May-2024

European refiners need to shift from volume to value

Now is the time to plan for the impact of the energy transition and establish how to secure value growth through diversification away from transport fuels.

Alan Gelder
Wood Mackenzie

Article Summary

Refining has enjoyed unprecedented profitability The low point of the global pandemic feels a long time ago for the refining sector. During early 2020, one-third of the global population was locked down to slow the spread of Covid-19. Oil demand collapsed by more than 20 million bpd, and refiners were hit hard. Global oil demand in 2024 continues to set records, with 2023 demand already above pre-pandemic levels. The only transport fuel still below 2019 levels is jet fuel, as the fuel efficiency improvements from newer planes are offsetting the return to pre-pandemic levels of passenger numbers.

Geopolitical tensions are supporting refining margins, particularly in Atlantic Basin locations, as both the Russia/Ukraine conflict and the Red Sea disruption are making global trade of crude oil and refined products less efficient. Figure 1 shows the historical weekly global gross refinery composite margin over the past five years. The bottom of the five-year range was set by the pandemic, with the top of the range set by 2022, when the Russia/Ukraine conflict spread fear of significant supply loss. Refining margins for 2023 were less skewed by geopolitical events.

However, Q3 2023 margins were driven by a combination of low European distillate stocks, high maintenance in the Middle East and Asia, and a low distillate yield from European refiners, which were processing much larger volumes of light, US tight oil feedstocks.

Refining margins in 2024 spiked in February in response to the Red Sea disruption, which caused a significant diversion of inter-regional trade through the much longer route around southern Africa rather than the Suez Canal.

The impression that refining margins will remain above the five-year historical average is, however, flawed. Global composite refining margins are likely to decline as we progress through 2024 and the wave of new refining projects in Africa, Asia, and the Middle East become fully operational, with more than 2 million b/d of refining capacity scheduled for this year. Figure 2 shows the short-term outlook for the global refinery composite gross margin, which is back to (or below) the five-year historical average later this year and for 2025.

The energy transition is a disruptive megatrend for refining
Refining margins are unlikely to return to the unprecedented highs of recent years. The challenge for refiners is how to continue value growth in their businesses as the energy transition takes hold. The adoption of electric vehicles in the passenger car segment is the leading edge of the energy transition that will further decouple economic activity from oil demand. Oil demand has already peaked in the industrial and power generation sectors and in regions such as Organisation for Economic Co-operation and Development (OECD) Asia Pacific and Europe.

Figure 3 shows how peak oil demand is set to come in waves across sectors and regions, with global oil demand peaking within a decade and then starting to decline. The peak in demand masks two contrary developments; first, the declining role of oil in energy use, primarily for transportation, and second, the growing demand for oil as a petrochemical feedstock. Mature OECD economies such as Europe and North America will lead the decline in oil demand for transport use as vehicles become more fuel efficient and increasingly electrified.

Peak oil demand is a direct threat to the refining sector, as declining demand lowers global refinery utilisation and profitability, leading to the closure of competitively weak sites. Refiners based in regions of falling domestic demand will become increasingly reliant upon the export market to retain high utilisation levels. This will be in direct competition with refiners in destination markets. Given that peak oil is not projected to occur this decade, refinery utilisation will be set by the balance between demand growth and new refining capacity currently under development. With global refining capacity to rise by 2.3 million b/d by 2030, lagging demand growth, refinery utilisation is to remain healthy during this decade, as shown in Figure 4.

Healthy refinery utilisation typically delivers refining margins that sustain operations, providing cash flow for future investments. However, with refined product demand in structural decline in regions such as Europe, refiners need to plan to adapt if they are to remain commercially viable after global oil demand has peaked.

It is critical in a globally competitive commodity market such as refining to understand the relative competitive position of your site. Wood Mackenzie measures competitiveness in terms of net cash margin, but given that the energy transition drives towards lower emissions, it is important to assess relative carbon emissions from refining operations. Figure 5 shows the distribution of assets when assessing net cash margins and emissions intensity, categorising sites into four quadrants.

The ‘target’ quadrant is the important place – above-average net cash margin and below-average emissions intensity. Moving from other quadrants into the target involves either investment to add value or emissions reduction. The requirement for both suggests to us that such sites may be at risk of closure or divestment from the portfolio (by owners who have multiple sites).

Decarbonisation of operations is a key focus for European refiners due to their exposure to the high cost of emissions from the EU’s emissions trading scheme. Europe’s introduction of the carbon border adjustment mechanism puts site decarbonisation not just on the agenda of refiners in Europe but also refiners who export product to Europe, the US, the Middle East, China, and West Coast India.

Value drivers beyond refining are essential
Given that the energy transition turns oil demand growth negative in the early 2030s, investments to sustain value growth need to be in sectors beyond transport fuels. Petrochemicals and liquid renewables are the obvious candidates.

Petrochemicals is the traditional extension of the refinery value chain, as there are synergies in the production of both fuels and commodity chemicals in an integrated facility. Petrochemicals typically achieve significantly higher prices than transport fuels and so add value. The value uplift does, however, depend upon the health of the petrochemical sector. Figure 6 shows this, as in 2021, the value uplift from petrochemicals was strong. However, in 2022, there was little additional value as the Russia/Ukraine conflict drove transport fuel crack spreads to unprecedented highs. During the latter part of 2022, a significant surplus petrochemical capacity emerged in China. Despite this apparent contradiction, integrated sites demonstrate:
•    Higher value from olefins rather than aromatics, with polyolefins adding the most value.
•    The higher the yield of chemicals, the greater the benefit of petrochemical integration.
•    Integrated sites are highly competitive compared to standalone fuels refiners with the flexibility to switch yields between fuels and chemicals.

This suggests that a pivot towards petrochemicals needs to be material to capture significant value and position a site in the target quadrant. Such an investment is unlikely to be available to all, as any petrochemical investment needs to be sufficiently large to be competitive against grassroots facilities currently under development.

A further challenge is that our closure threat analysis shows that although petrochemicals can add value, that value may not be sufficient to overcome the challenges and losses from a competitively weak refining asset.