RISING COSTS CALL FOR NEW EUROPEAN REFINING STRATEGIES
Brian N. C. Sweeney
Arthur D. Little Ltd.
London
The outlook for the global refining industry is for increased spending and reduced margins, largely because of efforts to improve the environment. A look at these trends through the end of the decade is thus in order.
Three major industry thrusts are proposed to see refiners through this uncertain period.
MAJOR CYCLES
The refining industry was on the crest of a wave in the 1960s, but in the 1970s, oil shocks brought a trough in its fortunes. The upstream, however, was thriving and upstream profitability carried refining through the downturn.
The industry "dematured" in the 1980s, with new competitors, new products, and renewed growth. But the 1990s could prove to be as threatening as the 1970s. The internal challenges may not be quite as severe but support from other sectors will certainly be less available.
The availability of cash to the downstream oil industry is being squeezed from the outside by the cash requirements of upstream oil and gas, and from the inside by low margins and environmentally driven investments. Although refining margins will improve, conventional thinking will not be able to restore downstream cash flow, and uncomfortable new strategies will be needed.
INDUSTRY CHALLENGES
There will be two key internal challenges to the industry in the 1990s:
- The growing surplus of conversion capacity in European refineries
- The investment consequences of environmental legislation.
On the external scene, cash will be needed upstream to expand the production capacity of the Organization of Petroleum Exporting Countries (OPEC) as the linkage between quota and capacity becomes even looser within OPEC psychology.
Additionally, huge quantities of cash will be needed to restore the productive capacities of C.I.S. countries. Only by bringing their oil fields toward normal industry standards of equipment and safety are the undoubted hydrocarbon resources going to be brought to market so that the people of those countries can begin to benefit from them.
Traditional investment will be needed in greater amounts as non-OPEC production moves out into deeper water, be it deeper cold water of the North Sea or deeper warm water off the Indonesian Islands.
But probably all of these demands will be dwarfed by investment requirements for the gas pipelines that will be needed to meet growing gas demand, which will have to be met by tapping increasingly remote resources.
A surge in crude prices cannot be relied on to supply these cash requirements. Although one can never be sure of anything in forward oil prices, there are some credible scenarios of continuing low crude prices. With Iraq's capacity still in waiting, it will be some time until the next OPEC capacity squeeze.
On the downstream end, the chemicals business-in the midst of its cyclic downturn and needing its own investment for environmental compliance-will not make any cash contribution to oil and gas. As Europe struggles with its long drawn out recession, there will be little support from market buoyancy.
Thus, in summary, the industry cannot expect much outside support in the 1990s.
COMPLIANCE COSTS
The capital and operating costs of environmental compliance are rising in the downstream industry. Some sources have estimated incremental costs over the rest of the decade to be as great as $5 billion/year. Environmentally driven investments will be inadequately remunerated and will reduce oil companies' average return on capital.
Downstream profitability is under pressure from the recession and from low margins caused by a growing oversupply of conversion capacity in Western Europe. Refining margins will stay low until 1995-96, when growth in white-oil demand could rebalance the need for conversion capacity.
These requirements are against a background of profitability which, in Europe in 1992, probably was about $1 net margin/bbl, or some $5 billion net profit/year.
The additional capital and operating costs needed for environmental compliance, on the one hand, and net profit produced, on the other, will have to change if refineries cannot pay for their capital needs.
The threat is clear; the solution is not.
EUROPEAN LEGISLATION
Table 1 shows the current status of key European Commission environmental legislations.
In 1988, the Large Combustion Plant Directive came into force for plants producing greater than 50 mw. This legislation requires existing plants to achieve a phased reduction of SO2 emissions totalling 60% by 2003.
New plants were given a sliding scale, depending on size, with the emissions of smaller plants limited to 1,700 Mg SO2/cu m flue gas. (This is approximately equivalent to a plant without flue gas treatment using 1% sulfur fuel oil.) Plants producing greater than 500 mw are required to meet a limit of only 400 mg/cu m (0.25% sulfur fuel oil equivalent).
This directive is due for review, probably in 1994, and a limit of 200 mg/cu m has been discussed by the German and Dutch governments. It is more likely that all plants will be required to meet new plant standards.
In many refineries, the only way for these standards to be met is to convert to gas firing.
In March 1991, the Gas Oil Sulphur Directive required that heating oil and diesel fuel have a maximum of 0.2 wt % sulfur by 1994, and that diesel sulfur be further reduced to less than 0.05 wt % by 1996. Reduction of heating oil to 0.1 wt % sulfur by 1999 is being discussed and a number of governments are pressing for this.
Two more directives are likely to come before the European Commission in 1993. These directives will have significant further implications.
The Small Combustion Plant Directive, which has been in the discussion phase for some time, will require plants producing more than 1 mw to meet the 1,700 mg SO2/cu m requirement. This will be one of the main driving forces for reduced fuel oil consumption and increased use of natural gas.
Even more far reaching is the Consolidated Fuels Directive. This directive is based on a memorandum submitted to the European Commission by France in 1990. The memorandum was aimed at reducing SO2 emissions from the entire petroleum chain. It proposed:
- All plants producing less than 50 mw, and all existing plants producing more than 50 mw, will be required to meet an emissions level equivalent to burning 2% sulfur fuel oil by 1995, and 1% sulfur fuel oil by 2000.
- Refinery emissions will be reduced from 3,400 mg SO2/cu m in 1991 to 1,700 mg/cu m by 2000.
- A limit of 2% sulfur for marine bunkers by 1995.
Some countries are pressing the International Maritime Organisation for a 1% sulfur maximum on bunker fuel oil. If these proposals are adopted, they could have a major impact on future investments and refining margins.
INVESTMENTS/MARGINS
In a recent study, Arthur D. Little Ltd. reviewed the investment requirement to meet the Gas Oil Sulphur Directive. The cost of compliance was found to vary considerably from refinery to refinery (Fig. 1).
As an example, Fig. 1 shows the total cost to produce 0.05% sulfur diesel and 0.1% sulfur gas oil for 49 North European refineries. Several refineries have the capability to produce these products now, and so face very little cost.
But for the majority needing to invest, the cost can vary by a factor of five. At the high end of the spectrum, smaller refineries will have to spend about $30/metric ton.
This is a formidable burden and many of the less well-placed will try to switch to lower-sulfur feedstocks-an action that will inevitably increase differentials between low and high-sulfur crudes.
The governments of The Netherlands, France, Italy, Spain, and Germany, together with the European Commission, asked Arthur D. Little to look at the potential impact of the French Memorandum proposals on the European refining industry. Results from the subsequent study were presented in July 1992 at an international symposium in The Hague. The conclusions drawn were Arthur D. Little's.
The study was based on:
- An update of the European Commission's scenarios of product demand.
The two main scenarios (high and low fuel oil) are shown in Fig. 2. In summary, oil demand in the European Community will be static, with growth principally in middle distillates and decreased use of fuel oil. In the "Low Fuel Oil" case, the reduction in fuel oil demand is equivalent to 5% of the barrel by 2000.
- An analysis of crude oil quality changes.
Table 2 shows that sulfur content increases in all regions as more Middle Eastern crude is used. This is in response to expected reduced production of sweet North Sea crudes.
- A review of current levels Of SO2 emissions from refineries.
Table 2 also shows that Northwest European refineries will have considerably cleaner emissions because of their already stricter regulations.
- The agreed changes and some assumptions about future product qualities and emissions standards (Table 3).
The most contentious assumptions are in the area of marine bunkers.
For purposes of the study, the European refining system was modeled in three regional groups, making allowances in the models for the "overoptimization" that grouping produces. Three prototypical refineries also were modeled, to enable identification of the effect on different refinery types.
First, allowances were made for investment that will result from changes in the product mix caused by shifts in European demand. Next, the impact of product-quality changes and emissions standards were identified.
Fig. shows that the Gas Oil Sulphur Directive drives a massive increase in the need for distillate hydrodesulfurization-about 1.2 million b/d by 2000. This is approximately 35% of current capacity and even more will be needed in the following decade.
For hydrocracking, 30% additional capacity will be needed. Although this is a smaller increase than that for hydrodesulfurization, 200,000 b/d of hydrocracking capacity is no small investment.
The largest percentage increase was in atmospheric residue desulfurization, which will need a 500,000 b/d boost by 2000, from virtually a zero base. And if bunkers are reduced to 1.5% sulfur, twice as much atmospheric resid desulfurization capacity will be needed.
Of even greater concern to investors is that, because of reductions in fuel oil demand, this need will diminish after 2000-when projects should be at their most profitable.
It is unlikely that refiners will invest in atmospheric resid desulfurization to this extent for two reasons:
- It is not part of the core business of motor fuels.
- It is not strategically sound to invest in a vulnerable, shrinking product.
These changes in product quality will have some significant side effects too. In response to regulations, refiners will switch to low-sulfur crudes, and sulfur premiums will increase.
Arthur D. Little has calculated that an average crude-slate sulfur content decrease of 0.5 wt % could cost the average refinery more than 50cts/bbl on its entire slate.
If bunker sulfur specifications are reduced to a maximum of 1.5 wt %, the additional cost of meeting the specification is in the range of $30-60/metric ton. Unless specifications worldwide change at the same time, bunker demand will probably migrate away from Europe.
This migration will not only reduce oil demand by 500,000 b/d, but also cause massive shift in the need for conversion, an increase in conversion margins, and further demand for light, sweet crudes.
But what about the impact on the refiner? Calculations of the capital needed to fund these investments reveal that refiners will need to spend $2-3 billion/year for the rest of the decade to achieve the requirements. This is roughly the same as is spent on maintenance and replacement of facilities and considerably greater than the investment needed for changes in the product mix.
Configurational changes that are driven by legislation rather than market opportunity typically are not well remunerated. All refiners invest to protect their core markets and the sum of the capacities of all the units built is frequently greater than the requirement.
This excess capacity leads to commodity prices and low returns. The example set by low-lead gasoline may well be followed by distillate desulfurization.
Fig. 4 summarizes a review of refiners' announced plans against requirements for changes in product demand and quality. The greatest current focus is on desulfurization. During the next 6 months or so, refiners will have to start implementing their plans to meet the 1996 regulations and much of the capacity gap will be filled, if not overfilled.
Octane processes are well advanced and conversion is well on its way to meeting demand.
The increase in distillation in the face of no increase in demand suggests that hydroskimming margins are not going to improve, especially when Eastern European overcapacity, is taken into account.
Fig. 5 shows European distillation capacity utilization in recent quarters. The effect of adding 200,000 b/d can be easily imagined.
The investments program needed, together with the low returns that mandated investment can be expected to earn, imply a reduction in returns on investment. This turns the discussion to the expected margins, from which refiners will have to pay for this investment.
MARGINS
Fig. 6 shows projected refining margins. Margins have fallen since the high point caused by the Gulf war, and this period of depressed margins is likely to continue through the mid-1990s.
The subsequent rise reflects a rebalancing of the demand barrel with the refining-system configuration, together with some increase in crude prices late in the decade.
The current downward pressure is principally caused by the growing surplus of conversion capacity in the Atlantic Basin, and in Western Europe in particular. This has arisen because refiners overbuilt in the early 1990s, and that capacity is now coming onstream.
Fig. 7 shows the changing product slate by estimating the decrease in heavy product demand and the increase in lighter products. Assuming that in 1991 conversion capacity was fully loaded, then the capacity of the units now coming onstream exceeds the need for conversion (shown by the shaded area on the right-hand graph).
Taking into account current plans, the conversion-capacity surplus will persist until 1995, when conversion margins can be expected to improve.
This cyclical overbuilding is exacerbated by the U.S. Clean Air Act Amendments which force the reformulation of gasoline and the displacement of high-octane pool components by oxygenates. There is a tendency toward surplus octane, not only to reduce the load on U.S. conversion facilities, but also to reduce the need for conversion capacity in Europe.
What does all this turbulence mean to the refining industry and are there actions that can be taken to help it better weather the storm?
STRATEGIES
Refining margins will be low until conversion capacity comes into better balance. But just when margins start to improve, sulfur premiums will increase. Both the Eastern European and U.S, refining systems will have negative influences on Western Europe.
Environmental regulations will demand investments that are unlikely to achieve attractive returns, and potential changes to bunker specifications could cause further upheavals. It is difficult to see how downstream cash flow will improve.
What should refiners do?
Unless the industry succeeds in changing the ground rules of its profitability, there may be a rash of acquisitions and withdrawals, which will leave the industry impoverished and in different hands.
Three main thrusts are necessary:
- Fixed costs must be reduced by re-engineering business processes and re-examining noncore business units against total and marginal costs. In this respect the best refiners are well ahead of the good ones.
- New cooperative ways of meeting regulations must be sought, to avoid wasteful overcapacity. Joint ventures and alliances with competitors will be needed.
- The cooperative principle upstream must be extended and new strategies must be sought to meet product demand changes and reduce feedstock costs.
The picture that has been presented is tough, largely because of the wish to improve the environment. The question that must be continually reviewed is "Have governments got the right balance in these regulations between the environment and the downstream industry?
Copyright 1993 Oil & Gas Journal. All Rights Reserved.