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Time to prepare for the downstream downturn

Refining margins have recently been at all-time highs, but the industry faces much uncertainty and needs to prepare for a downturn. So says Derek Marshall, one of the heads of business development at Shell Global Solutions International. Interview by Alex Forbes

IT IS DURING good times that it is best to prepare for bad times. This is an adage that applies particularly to the global refining industry. Refiners have in recent years been enjoying record margins, but now face multiple challenges, making the future highly uncertain.

That is the message being put forward by Shell Global Solutions, Royal Dutch Shell's technology and consultancy arm. "There is still a lot of uncertainty about how the market will evolve – in terms of specifications, in terms of investments in refining capacity, in terms of carbon dioxide (CO2) caps and in terms of margins," says Derek Marshall, director of business development for Europe, Africa, the Middle East and Russia – regions that together accounted for two-fifths of the world's refinery throughputs in 2006.

"Margins have picked up for a variety of reasons. Demand growth has seen extremely high refinery run rates with little spare capacity left in the system. At the same time, there has been length in global fuel supplies. This has seen the by-product of fuel oil emerging, which has gone to the power sector on the margin. When you combine that with high absolute oil prices you get a tremendous upgrading in margin."

According to statistics published by BP, global refining margins averaged a record $8.56 a barrel in 2005, when hurricanes shut in several US Gulf Coast refineries, and fell very slightly in 2006 to average $8.49/b. Margins have continued to rise during 2007 – and this is where the danger lies, says Marshall.

"It's hard to make rational decisions about the future when you are making so much money. What we are preaching to our customers is: 'You may well be enjoying high profitability now, but be aware that this industry has been historically cyclical and you have to be prepared for the time when the downturn may eventually hit you.'

"When margins were low, people were very much focused on cutting costs, energy efficiency, fixed-cost reduction, head count. Frankly, that kept many of them alive. Since margins have picked up, people have begun investing again, less so in Europe, but more so in the Middle East and Russia.

"However, they will need to be prepared for the moment when it arrives. So finish your projects – successfully to time and to budget – but at the same time be aware that you have a base operation that you have to manage and be prepared for that moment when life is not so good."

Many uncertainties

Among the many uncertainties that the industry faces is the recent cost escalation that has taken place in commodity and contracting costs. This has led to the cancellation and postponement of several proposed refinery projects. Says Marshall: "People are beginning to re-consider investments, because they are seeing cost over-runs, delays, and quality impairment from the EPC (engineering, procurement and construction) contracting sector. So some people are playing a wait-and-see game.

"In the Middle East, there have been some cancellations and deferments, and we are now seeing this in Europe. We have an example where one of our clients wanted to build a new refinery, but the capital expenditure estimates went from something like $2bn to $4bn. So the economics clearly become much more questionable."

Marshall adds, however, that economics are not always the driver. Some countries are often less driven by economics than by issues of security of supply, particularly those that are rich in crude oil but poor in refined products. A topical example is Iran – the second-largest Opec oil producer after Saudi Arabia – which recently imposed gasoline rationing to reduce its dependence on imports while it ramps up domestic refining capacity (see p24).

Compounding the uncertainty of cost escalation is the uncertainty over how refining margins will evolve. There are, says Marshall, a number of factors at work: "The addition in the energy mix of biofuels and other new sources of energy will eventually affect what we make and sell from refineries. Refineries are sweating assets to meet present demand and at the same time a capacity creep is giving an increase in production capacity, affecting margins.

"With these production levels we could also reach a position where fuel oil is no longer long, but balanced or even short. It could reach the point where fuel oil prices increase as people compete for feedstock for this upgraded capacity. You could get to the situation where fuel oil is high enough that it is valued at the marginal conversion valuation. That could lead to a squeeze on margins even with a high oil price.

"Another thing to focus on is cost inflation. This may have a knock-on effect in terms of margins as projects may fall by the wayside, which means extra capacity does not come on stream, reducing the risk of over-building, which, in turn, would support margins."

Changing slates

In the longer term, the industry must adapt to a heavier crude slate and meet tightening environmental regulations. Unconventional crudes, such as bitumen crudes or oil sands with heavy fuel oils, can be so heavy, says Marshall, that they cannot be processed in a conventional refinery. They first need to be upgraded near the source, not only to make them suitable for the refinery, but also because they are so heavy that they are too viscous to transport by pipeline.

"This will need investment in upgrading, both near the source and in refineries," says Marshall. "And you have to find the right balance between those investments – which are so huge that you need to find creative ways to do it. It also requires the upstream and downstream sectors to work closely together – that becomes absolutely essential."

Moreover, refining processes need to be modified if new direct emissions standards are to be met. Consumption of energy in the refining process typically represents around 1-4% of the crude itself. "Refineries have made great strides in improving their energy efficiency," says Marshall. "Research conducted by Solomon Associates [a US-based firm that provides benchmarking and consulting services to the energy industry] shows about a 13% reduction since 1990. It is a trend that will continue, but not at such a rate. Improvements are likely to be between 5% and 10% over the next 10 years."

A particular problem in the European Union (EU) is that while refiners can choose the crude they process, there is little flexibility in the total crude supply available to EU countries under reasonably economic and secure terms. "This," says Marshall, "makes it difficult to achieve an overall emissions reduction at a European level by differentiating crudes according to their potential to generate CO2.

"Also, with crudes getting heavier and refiners keen to gain the financial benefits of conversion capacity, refineries are becoming increasingly complex, leading to additional energy requirements."

Concawe (Conservation of Clean Air and Water in Europe, an oil companies' association) estimates recent gasoline and diesel/gasoil specification changes have led to a 4-6% CO2-intensity increase, while the evolution in demand, particularly with deepening gasoline imbalances, has led to up to a 10% intensity increase. Solomon, meanwhile, says European refinery intensity will increase by at least 10-20% in the coming decade, more than offsetting the effect of mitigation measures.

"Using ethanol blending to decrease well-to-wheel CO2 emissions has also initiated much debate about how to balance the use of foodstock and feedstock for fuels manufacture, says Marshall. "This dilemma will not resolve itself until competitive technology is used to develop second-generation cellulose-based biofuels.

Shifting production

"The environmental benefit of ethanol blending will also be felt at the refineries as CO2 emissions decrease as gasoline production falls. However, this holds only if refineries can effectively shift production towards other desired products. This brings with it a need to invest in plant at the same time that reduced gasoline production means falling margins."

Another problem for European refiners, and to a lesser extent for those in Asia, is the rapid dieselisation of vehicle fleets over the past decade. A new vehicle in Europe is now more likely to run on diesel than on gasoline.

"There was a time," says Marshall, "when everyone thought gasoline demand growth would continue, but instead the dieselisation of Europe continues, and if you have driven today's diesel cars you can understand why – because you can't really tell the difference these days between diesel and gasoline.

"In Europe, at least, we have assets that are geared towards gasoline, and if we make too much gasoline we have to ship most of it to the US. If Europe wants to stay in balance then it will have to employ new technologies, mainly around hydro-cracking or gasification technologies."

Preparing for the squeeze

And how is Shell, a major refining company, planning to cope with these uncertainties? "We are preparing for the day when margins are being squeezed," says Marshall, "so our focus at the moment is very much around improving the asset efficiency and integrity of our refineries and chemical plants. We are looking at energy reduction, we are looking at ways to improve our maintenance efficiency.

"It's the less sexy stuff, but it's so essential to get those things right if you want to be profitable during the downturn."

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