EUROPE: A Journey Down The Stream - How Flexibility Walks You Through The Good Times And The Bad Ones

The oil and gas industry this year has been through ‘perfect storm’ along with all other industries of the world, but with its own special features.

An OPEC+ transaction to reduce production by approximately 9 million barrels per day, in parallel with the start of the global production recovery after the lockdown restrictions were lifted partly, has led to unstable crude oil prices, although demand for refined products, particularly gasoline, remains low.

Today, the global refining industry has been hit the hardest by the epidemic: oil products and petrochemical feedstock for the production of plastics were not able to enter the market freely due to the idle time of many enterprises closed to quarantine and reduced consumption of gasoline/jet fuel in transport. This is especially true with the European region, being the oldest and largest market and transition point for decades – producers had to make vital choices to survive and ensure the plants have the future. In the article, we will look into the global context and ways Europe adapted to drastic changes.

Oil peak coming or passed? Dispute is ongoing

Even before the strategic meetings took place, global proved oil reserves by the end of last year were down almost 2 bln. barrels compared to 2018. About 50-60% of planned licensing activities were cancelled as well as ‘appetite’ for size of lots on bidding was smaller – these coupled with the negative revaluation of developments will not help to improve the situation with oil supplies in the future for sure. In Europe, most of the decreases will come from offshore - Arctic developments by Russia and Barents sea by Norway. The good news is that the reserves-to-production ratio globally is still estimated in 50 more years (quite enough for any energy transition activities planned).

The price of oil tends to change rapidly, which can seriously harm the economy of both exporting and importing countries. Thus, high oil prices observed in 2005-2008 and 2011-2014 led to a slowdown in GDP growth, increased unemployment and inflation in developed economies. For exporting countries, on the other hand, high oil prices often meant a raw material bias on their economies. The oil industry and its services grew most rapidly, while other industries tended to lag behind. Low prices for non-harmoniously developed economies threatened trade and budget deficits, a volatile exchange rate of the national currency and, as a result, higher inflation. However, developed countries identified the issue at an early stage and ‘cured’ it with investments into diversification which helped them balance their economies and transform into service- and technology-led centers rather than manufacturing or agricultural ones.

The global demand for oil has seriously declined due to the consequences of COVID-19. Many experts believe that consumption may never recover to the levels observed before the pandemic. Recently DNV GL published a report stating that the demand for oil reached a maximum in 2019. However, the report notes that consumption will remain at the current level until 2050. However, Goldman Sachs strongly disagrees with the DNV forecast. The bank believes that the peak of demand is still far away. For consumption to remain at the current level, it will take four factors. These are, in particular, the accelerated development of the electric car market, rising prices for crude oil, a decline in global GDP and improved energy efficiency. The bank expects consumption to recover quickly, surpassing the pre-pandemic level after 2022.

The Bank predicts annual growth in demand of 1.1 million barrels of oil per day between 2023 and 2025. After that, consumption growth will slow to 0.9 million barrels per day for the remainder of the decade. The average annual growth of the energy market till 2040 is predicted to not exceed 0,9% which explains the sensible interest of governments and O&G majors in sustainable energy solutions. But this shall be a separate topic for discussion. Still, the "Fuel portfolio" in 2040 may include 60% of oil and gas.

Pic. 1 - Key Challenges for the Downstream Industry

Global demand for oil products will increase by ~4 million BPD in 2019-2023.

Global oil demand forecast is cut by 1.1 mb/d and for the first time in 10 years, it is expected to fall year-on-year by 90 kb/d. Demand for petroleum products in Eastern Europe will increase by 10% on average over 2018-2023, key products - GO/diesel fuel, fuel oil and gasoline.

Pic. 2 - Global demand for refined products, MPBD, 2019 vs. 2023

Production of petroleum products - oil refining capacity is expected to grow + 6 million barrels per day by 2030.

The major issue for the refinery is that what is favourable for E&P is harmful to refining. Thousands of people work at multi-billion-dollar refineries, and there is a risk of shutdowns and bankruptcies on the horizon. Global refining throughput in 2020 is expected to decline for the second consecutive year, falling below 2017 levels as demand for transport fuels plunges in the wake of the coronavirus. But according to Roland Berger’s estimate, total net refinery capacity additions will be close to 8 MBPD – with all regions showing growth (Europe being slower in pace though – about 200 KBPD of capacity developments). Production of oil products in Europe has gone down by 100 million tons of capacity for the last 10 years.

If for oil, i.e., Brent, the situation is more positive: the price has increased from $16 to $42 per barrel, for the demand it is not the same, because the prices for gasoline and other petroleum products have not recovered. Equally important is the fact that demand is recovering very unevenly, depending on the refined product slate.

Another problem has also come to the forefront, the consequences of which the market will feel in the long-term: in recent decades, the entire refining industry has been restructured, and mature refineries in Europe and the United States can no longer compete with new ones operating and due in 2021-2024 in China and other fast-growing countries. These new capacities will force all other global refineries to reduce their aggregated output by 3%.

In 2020, the hydrocarbon processing industry’s capital, maintenance and operating budgets were expected to reach nearly $440 billion, but with a 40% cut, the plan now seems a bit unrealistic to achieve.

Pic. 3 - Global Refining investments, bln. $

Refining margins were slightly lower (Asia, USA, Europe) falling from 5.4 $/barrel in 2018 to 4.7$/barrel. Oil trade decreased by 230,000 b/d (0.3%) – the first decline since the crisis in 2009, concentrated n ME.

IHS Markit predicts refinery margins over the next five years to be lower than the average over the last five years, and especially in Europe. Key players in Europe - Total, ENI, Neste, Orlen, OMV, MOL - lost 30 to 70% of their refining revenues in 2018 (e.g., from $3,800 million to $720 mln. or from $2,000 mln. to 242 mln.).

How European companies reacted to the shift:

• PKN Orlen refinery profitability - the margin of the Płock refinery in 2020 decreased by almost 5 times compared to the last year. Anti-crisis measures: PKN Orlen will acquire Polish company PGNiG and conduct a merger with Grupa Lotos.
• Shell plans to become an "energy" company instead of an "oil and gas" and "environmentally neutral" one by 2050
• BP is selling its petrochemical assets to INEOS
• Total to increase OPEX savings from $300 to $800 mln.
• Equinor (same as Total) suspends a buyback program

Gasoline consumption shall recover as the road traffic resumes. And the fear of public transport in the pandemic will force many people to move into cars. On the other hand, the demand for jet fuel may not return to the pre-Pandemic level until 2023. The decline in capacity utilization occurred geographically uneven. Thus, on the eastern coast of the US, where most of the imported European gasoline is delivered, the load has dropped to 50%. At the same time, on the coast of the Gulf of Mexico, where the largest U.S. refineries are concentrated, the load is above the U.S. average, the figure is 77%. This level of loading is ensured both by wide opportunities for product export and technological advancement of the plants in the south-east. Apart from the fact that demand has not fully recovered, large stocks of oil products have been accumulated during the pandemic. This is coupled with increased capacity utilization, which leads to the refineries' dependence on export opportunities.

Growing competition on the European diesel market may weaken Russia's position: its share in supplies may decline to 9% by 2035. Gazprom neft Trading estimates that the share of Russian diesel fuel in the European market may decrease from the current 11% to 10% by 2025, and another 1% by 2035. During the 2008 crisis, the European diesel market shrank by 4% and could only return to its pre-crisis level in eight years. At the same time, demand in Germany fell by 6% and never recovered.

The solution to the problem of excess capacity will be either partial elimination in developed countries, be it conservation of the Antwerp plant owned by Gunvor Group Ltd. or the transition of HollyFrontier Corp. (U.S.) from oil refining to other products. Some 2 mb/d of refineries in Japan and Europe have shut down their facilities since 2013. Several European plants have been converted to bio-refineries (e.g. Total’s La Mede, Eni’s Venice and Gela), which also serve EU biofuels policy targets (see below). Brazil’s Petrobras has scrapped the second phase of the Comperj megaproject and has instead kick-started the process of divesting its refineries as part of its portfolio optimisation programme. It will be interesting to see how many ‘clean’ refineries emerge in the course of 5 years. Perhaps the industry's response to the pandemic is a consolidation of the refinery industry.

Transactions in the industry (M&A) - activity is decreasing but not stopping: in 2019 downstream deal value was up 43% to nearly $124 bln. But this surge was mostly due to the largest deal, without it, value was down 31% and volume fell by 10%. Deal activity in North America and Europe fell by 70% to $24 bln. in 2019, and deal volume fell 12%, from 137 in 2018 to 121 in 2019.

Another circumstance of importance is IMO regulation standard that affects marine fuel demand: HSFO demand will be 3.8 times lower than at the start of the millennium, about 40% of HSFO displaced will be replaced by VLSFO (total 26% of bunkers), with remaining 60% replaced by diesel/gasoil, only 1.5% covered by alternative fuel (LNG). Europe possesses about 15% of global CDU capacity with an average conversion/ CDU index of about 33% - better than in many developed regions. In the period of 2016-2035, marine fuel demand will increase only in ME and US, in Western Europe it will decrease by ~20 mln.t, 12 mln. in Central and Western Europe, majorly accounting for net global cut in marine fuel demand by 7 mln. t. According to OPEC, nearly 12 MMbpd of new secondary unit capacity will begin operations by 2024.

Options for refiners?

Example of a European refinery: the goal was a reduction of sulphur content in the plant residues (capacity 1.5 million tons/year) from 3.5% to 0.5%. Two cases were considered: H2+WSA+Atmospheric residue hydrotrating (different capacities) with and without SDA unit, both with CAPEX around 220 mln. euro, the project payback period was 2-4 years depending on oil price which is a good profitability indicator. Such projects of relatively moderate investment can help refiners solve the problem with Sulphur and produce higher quality fuels

Another 'creative' solution that minimizes investment on refiners’ side is the partnership between the plant and ship owners: refineries buy scrubbers for ships ($1-3 million per unit) instead of investments in full desulfurization capacity (~$900 million) and with this secure the market for fuel oil produced by aircraft and set a price premium, but this option has certain flaws.

Refining value pool is expected to drop by ~5-15% by 2030 (as a result of lower utilization rates in Europe) possibly leading to the rationalization of capacity, increasing the margins and correspondingly the value pool.

petrochemicals - The great hopes?

The size of the chemicals market will double till 2030 compared to 2016 and will exceed 6.3 trln. Euro, opening enormous opportunities to producing countries, China alone accounting for 44% of the global share, Europe – 15% (same as Northern America). In 2018 Europe has been the second-largest chemical producer in the world, production volume was close to 550 bln. euro in monetary terms.

About 9% of total projects announced in 2018-2019 were to be located in Western Europe, another 8% - in the Eastern part and the CIS, accounting for ~20% of total investment in petrochemical projects in the period.

Petrochemicals have been a focus of interest not only for traditional market players but also refiners activated plans for integration. Many new and complexes in ME and Asia comprise both refining and chemical processes, increasing overall conversion rate and margin. As a rule of thumb, producing fuels allow to capture value of around 15 $/barrel of crude, while petrochemicals add up to an extra 30 $/barrel. Major technology companies like ExxonMobil and Honeywell UOP predict that the future downstream asset will be: fully integrated (crude-to-chemicals concept), connected (digital) and flexible (to feed and process parameters changes).

Let us quickly look at the largest European chemical producers:

BASF operates in six segments, including chemicals, plastics, high-performance products, functional solutions, agricultural solutions, and oil and gas, with sales of $68 billion in 2019.

The second place is occupied by the Dutch company LyondellBasell with a revenue of USD 38 billion. The company is one of the largest in the world for processing plastics, chemicals and petroleum products. LyondellBasell sells products in more than 100 countries and is the world's largest producer of polymer compounds and the largest licensor of polyolefin technologies.

The leader's list is closed by the French company Air Liquide with a revenue of 23 billion USD. Through its subsidiaries, it manufactures and sells industrial and medical gases including liquid nitrogen, argon, carbon dioxide and oxygen throughout the world.

The German company Linde had revenues of USD 18 billion in 2019. The company produces and distributes industrial gases and provides engineering services.

Evonik Industries is one of the world's leading companies producing specialty chemicals, with revenues of USD 16 billion in 2019. The company offers various products in the field of consumer goods, animal nutrition and pharmaceuticals.

Covestro is a world leader in the development, production and marketing of polyurethanes, plastics classes. The company's revenue in 2019 reached 15 billion USD. Covestro's core business consists of three segments that produce and continuously promote raw materials for polyurethanes and their derivatives, high-quality plastic polycarbonate, as well as coatings, adhesives and other specialty products.

Umicore N.V.'s revenue in 2019 was 15 billion USD. This is the Belgian global group on materials technology. Its fields of activity include: materials К&В, chemistry and metallurgy. The company is focused on catalysis, energy and recycling. Umicore generates most of its revenues from clean technologies such as emission control catalysts, materials for rechargeable batteries and photovoltaic cells, fuel cells and recycling.

Brenntag is a leading global distributor of chemical products and food ingredients, with revenues of USD 14 billion in 2019. The company sells and distributes industrial and specialty chemicals. It also develops and prepares specific chemical compounds and offers analytical services. Brenntag customers are oil and gas, cosmetic, pharmaceutical and water treatment companies.

The revenue of Johnson Matthey, a British company, in 2019 is 13.5 billion USD. It manufactures catalysts, pharmaceutical materials and pollution control systems. Johnson Matthey also processes platinum, gold, silver and produces pigment and paint materials for the glass, ceramic, plastic, paint, ink and construction industries.

Revenue of the Norwegian company Yara International in 2019 was 13 billion USD. The company produces, distributes and sells nitrogen mineral fertilisers and related industrial goods. Yara International sells a number of phosphate and potash-based mineral fertilisers, as well as complex and specialty mineral fertilisers.

In the global petrochemical sector, Formosa Plastics Group is expected to lead this year with an estimated CAPEX of $8.3 bln. to be spent on 9 petrochemical plants in 2018-2025, followed by Badlands NGLS LLC Plc with an estimated CAPEX of $6.8 bln. and Royal Dutch Shell with $5 bln.

One of the most important factors affecting margin is production cost. When we compared average PE costs and logistics to China, we came to the conclusion that the best results are still with the Middle East (especially Saudi Arabia) and the USA – taking an average price of PE in China 1.450 $/t, the margins could be as high as 800-1000 $/t. First, they benefit from cheap and available ethane, and the cost breakdown structure of transport, feedstock and process costs (CAPEX and OPEX) is balanced. Europe in this relation is in the least favourable position among producers (process costs 1350 $/t), having to spend ~80% of total costs on naphtha, leaving little reserve for margin and product price flexibility.

An interesting case is MOL Group’s strategic development till 2030 plan. The main goal is to increase the share of non-fuel products from the existing less than 30% to 50%. For the company, whose main oil product market is Eastern Europe - a region still far from the saturation of the vehicle fleet, such a statement is equivalent to recognizing that further motorization of the region will not result in increased demand for motor fuel.

The path chosen by MOL Group to achieve the goal is also interesting. Realizing that the chances of success in competing with large European producers of basic petrochemical products (polyolefins, elastomers, aromatic hydrocarbons, etc.), the company relied on special chemical products.

As the first stage of the strategy implementation, the execution of the Polyol Project is indicated. The project process configuration includes the following productions: hydrogen peroxide, propylene oxide and propylene polyols. Polyols are the most valuable product in the project; they are used as feed for the production of polyurethanes - petrochemical synthesis products, which are increasingly used in such industries as automobile, construction, packaging and furniture production. In addition, polyurethanes lead in terms of the predicted growth rate of demand - it is expected that it will be 4.4% per year by 2025. Until 2021 MOL Group plans to invest in this project about $ 1.9 billion.

As a conclusion and recommendation, we observed a few trends in strategic response of the downstream industry:

1. Optimization and efficiency, incl. energy saving, digital solutions and asset reconfiguration, outsourcing non-core businesses, etc.
2. Looking into future – investment into clean/alternative fuel developments, new technologies, sophisticated chemical products, environmental policies.

The majors seek to maintain their market positions, "capture" a share in promising markets:

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