Global oil refining: market signals last wave of growth
Oil refining is a cyclical business which trails and responds to demand for oil products. In recent years, the sector has undergone a significant strategic shift, with global refining sliding into negative growth during the pandemic years as demand collapsed.
Oil refining is a cyclical business which trails and responds to demand for oil products. In recent years, the sector has undergone a significant strategic shift, with global refining sliding into negative growth during the pandemic years as demand collapsed. The start of the Ukraine-Russia crisis at end-February 2022 then catapulted refining from famine to feast in term of margins. In June 2022, the global composite margin touched $30 per barrel levels. So far, 2023 has turned out to be a year of relatively lower margins, between $5-10 per barrel, with hopes of further demand growth in the second half of the year. While this looks positive, a double impact is coming from a collapse in steam cracker and aromatic margins as the petrochemicals sector undergoes a downcycle after over-producing during the pandemic years. This is underpinned by an accelerating trend in recent years for the world to pivot away from fossil fuels to clean energy, leaving the refining industry facing existential questions over its long-term future.
From December 2018 to December 2025, the refining industry is projected to add 12 million barrels per day (bpd) of production capacity. This is the result of several projects which were sanctioned some years ago and are due online in 2023 after years of delays. Examples include the start-up of Kuwait’s Al Zour refinery and Nigeria’s Dangote refinery. Over the same period, refinery closures are projected to remove 10 million bpd of capacity from the market. Without this, refining capacity would have reached 116 million bpd by 2025 instead of the 108 million bpd projected by Rystad Energy.
This begs the question: is the global refining sector entering its final few years of growth? The answer requires a detailed analysis of global oil supply and demand trends along with global appetite for capital expenditure (capex) investment to keep refineries in compliance with ever-increasing carbon emission reduction regulations. At a macro level, it is not hard to conclude that the concept to start-up pathway no longer exists for refining due to the accelerated pace of transition away from fossil fuels. Depending on region, it typically takes 5-10 years for refineries to start up from the time of announcement. Furthermore, due to the cyclical nature of refinery margins and profitability, refineries need 10-20 years of cash flow to justify the huge capex required. A single year of very high margins, as seen in 2022, is not enough to spur long-term investment in refining.
The main purpose of oil refineries has been to make road and aviation transport fuels. The US refining sector is a good example, producing almost 50% of motor gasoline yield with other outputs mostly by-products. By 2040, road transport fuel demand in the US is projected to decline to 50% compared to 2022 levels, and to 25% by 2050. With such a steep decline in road transport and distillate fuel demand in the coming decades, the US refining industry is losing a pathway to operate, invest in upgrades and maintain operations long enough to recover costs and make profits. This is a key driver that will force oil refining to consider extreme measures such as closures and conversions.
In retrospect, 2021 turned out to be a year of transition with refinery capacity closures touching 6 million bpd (mostly in Europe and North America) compared to additions of around 4 million bpd (mostly in Asia, the Middle East and South America). In the coming two years, additions are likely to come from projects in Asia and the Middle East that are already in the advanced stages of completion. The pace of refinery closures and conversions is a subject of intense debate and evaluation across the industry, with the number of closures likely to increase in the EU and North America. Even in China and Russia, there are increased chances of simpler and teapots refineries to close.
For the global refining sector, future options are limited and can be grouped into three possible scenarios:
A steep slide in refining: In anticipation of an uncertain future and high capital costs to decarbonize, the spate of refinery closures or conversions gains very strong momentum in the US and Europe.
Refining stays resilient: The US refining industry enjoys some strategic advantages in terms of technological complexity, location, crude supply, and fuel costs. The sector could stay resilient with government-aided decarbonization initiatives and shift towards bio-refining and petrochemical integration. Europe is unlikely to provide that support and is unable to withstand the volume of products coming from Asian and Middle Eastern refineries and the rising costs of utilities. An integration with petrochemicals, bio feeds, carbon capture, utilization and storage (CCUS) and green hydrogen technologies is the only feasible path.
Volatile and unpredictable shifts: This scenario is harder to predict and most likely to materialize. The key factors would be policy-driven shifts and volatility in a carbon credit-driven financial operating environment. In recent times, the oil industry has seen multiple shifts and divides, which are being heavily influenced by the US political system and policies adopted by individual parties. Recent news of the US Environmental Protection Agency’s (EPA) recommendation to delay a scheme to give electric vehicle (EV) manufacturers tradable credits under a federal biofuels program is symbolic of the future energy policy world. Similarly, profitability in a carbon credit-debit trading world would require significant changes in the existing refining kit and associated logistics infrastructure.
In light of this, Rystad Energy believes there are three market signals to watch out for in the short and medium term:
East of Suez gradually gaining control of the products market: As demand recovers ahead beyond the recessionary clouds seen in 2023, the product market is projected to stay tight for many years to come. The refinery capacity control pendulum is shifting from west of Suez to east of Suez with China, Asia Pacific and the Middle East having the sparest capacity in excess of domestic demand. This would make the west increasingly dependent on flows from the east. It is not unthinkable that western countries may need to consider building large strategic stocks of products. As global crude demand declines in the west with refinery closures, the Middle East is likely to accelerate crude to chemicals. OPEC may transition from controlling just crude to also controlling products, rebranding itself as the Organization of the Petroleum Products and Exporting Countries (OPPEC) in the years to come.
Price spikes and higher volatility in the aviation and petrochemical sectors: The decline in refining will produce shortages in ‘sticky’ demand sector products such as jet fuel, liquefied petroleum gas (LPG), bitumen, and petrochemical feedstocks. With refinery closures happening faster than the transition to EVs, we could also see shortages emerge in road transport fuels. Similarly, the lubricants market is facing a dramatic downturn in refinery manufacturing of lube feedstocks.
Refineries facing an upside-down operational shift: In a transition from bottom-of-barrel upgradation to top-of-barrel upgradation, the heavier sour crudes market will suffer a huge blow. In a recent report, the Canada Energy Regulator (CER) noted that the nation’s oil production would plunge 76% in under three decades if the world took sufficient action to limit global warming to 1.5°C (2.7°F). At the same time, light sweet paraffinic crudes of shale quality would become particularly sought after, prolonging the life and scale of shale oil beyond US borders.
Hear more of Mukesh Sahdev’s views on global oil trading markets in this podcast.