Déjà-Vu

In 1995, the oil company I was working for decided to expand its refining operations. At that time, global overcapacity exceeded 7 million barrels per day,¹ but our senior management had a “long-term view” of the sector. I visited several refineries across Europe looking for suitable assets to buy, and we even considered building a new one in China (until we saw the requirements of the Chinese government, including the minimum number of workers, minimum output, suppliers to be approved, just to name a few). In the end, we didn't buy or build any new refineries, but all the estimates from research houses, brokers, consultants, and industry experts estimated that the overcapacity in refining would be fully absorbed by demand before 2000.

In 2013, during a visit to some of the key oil-producing and refinery assets across Latin America, I gazed through some research notes and found an interesting sentence. “Global refining overcapacity stands around 7 million barrels per day. However, we estimate that this will be fully absorbed by demand growth by 2020”. I put the iPod on and listened to “Déjà vu” by Crosby, Stills, Nash & Young.

In addition to suffering from long periods of overcapacity, refiners have also suffered the squeeze between producers (who limit production) and consumers (who set the price they are able and willing to pay).

The “revenge of the old economy” was particularly acute in refining. The surge in demand from emerging markets surpassed the most optimistic forecasts, and refining bottlenecks played a key role in the run up towards $140+/bbl in 2008.

For the first time in decades, refining was in charge and OPEC was on the back foot.

Unfortunately for the refiners the party did not last long, and new refining and upgrading capacity responded quickly to the incentives of high refinery margins.

Since then, refining has become a tail of two regions, with North American refiners enjoying the benefits of cheap domestic landlocked crude oil, while the European and Asian refiners are suffering more than ever from overcapacity and the squeeze between producers and consumers.

Diplomatic demand outlook

The rolling optimistic mindset of the industry, by which “demand will absorb the overcapacity within x years in the near future” is perhaps partially to blame, but there are other flatteners and deflationary forces that have played an important part too.

Historically, some of the largest refineries in the world were located within the producing countries themselves, who would then export the refined products to the consumers.

Consumers, on the other hand, have their own incentives to build capacity at home, partially as a way to protect themselves against the risk of supply shocks.

Whatever the rationale, the fact is the growth in capacity across both producers and consumers has contributed to the rolling structural overcapacity.

Saudi Arabia heavy sour crude oil

Saudi Arabia produces “heavy sour” crude oil. The term “heavy” means that distillation would yield larger quantities of residual fuel oil and “sour” means it contains sulphur, which if not removed could create acid rain. WTI and Brent are “light sweet” crudes, yielding larger quantities of cleaner products, such as gasoline, diesel, and kerosene.²

During the 1980s and 1990s, crude oil prices were anchored around $20/bbl, subject to the cyclical ups and downs, and the supply and demand shocks of 1991 and 1998, but were overall quite stable, helped by Saudi Arabia and OPEC.

But in 2002 crude oil prices started to move up, slowly but steadily. By 2006, the price was $60/bbl, and the super-cycle was evident in other commodities. There was no shortage of physical crude oil, but the spare refining capacity was tightening up, while politicians were blaming the apparent disconnect between prices and supply and demand on the speculators.

I was on the trading floor in London when the news came out. “Saudi is cutting production by 500,000 barrels per day”. The news came as a shock to many people. While production cuts to support the price were nothing new, this cut was happening in a rising market. What was going on? Saudi's oil minister Al-Naimi had openly said that crude oil prices were too high, and disconnected from the supply and demand reality. Wouldn't a cut send prices even higher?

OPEC had lost control of the market.

For the first time in decades, the refiners were in control.

Saudi's heavy sour crude oil was closer to fuel oil than to WTI or Brent. And for months, the inventory of fuel oil had been increasing. The fuel oil forward curve was by then in super-contango, reflecting the glut in the physical markets. The world needed more clean products, not more fuel oil.

But the refineries at that time were not ready to convert the large amount of Saudi crude into clean products without creating a large residual amount of fuel oil that no one wanted.

As a result, Saudi was forced to cut the production of its heavy sour crude to try to stabilize the price of the fuel oil market, and with it the price of the sour heavy crude. Yes, Saudi Arabia was acting in its own self-interest. Anyone surprised?

Saudi's cuts managed to stabilize the fuel oil market, but tightened the market of light clean products even further, and the light sweet crudes started an unstoppable run towards $140/bbl. Producers were enjoying the ride, particularly the high-cost producers such as the Canadian oil sands.

And the refiners were having the time of their lives. While WTI was trading at $140/bbl, the prices of the middle distillates such as jet fuel were trading above $200/bbl.³

These refineries were buying sour heavy crude at a steep discount, turning it into light clean products and were making a fortune.

And then Lehman Brothers happened.

The super-economic returns had already triggered a wave of investing in new refinery capacity, particularly “upgrading capacity”, which has dramatically reduced the spread between light and heavy crudes. Refining is a very capital-intensive business. New assets are expensive to build, but once they are built, their average life is around 30 years.

Not good news for the refiners, who in addition to the structural overcapacity, have historically been squeezed between the oligopolistic producers and the price-sensitive consumers.

Location, location, location

The location of refineries has turned out to be a major driver in the profitability of refiners.

In North America, the surge in domestic production, combined with the regulatory restrictions to export crude oil, have dramatically widened refinery margins and enhanced profitability. The bottlenecks in Cushing we discussed in the previous chapter, allowed refiners in the region to buy crude oil at much discounted levels, which they could convert into higher valued refined products. North American refiners are enjoying a period of bonanza, but at the expense of the North American producers and consumers.⁴

In Europe and Asia, on the other hand, refiners are struggling. The price of Brent and other relevant crude oils has remained at a high premium, as the overcapacity in the sector has led to extreme competition and lower margins. Outside of North America, the producers continue to enjoy a period of bonanza, much at the expense of the refiners and consumers.⁵

Pro-cyclical behaviour

The overcapacity is also a result of the pro-cyclical nature of the energy industry, which is particularly evident in the refining and power generation sectors. The structural optimism of demand growth has resulted in structural overcapacity and, alongside, declining profitability. “The industry always invests in the incorrect belief that no one else is going to do what they are doing”, a seasoned colleague once told me. How true.