Refining - what is the path of future growth?
A look at the key risks and uncertainties for the oil and refining industry in 2023, and what it should invest in to become more resilient to the energy transition.
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Refiners now have cash in the bank
In hindsight, 2022 was a truly unprecedented year. Oil demand growth was forecast to be strong as the economy continued its recovery from the global pandemic. Russia’s invasion of Ukraine introduced huge geopolitical uncertainties, as Russia weaponised its energy exports in response to EU and G7 sanctions, causing energy prices to soar. The shadow of Covid-19 loomed large over China, with sizable parts of its petrochemical and manufacturing sector locked down for many months in the first half of the year. Central banks abruptly switched tack as rocketing energy prices stoked inflation. Recession fears started to loom large in the second half of the year. The EU’s crude import ban and G7 price caps on Russian crude oil came into force on 5 December 2022, with the refined product import ban scheduled for 5 February 2023.
Looking back, global oil demand in 2022 was 99.0 million b/d, growing over 2 million b/d from 2021 but remaining just under 2 million b/d below pre-pandemic levels. Russian crude oil exports largely continued to flow but were diverted away from Europe to India, China, and Turkey. As we had been forecasting, global oil supply growth outpaced demand growth by almost 2.5 million b/d on a year-on-year basis, so oil prices weakened towards year end. Pandemic-driven refinery closures, self-sanctioning by many European companies, and low product export quotas from China tightened the refined product markets, with refining margins hitting record highs during the summer months. Consumers suddenly appreciated that refining is another step in the value chain which links crude oil to retail fuels. The global refining system is still running in max distillate mode, with cracks for light distillates, such as naphtha and gasoline, very weak, particularly as over-supply and poor profitability now haunt the petrochemical sector.
In our latest economic outlook, Wood Mackenzie expects some key economies to enter recession and the global economy to slump in 2023 before recovering in 2024. Global GDP growth is downgraded to 2.1% for 2023 – the weakest global expansion, outside of the Covid and global financial crisis contractions, since 2001. Europe is likely already in recession or will enter a downturn over the winter. In the US, we expect the Federal Reserve to continue the tightening cycle, with interest rates reaching a peak of 5-6% in Q1 2023. However, this is not a synchronised global recession. China’s economic growth will improve in 2023, although the growth path is likely to be bumpy and dependent upon the handling of the new Covid cases. The cessation of its zero-Covid policy will kickstart the domestic economy – we expect this will happen towards Q2 2023. Despite this economic uncertainty, 2023 oil demand is to grow by just over 2 million b/d, reaching over 101 million b/d and exceeding 2019 levels in the second half of 2023.
Refining sector tightness should ease during 2023 as new sources of supply become available to the global market. Over 1.4 million b/d of additional refining capacity is scheduled to become fully operational over the course of 2023, enabling crude runs to increase to satisfy diesel/gas oil demand, so easing the pressure the sector is facing. Our forecast is for refining margins to remain elevated during the first half of 2023 and then decline back to the top of the historical five-year range, as shown in Figure 1.
There are, however, several uncertainties, beyond the typical challenges of project completion and commissioning, that could disrupt this outlook:
• China’s product export policies. This is a relatively new risk to the global refining market as China’s export quotas did not previously constrain the operations of its domestic refining sector. In 2022, China restricted exports, initially to both drive the rationalisation of the independent teapot sector and reduce its overall carbon emissions, as refining is considered a low value-added sector. In 2023, we are expecting exports to grow as China attempts to stimulate economic growth, particularly in the first half of the year.
• The EU refined product import ban from Russia and price cap, to be implemented on 5 February. Given that very little of current Russian diesel/gas oil exports go much beyond Europe, the diversion of these flows could be disruptive. We expect Russian distillate exports to fall in Q1 2023 and this loss to then decline over time as global distillate flows re-establish themselves. The refining system returns to being heavily distorted if significant volumes of Russian exports are lost to the global market.
• Russian exports of natural gas to Europe fell dramatically during 2022. Despite currently high gas inventories, the risk of high European natural gas prices remains during 2023. This has a direct impact on European refinery operating costs and the cost of diesel production. Higher European operating costs are reflected in its regional product crack spreads, which provides a potential upside to refiners elsewhere.
The current refining investment wave, focused on Asia and the Middle East, will be largely operational by 2025. There are limited capacity additions considered firm thereafter. The growth in refined product demand and additional refining capacity and other non-refinery sources of supply is well balanced. The margin environment for the refining sector looks healthy for the rest of this decade.
Given that the risk of closure is low, refiners will hence have funds to invest. What do they invest in to become more resilient to the energy transition?
What are the investment options to deliver resilience?
There are many attributes of resilience, but we have simplified them to two key parameters: site profitability, measured as net cash margin (NCM), as positive cash flow is critical to sustain future investment requirements, and site emissions intensity, as relatively low carbon emissions can be a source of competitive advantage. Figure 2 categorises European refiners into four quadrants (based on their position relative to the regional volume-weighted averages for 2021), along with proposed investment strategies.
Emissions reductions focus on energy efficiency, adoption of low-carbon hydrogen, renewable power, and CCS deployment, along with the use of biomass/biogas for internal fuel and other such initiatives. The investment strategy for margin improvement is largely petrochemical focused, as petrochemical demand is forecast to continue to grow during the energy transition even as transport fuel demand falls. This opportunity is clearly shown in Figure 3, which depicts the added value to integrated refiners of petrochemicals for 2021.
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