The global refining industry is ending this decade on a decidedly down note. US and European refiners have struggled over much of the last 10 years to provide adequate returns for shareholders, and this year has been especially difficult. In Asia, refining overcapacity and a collapse in demand have sunk margins to historically low levels. Is the downstream doomed to another decade of poor operating conditions, or is a return to prosperity imminent?
The answer to this question is quite complicated. Certainly there are many more hurdles in the near future that the industry will have to overcome. European and US refiners face tough new fuel product specification changes over the next 5 years, which will require costly investments and upgrades to plant technology. In the meantime, natural gas substitution for heating oil and fuel oil, as well as environmental taxes, will tend to eat away at petroleum's overall market share. Asian refiners have not yet seen any convincing return of demand after the dramatic collapse of the last 2 years and now face another surge of overcapacity in the region.
ESAI has identified a number of major trends or issues that will almost certainly have some impact on global refining margins over the next 10 years.
The conclusions of our analysis suggest that, even though refining margins will remain under the burden of too much supply chasing too little demand in the short term, growing gasoline and diesel demand throughout the next decade, combined with restricted refining capacity and an increasingly tight market for clean product components, will ultimately yield significant upside for many refiners.
The upside will be sustainable as early as 2001 in the transportation-oriented US, while the upside in Asia may not be felt until 2003 or 2004. Europe will be caught between the two, tracking US margins more so than Asia's, but still rising the most when both Asia and the US are improving. Not all refiners, however, will benefit or suffer equally. Where one fits in the refining food chain will depend ultimately on the combined factors of geographic location and technological capability.
Outlook for Asia
The first stop on the global refining outlook is Asia, which has been mired in an economic recession for much of the past 2 years. Despite some promising macroeconomic indicators, such as decreasing interest rates and recovering equity markets, oil demand has bottomed out but has shown no sign of quick rebound. Diesel demand, a key reflection of investment and general economic activity, has been especially hard hit.
Eventually, demand will return, and with it, Singapore refining margins will improve. However, this will not be an overnight process. Individual economies have been hurt to varying degrees. Indonesia, Malaysia, Thailand, and South Korea have been the most severely affected, and as a result will require the longest period to regain former levels of demand. On the other end of the spectrum are Taiwan and Singapore, whose economies have been affected but which enjoy relatively potent financial and monetary weapons that have helped them ward off total collapse.
These countries will grow again, but the extraordinary growth rates of the precrisis years are probably a thing of the past. Returning growth is more likely to be steady but modest as the short-term capital inflows that exaggerated and distorted growth prior to the collapse are unlikely to return at their previous rates (Table 1). Direct foreign investment will return to the region, and this, coupled with more sound government investment strategies, will lead to more sustainable growth rates by 2005 instead of the unsustainable rates of the precrisis years.
The outlook for China is complex, but suffice it to say that economic growth is constrained by structural barriers remaining from years of centralized planning. Restructuring the Chinese economy will inevitably result in unemployment and disruption, but the government's preoccupation with maintaining social and political order will mean that reforms are carried out in only a halting manner. The extraordinary growth rates of 1978-95 are unlikely to be repeated, but a more sustainable rate should be achievable.
As a result, overall oil demand growth in Asia could reach as much as 750,000 b/d per year by 2001-02 (a large jump compared with a drop of roughly 300,000 b/d in 1998, but less than the 900,000 b/d-plus increases posted in the mid-1990s).
In the meantime, however, a new bubble of refining capacity will emerge, keeping product markets-especially the critical diesel market-very weak. The most publicized projects are already under construction: The Indian company Reliance Petroleum Ltd. will bring on-line 500,000 b/d of distillation capacity by the end of 1999, while Formosa Plastics Group in Taiwan will bring on 150,000 b/d by this fall and another 300,000 b/d over the next year. This is a huge amount of capacity to throw on an already weakened market. ESAI estimates, for example, that India's diesel import requirements will be cut roughly in half by the addition of the new refinery. Other refining projects in India, China, Pakistan, and Vietnam have also been announced, but their ultimate disposition remains unclear.
The result for the next few years will be continuous struggle for those Asian refiners most exposed to market forces. Razor-thin margins may persist for the next 2 years, and some companies may be forced to shut in capacity. By 2003, however, the horizon will be distinctly brighter. Assuming fairly constant demand growth, and even some rationalization of existing refining capacity, Asia will ultimately grow itself out of the refining malaise. Population growth and the continuing industrialization process will ensure relatively healthy oil demand. ESAI's notional yearly average assessment of Singapore refining margins sees a bottoming-out through 2001 and then a steady improvement of $2/bbl over the next 10 years.
The other major development that ESAI sees affecting refiners in Asia is the inexorable path towards almost complete deregulation of Japan's petroleum sector. This will have profound effects within Japan, leading to cuts in refining capacity, slashing of fuel oil margins, and a recapitalization process, whereby inefficient companies are forced to sell assets to more-dynamic and competitive players. The process will be felt outside Japan, as well: Japan's days as a "price-taking" country are numbered, and it is only a matter of time before Japan is transformed into a "price-making" market, rivaling Singapore.
In 1998, the utilization rate of Japanese distillation units averaged 79%. In order to raise the rate to 90%, refining capacity will have to be cut by more than 500,000 b/d. While this has bullish implications for refining margins, conditions first will have to become poor enough to actually trigger the rationalization of this amount of capacity. And conditions will indeed become tougher in the Japanese sector. The gasoline price wars will continue to lead to ultrathin gasoline margins, and when the Ministry of Trade & Industry finally eliminates coal industry subsidies in 2002 (currently financed by high fuel oil tariffs) there will be little justification to keep the fuel oil tariff intact. This will lead to a collapse of fuel oil margins as cheaper imports bring down prices. The pressure to close down inefficient plants, therefore, will only intensify.
A domestic spot petroleum market will also develop in Japan over the next few years. As the race for survival has become more serious in the Japanese downstream, it is only a matter of time before suppliers recognize that a lack of wholesale price transparency will harm their business by making hedging impossible. Kerosine and gasoline futures trading began in July 1999 on the Tokyo Commodity Exchange and diesel futures will start trading on the Chubu Commodity Exchange in 2000.
Up to now, crude oil import costs of Japanese refiners have been linked to prices of Dubai crude, and product import costs based on Singapore markets. This price-making process has been one-way, starting from the Dubai markets in New York and London, through Singapore and ending in Tokyo. However, this one-way price-making process will eventually change to a two-way process once large open domestic markets emerge in Japan. As the Japanese spot market grows, domestic Japanese supply and demand conditions will become more influential factors in the international markets, through interactions between Tokyo and Singapore. And because crude and product prices tend to interact in spot and futures markets such as the New York Mercantile Exchange, the emerging Japanese product spot markets will also start to influence benchmark Dubai crude prices.
Japan should therefore gain price making power vis-á-vis imported crude from the Persian Gulf. To the extent that gulf crude suppliers use gross product worth formulas to establish selling prices to Japan, the emergence of a liquid spot market in Japan will lead to lower product prices and thus lower gulf crude sales prices.
Product specs, refining margins
Trends in Atlantic Basin transportation fuels suggest refining will be an increasingly profitable activity as the new century unfolds, especially for those companies that are able to produce clean fuels. Atlantic Basin fuel demand will remain strong, led by gasoline and diesel demand growth in the US, where demand will grow faster than increases in refining capacity, implying higher import volumes and firmer product prices relative to crude. While capacity creep and other small refining projects can continue to increase domestic supply, these modest gains are probably no match for another decade of strong gasoline and diesel growth.
The only spoiler for the Atlantic Basin remains Europe's problematic gasoline surplus. With the tax burden on European fuel prices growing ever higher, the result has been a dieselization of the car fleet, a general emphasis on fuel efficiency, and seeming permanent retreat for gasoline demand. As refiners increase throughput rates to supply other oil demand, the gasoline surplus has increased year after year, threatening to swamp both Europe and the US in product. While some hope that upcoming reduction of benzene in European gasoline will result in a net decrease in output, others are not so sanguine, noting that there was little change when the US made the same changeover some years ago. Without a net reduction in European supplies, the Atlantic Basin outlook will be highly dependent on strong demand growth from the US, and to a lesser extent, Latin America.
Diesel, however, is set to enter the next decade on an even stronger fundamental note in the Atlantic Basin. Both the US and Europe will be increasingly net short of this product. Despite the current weakness in the distillate market, diesel values should increasingly strengthen for refiners. And if the gasoline market is not inundated with supply, gasoline values too should rise, implying better refining margins overall. ESAI sees margins showing general improvement through 2005, with notional average yearly Gulf Coast margins rising $1.50 from current levels by that time. Margins will tend to level off after that. European margins will also essentially track this pattern.
Environmental regulations may provide the second prop to refining margins for those companies that survive as clean product suppliers. The US Environmental Protection Agency is following a policy of applying equally tough standards towards both automakers and oil companies. The resulting move towards ultralow sulfur content for gasoline and diesel fuels in the Atlantic Basin by 2005 will result in further refining capacity rationalization as smaller or less sophisticated refiners find themselves unable to justify the costly technology investments required (such as naphtha hydrotreating, gas oil desulfurization, alkylation, and hydrogen units) that will be required to meet the tighter specifications. This rationalization, combined with the simultaneous movement in Europe, the US, and Canada towards ultraclean fuels, will keep critical high-quality gasoline and diesel components scarce, putting a premium on products such as on-road diesel and reformulated gasoline. A scarcity of blending components will be especially important if current US importing trends continue. In recent years, the US has imported a larger and larger percentage of its gasoline as components instead of finished product (see chart). Any further removal of methyl tertiary butyl ether (other than in California) from the gasoline pool will only intensify the hunt for alternative high-octane, low-sulfur, low-volatilty components.
Product sulfur levels will also inevitably drop in other parts of the world. This will lead to a further splintering of the global diesel market into several "tiers" according to sulfur content (Table 2). Japan, India, and other countries of Asia have already or plan to clean up their diesel pools. In this sense, however, supplier regions such as the Persian Gulf and the former Soviet Union face a dilemma. The woeful state of the Russian economy and last summer's financial meltdown have placed the country's refiners' ability to meet the European 2000 diesel specifications of 0.035 wt % in doubt. It seems that only a few of Russia's more sophisticated and creditworthy refiners will be able to meet the new specifications on time. Unless the Russian banking and industrial sectors can attract foreign capital, it is unlikely that more than a few elite refiners (if any at all) will be able to finance the necessary projects to meet the much more stringent European specification of 0.005 wt % sulfur content by 2005.
The Persian Gulf, another big diesel export region, faces a similar problem. Persian Gulf distillation capacity and diesel output are scheduled to increase substantially through 2005; however, this region's traditional export market, India, will reduce its import appetite as it both moves to a lower sulfur specification and as new refining capacity reduces the import requirement. Other refining projects elsewhere in Asia will also tend to strand Persian Gulf exports of diesel with higher sulfur content.
The implication for refiners of these specification shifts will depend on geographic location. Refiners in regions where low-sulfur diesel specifications are tightest will have limited competition from imports from outside regions. As their import requirements rise, however, it is not clear that foreign supplies of fuel will be able to meet the tighter specifications. This will increase the premium on the lowest-sulfur diesel, while higher-sulfur diesel values will tend to weaken due to falling demand and oversupply.
This simultaneous lowering of sulfur levels in both gasoline and diesel in North America and Europe (and other countries around the world) suggests that light-heavy crude differentials will widen in the future and that refiners should consider investing in upgrading units that can both upgrade low-quality feedstocks and desulfurize gasoline and diesel streams.
Fuel oil demise
Refining profitability over the next 10 years will also be affected by a decline in higher-sulfur fuel oil values relative to crude. Energy markets in the US and Europe will increasingly turn to natural gas as access to regional supplies improves and stricter environmental regulations come into effect. While gas will displace coal and nuclear power as much as fuel oil, fuel oil's market share is set to shrink, and high-sulfur fuel oil prices will be especially weak.
Deregulation of the power industry in both the US and Europe will hasten this switch away from fuel oil as a generating fuel. As the electricity market liberalizes, utilities will become more price-sensitive to the input costs of fuels and will have more incentive use whichever fuel is cheaper at the time. High-sulfur fuel oil will be especially vulnerable to displacement by the new gas supplies as utilities begin to internalize the cost of nitrogen oxide and sulfur dioxide emissions and take such factors as the cost of permits into consideration when making decisions of fuel choice. Permits will be priced on tons of emissions; this will effectively tax fuel oil at up to six times the rate of natural gas, giving gas an automatic economic advantage vis-
New natural gas pipelines connecting Canadian supplies to energy markets in the US Northeast will be completed over the next 2-3 years, with over 8.3 bcfd of capacity. This will lead to increased gas consumption by the utility, industrial, and residential sectors, with fuel oil vulnerable to displacement. Of existing generating capacity in New England, for example, 140,000 b/d of fuel oil-burning capacity is in dual-fired units.
European fuel oil markets are also poised to shrink over the course of the next decade as the same forces in North America sweep across Europe. Better access to North Sea, Russian, and North African gas is a critical part of Europe's long-term plan to increase natural gas in its energy mix. For example, together, the Norfra and TENP-Transitgas pipelines will have the capacity to transmit the btu equivalent of 200,000 b/d of residual fuel to the Italian market by 2000. Indeed, the Italian state power company, ENEL, which is the largest consumer of residual fuel in the world, plans to significantly reduce its reliance on oil for generation and increase its gas-fired capacity. Gas will also get a boost in Italy from new carbon taxes that will levy taxes on oil at roughly three times the rate of taxation on natural gas.
In addition, specification changes for fuel oil will quickly relegate high-sulfur material to the 600,000 b/d bunker market. By 2003, the European Union plans to ban inland use of fuel oil with greater than 1 wt % sulfur content, and Italy will require 0.25 wt % sulfur-content fuel oil or better for electricity generation. As a result, low-sulfur and ultralow sulfur residual fuel will command a premium relative to high-sulfur material.
Overall, residual fuel will become less of a factor in affecting margins as it will represent a decreasing percentage of product yields, especially in Europe. Faced with the challenge of disposing of residual fuel in a shrinking market, refiners will reduce their yields through either upgrading projects or resid-destruction projects such as gasification. However, those refiners that are unable to invest in conversion processing or other elimination of fuel oil output will find their margins dragged down by weak values for resid relative to crude.
CO2 emissions' role
Finally, a long-term look at refining trends would be remiss without mention of the continuing global warming debate. The quest to reduce carbon dioxide emissions is probably the biggest unknown for refiners. It is clear that the industry and transportation sectors will be the primary targets of any government strategies to reduce greenhouse gases, as most manmade CO2 emissions are produced from fuel combustion or industrial processes.
It appears that Europe is not waiting to see whether the Kyoto Treaty will be ratified by the necessary number of countries, and is going ahead and adopting its own CO2 emissions-reduction program. Already, for example, the European Automobile Manufacturers Association (ACEA) has voluntarily entered into an agreement with the EU to reduce CO2 emissions from automobiles. Under this agreement, the ACEA and EU will work to reduce emissions to 140 g/km of CO2 for new car sales by 2008 and to 120 g/km by 2012 (roughly translating to about 38 mpg of gasoline).
In the US, while there appears to be less willingness to ratify the Kyoto Treaty as it now stands, it is likely that efficiency gains will eventually be made in the automobile fleet via attempts to reduce local pollution. The EPA's recent Tier II proposals, for example, will require light trucks to achieve the same NOx and SO2 emission levels as cars. This implies efficiency gains, of which one by-product will be reduced CO2 levels.
On balance, any assessment of the future of refining margins must carry an implicit sensitivity for environmental policies that restrain or reduce oil demand. The global interest in CO2 emissions reductions can only intensify that sensitivity. Beyond that, it is hard to quantify. Oil consumption policies (whether promotion of fuel efficiency technologies or plain taxes), bolstered by CO2 emissions concerns, are unlikely to shave as much as 10% from global oil demand by 2010, as some estimate. Lopping 2-3% from expected demand in 2010, however, may not be out of the question.
Aaron F. Brady, is Manager, Global Petroleum Products , for Energy Security Analysis Inc., a Wakefield, Mass., consulting group. He oversees petroleum product market research, analysis, and writing for ESAI. Brady was the principal investigator for ESAI's study of the oxygenated fuels markets conducted for the California Energy Commission and the principal investigator for ESAI's study of alternative fuels conducted for a major automaker. He is also a registered Commodity Trading Adviser and holds an MA from the Paul H. Nitze School of Advanced International Studies of the Johns Hopkins University and a BA from Amherst College.