tough times and beyond.
Turner, Mason & Company is continually monitoring developments in the global petroleum markets and assessing how they will impact the industry. Considering the dynamic events impacting the petroleum industry (IMO, COVID-19, trade wars, low carbon standards, EV incentives, sanctions, OPEC policy, etc.), the future landscape of the petroleum industry is as uncertain as ever. TM&C not only executes regular and comprehensive studies of the industry, such as our Crude and Refined Products Outlook and World Refinery Construction Outlook, but also one-off studies focusing on specific issues. We also use the findings of these studies and our expertise to assist clients in all segments of the petroleum supply chain in specific and focused consulting engagements. For more information on our subscription studies or our consulting capabilities, please call us at 214-754-0898 or visit our website at turnermason.com.
