Oil Refining Could Become Much Less Lucrative

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by: Oilprice
Summary

If the world gets serious about cutting greenhouse gas emissions, the global refining industry will be forced to contract.

Policies to cap emissions would weaken oil demand, which tends to depress refining margins.

But, of course, there is a lot of downstream capacity that is still under construction or in the process of being developed.

By Nick Cunningham

If the world gets serious about cutting greenhouse gas emissions, the global refining industry will be forced to contract. That may seem like an obvious conclusion, but a new report from The Carbon Tracker Initiative (CTI) ran the numbers, predicting that the refining industry would contract by 25 percent if governments adhered to the 2-degree Celsius warming target.

Policies to cap emissions would weaken oil demand, which tends to depress refining margins. CTI estimated in its report that refining margins would shrink by $3.50 per barrel by 2035, forcing refiners to take less competitive refineries offline. The global refining industry would see EBITDA earnings shrink by 50 percent over that time frame.

Another staggering conclusion from the report is that if governments around the world try to stick to the 2-degree target, the total refining capacity that already exists today would be sufficient to meet global demand going forward. No new refineries would be needed.

But, of course, there is a lot of downstream capacity that is still under construction or in the process of being developed. The danger is that there is a massive overbuild in refining assets, which would lead to depressed margins and ultimately stranded assets and destroyed capital. Carbon Tracker puts it bluntly: "[W]e consider that prospective investors should be wary of all new refinery investments, whether the build out of greenfield capacity or upgrades and expansions to existing facilities."

Regionally speaking, the downstream sectors in Europe and the U.S. will probably feel the effects more than elsewhere. Because there are some newer refineries under development in the Middle East and Asia, "mature regions, predominantly within the OECD, are likely to need larger cuts than the global demand trend might imply," Carbon Tracker wrote in its report.

While the threat is very serious, the oil industry does not appear to be concerned. Refining is still extremely lucrative. BP (NYSE:BP), for example, earned $1.6 billion from its upstream unit in the third quarter of this year, but the British oil giant took in $2.3 billion from its downstream assets. Chevron (NYSE:CVX) posted $1.814 billion in third quarter profits from its downstream unit, while its upstream division only earned $489 million. The past few years have been good ones for refining, as oil demand has expanded at very high rates.

Downstream earnings have also insulated the integrated oil majors from the market downturn to some degree. Shale companies have been hit hard, even as they have grown production they continue to post losses. The oil majors, on the other hand, are back to profitability - and they have their downstream units to thank.

But just because the past two or three years has been a sort of "golden age" for refining, that does not mean that the good times will last forever. In fact, such a contraction has occurred before. The oil price spike in the late 1970s led to a 10 percent decline in global oil demand by the early 1980s, which translated into an 8 percent drop off in global refining capacity, Carbon Tracker argues. The OECD suffered a contraction twice as large as that global figure.

At the facility level, the conclusions from the report offer some nuance. Very large, complex refineries would fare much better than simple facilities that are of lesser quality, many of which would be forced to shut down. But new - and more competitive - refineries still pose a massive investment risk. "When demand growth stalls and turns negative, new investments will carry the risk of failing to earn an adequate return -- wasting capital -- even if they result in improved competitive positioning or reduced losses for existing capacity," Carbon Tracker wrote.

Companies are also exposed to varying degrees. Among the oil majors, for example, Total SA (NYSE:TOT) and Eni (NYSE:E) are highly vulnerable to a contraction in global refining capacity. Carbon Tracker estimates that the two European oil majors could see a 70 to 80 percent decline in EBITDA from their refining assets between 2015 and 2035 if the world sticks to the 2-degree target.

Saudi Aramco would be hit even worse, with an estimated decline in EBITDA from its downstream unit by a whopping 130 to 140 percent. However, as a state-owned actor and not a private company, its refining assets are of strategic importance to the Saudi state, and would thus likely stay open even if they are loss-making. As a result, it will be the private companies that will bear the brunt of the capacity reductions over time.

At the end of the day, investors need to be skeptical of the demand assumptions that are used by oil companies, Carbon Tracker argues: "[S]hareholders should continue to be wary of any refining investment, even in the so-called growth regions."

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.