The Refining Industry Is Struggling To Adapt To The Future

The upstream oil and gas business is recovering from one of the worst slumps in recent memory as oil prices sit at around $75 per barrel and global demand rises. The expectation now is that prices will reach pre-crisis levels in just a few quarters.

However, the downstream segment's suffering is set to linger—and not only in the short term. Lower refining margins and structural overcapacity are the near-term challenges ahead for the oil refining industry. But there are two other challenges that refiners need to overcome if they want to remain relevant despite the energy transition and pledges for net-zero emissions, energy consultancy Wood Mackenzie says.

Persistently Low Refining Margins

Global refining margins are now higher than at this time last year, but they are still well below five-year averages and below the margins of the last 'normal' year for demand, 2019.

"[T]he refining margin is higher than the fourth quarter but still quite low. And then the marketing business from a volume perspective also not as strong as we've had certainly on a steady-state basis," Royal Dutch Shell's chief financial officer Jessica Uhl said on the supermajor's Q1 earnings call at the end of April.   

So far this year, margins have somewhat improved with recovering gasoline demand in China and the United States. But recovery has been uneven across various refined products. Global jet fuel demand is still trailing the demand recovery in gasoline, forcing refiners to blend jet fuel with diesel, thus increasing diesel supply and depressing the margin, according to Wood Mackenzie.

Refinery Overcapacity

Refining margins also come under pressure from more facilities stating up, especially in the Middle East and Asia. This exacerbates the overcapacity in the industry, which had started to become evident even before the pandemic-inflicted crash in fuel demand.

"Wood Mackenzie's global composite margin averages US$1.8/bbl this year so far, less than half the US$4.25/bbl five-year average. With new refineries in the Middle East and Asia coming online, we don't expect refining margins to recover further next year," says Alan Gelder, Vice President Refining Analysis at WoodMac.

The overcapacity in the industry is driving down global utilization rates. Wood Mackenzie expects this key metric of profitability in the industry to average slightly over 75 percent in 2021. While this would be up from the 68 percent from the second quarter of 2020, it is still below the some 80 percent average in the five years prior to the 2020 downturn.

If the global refinery industry doesn't see extensive further rationalization, the sector may never return to 80 percent capacity utilization, WoodMac noted.

The current crisis is an existential threat to smaller and less efficient refineries in Europe and Asia that were struggling to turn profits even before the pandemic. Even oil majors acknowledge that some sites have become permanently uneconomical amid depressed refining margins, fierce regional competition, and expectations of declining road fuel demand in the long term. For example, ExxonMobil and BP announced in the span of just a few months closures of their respective refineries in Australia. They now plan to convert them into fuel import terminals.  

In Europe, 1.4 million bpd of refining capacity is under serious threat of closure by 2023 at the latest, according to a Wood Mackenzie analysis from the middle of last year. 

Refiners around the world announced permanent closures of refinery capacity last year after the pandemic crushed fuel demand worldwide, the International Energy Agency (IEA) said in November 2020. Yet, even after the announced closures, "there remains significant structural overcapacity," the Paris-based agency added.  

Emissions Issue

How to turn in consistent profits amid industry overcapacity is the key short-term challenge to the sector. How to decarbonize operations and how much oil demand electric vehicles (EVs) would eliminate are the major longer-term challenges for refiners.

In a world where pledges for net-zero emissions are now the norm, the refining industry needs to show it is trying to clean up its act and reduce emissions from operations. This can be done through electrification of processes, low-carbon hydrogen, and carbon capture and storage (CCS), Wood Mackenzie says.  

Some integrated majors have already started to think along this line of business. For example, TotalEnergies, in cooperation with a unit of ExxonMobil and chemicals companies, has just announced it would explore the development of a CO2 infrastructure, including capture and storage, to help decarbonize the industrial basin located in the Normandy region in France.

Emissions from operations would be easier to tackle despite the potentially high costs and years of development and implementation of projects. The issue with emissions generated from the use of refined oil products, Scope 3 emissions, is still a major issue.

"[T]he industry's restrained commitments beyond a handful of companies to reduce Scope 3 emissions reflect differences of opinion as to whether the responsibility lies with producers or consumers," WoodMac said.

EV Threat To Oil Demand

Finally, there is the big question that will differentiate winners and losers in the refining sector in the energy transition: how much fuel demand will EVs erase?

If the world were to get on the 2-degree pathway in an accelerated energy transition scenario, an aggressive EV market penetration would result in global oil demand falling to just 35 million barrels per day (bpd) in 2050, according to Wood Mackenzie. 

This scenario may be overly optimistic about electrification in transport, but there will surely be some oil demand that would come off the market in the next decades.

To survive in a world where oil demand is not growing every year, the refining industry would need further rationalization. The winners will be the most competitive assets, such as coastal integrated petrochemical facilities processing not only crude but also waste and biomass, WoodMac notes.