The downstream sector of the oil and gas market may be facing challenging times ahead as the demand picture for refined products such as diesel, gasoline, and petrochemicals is expected to shift, and as heavy crude oil supplies shrinks.
The downstream sector in the oil industry, for those not in the know, include all the last-stage operations of the entire oil process—namely refineries and distributors, or generally speaking, anything post-pumping.
While the downstream oil sector may be more insulated than the upstream sector (drilling, exploring) from the volatile prices that have plagued the industry as of late, it does face new challenges in the volatile crack spread and shifting landscape that has prompted refineries to adapt to survive.
Unlike the upstream sector, the downstream sector derives profit from the spread between the price of crude oil and the price of the end product—such as gasoline—also known as the crack spread. This means that the downstream sector has had an easier time withstanding the recent crude oil price volatility than its upstream sibling. But that doesn’t mean it is without its challenges, and the downstream sector is now facing a whole new set of challenges that will cause downstream companies to adapt or die.
Heavy Crude Oil More Expensive As Supply Tightens
The type of crude oil available plays a major role in determining refining profits. Refiners are equipped to deal with usually one specific grade of oil, and US sanctions on Venezuela and Iran and pipeline capacity constraints in Canada have resulted in decreased heavy crude supplies for US refineries that are equipped for the most part to refine heavy oil into a usable product, pushing up the price of the heavy grade and cutting into refining profits in the process. Reconfiguring a refinery to process a different grade of crude oil is no small matter and requires time and investment. And this current constraint on heavy crude may be somewhat temporary—something that doesn’t inspire refineries to sink money into reconfiguring. Many of the Gulf Coast refineries rely on these heavy crude supplies that are now dwindling—and the spread between what little there is of this heavy crude and the finished product are now at an all-time low, according to data from Oil Analytics Ltd, as cited by the Vancouver Sun. This lower spread is eating into refinery margins.
Nothing threatens—or provides an opportunity for—the current downstream oil business model like IMO 2020, the new regulations that will dictate how much Sulphur can be included in bunker fuel. Currently, Sulphur can account for 3.5% of the fuel. Starting on January 1, 2020, that will be reduced to just 0.5%. To achieve this, refiners will need to magically anticipate what type of fuel shipowners will be purchasing when the new regulations take effect—because the end users will get to choose between buying fuel with the lower Sulphur-content, or installing scrubbers (at significant expense) to mitigate the Sulphur themselves. For refiners, this could be an opportunity to reap higher profits with a higher-grade fuel that has less Sulphur—a premium, if you will. Or, it could mean much of the same-old same old, with shipowners tackling the Sulphur problem on their own. Because of the uncertainty involved in predicting the demand, refiners are in a precarious position of having to react now, before knowing the knowns. Because producing fuel with less Sulphur will mean an added expense stemming from reconfiguring their refineries, getting it wrong could be disastrous. On the other hand, refiners who choose to refine as usual may not find a market for the higher Sulphur fuel.
The IEA had a not so rosy picture of what this could mean for refineries:
“Global refiners will be put under enormous strain by the shifting product slate. If refiners ran at similar utilisation rates to today, they would be unlikely to be able to produce the required volumes of gas oil. If they increased throughputs to produce the required gas oil volumes, margins would be adversely affected by the law of diminishing returns. In order to increase gas oil output, less valuable products at the top and bottom of the barrel would be produced in tandem, which would likely see cracks for these products weaken and weigh margins down.”
The Electric Vehicle Aspect
Gasoline and diesel used for transportation account for roughly half of all oil demand. This leaves oil demand theoretically vulnerable to the onslaught of the electric vehicle segment. This market has been breathing down the neck of the oil industry for a few years, although it has not yet had a significant tangible impact on oil demand.
Still, the threat is there, and refiners could in the future see demand for these refined products diminish (or rather, growth slowed) in the coming decades.
The latest of the refinery shakeups came today as President Donald Trump indicated that the United States may levy a 5% tariff on all Mexican goods. The United States imports as much as 700,000 barrels per day of oil from Mexico, according to Reuters. This is refined, and then Mexico imports a million barrels per day of these refined products
With this free-flowing energy-knows-no-borders arrangement now in jeopardy, US refineries could see another threat on this front as yet another crude oil source potentially becomes more costly, eating away at refinery profits.
Petrochemicals, Petrochemicals, Petrochemicals!
If anything will insulate the downstream sector from a dip in demand for other refined products, it’s the petrochemicals industry. One need not look any further than Saudi Aramco and its push into the petrochemicals sector to see which way the wind is blowing. Aramco has been on a reconfiguration spree in its quest to be first to get its hands into the petrochemical sector to hedge its bets from its current money tree, crude oil.
Aramco is jumping into petrochemicals with both feet, taking a bite out of SABIC in a $69 billion deal as the biggest oil company merges with the biggest petrochem company to create a marriage made in big oil heaven that will allow Aramco to increase its refining mojo from a capacity of 5 million bpd to as much as 10 million bpd in the coming decade—2.3 million of which will be in petrochem products.
Aramco is also looking to get its hands on a piece of India’s refining behemoth, Reliance, in a $10-$15 billion deal. And the deals keep coming. Aramco signed a deal to build another petrochemical project with Total in Jubail.
The downstream sector for oil and gas will be provide interesting opportunities as the landscape continues to change over the next decade. And some of the biggest names in US refining will be in the investment spotlight as the various challenges roll out, including Marathon, Phillips 66, Valero, HollyFrontier, and more.