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First study of downstream sector’s exposure to climate risk finds refinery values and earnings could halve...Read More
"The consequences of achieving a 2˚C world are far more detrimental to the refining sector than the upstream sector, as it results in structural over-capacity and associated poor refining margin environment, which can only be addressed by sustained capacity rationalisation.” Alan Gelder, Wood Mackenzie Vice President Research
What does a 2°C scenario mean for future refining capacity?
In this paper, we look at how a scenario for oil demand that is compliant with limiting the rise in global warming by 2035 to 2°C (a “2D” scenario) might affect the oil industry’s refining assets. The IEA’s 450 Scenario is used as the basis of 2D demand, under which oil demand peaks in 2020 and declines at 1.3% p.a. thereafter. This follows on from our recent analysis ‘2 Degrees of Separation’ which focused on the upstream activities of the sector.
At the simplest level:
lower oil volume = less refining capacity = smaller margins
Less volume = fewer refineries needed
Under a 2D scenario, global oil demand could decline by 23% over a 15 year period. Historically, falling or weak demand has often been accompanied by weak refining margins. With demand falling, refinery output would need to fall commensurately. Market forces would drive margins down in order to force the least competitive refiners out of the market. Accordingly, under a 2D scenario, the industry is likely to see major rationalisation with many players exiting the market rather than haemorrhaging cash. Our analysis implies rationalisation equivalent to 25% of 2016 capacity.
Margins suffer across the board
To drive this rationalisation, we estimate that a sustained refinery margin contraction of the order of $3.50/barrel by 2035 would be necessary. This compares to a global composite margin in 2016 of $5.00/bbl. We consider this estimate to be conservative. For example, BP’s history of global refining margins since 1990 shows an annual standard deviation of nearly $5/barrel. Past periods of weak demand have led to higher declines in margins. For example, in 2008 US demand fell by 5%: BP’s US indicator margin fell by over $6/barrel. 
The combination of reduced refining throughputs and the consequent fall in margins could have profound implications for the industry. We estimate that EBITDA for the refineries we have analysed (94% of 2015 global capacity) could fall by over 50% by 2035 from an estimated $147bn in 2015. There is likely to be a fall in valuations of refinery assets of a similar order although the impact will be disproportionate. Complex refineries, which tend to have higher margins, are likely to suffer least; simple, low quality assets could become worthless.
Transport fuel most profitable but most at risk
Diesel, gasoline and jet fuel products offer the highest margins across the product mix from refineries, and they also constitute around 70% of global product yield. As covered in our previous research ‘Expect the unexpected’ the rate of technological change in road transport may surprise the industry and erode demand for these fuels faster than currently anticipated.
OECD capacity hit hardest
Under a 2D scenario the existing refinery stock is already sufficient to meet future demand; no new refinery capacity needs to be added globally. However, differences in regional demand trends may mean that new capacity is needed in areas such as the Middle East and Asia. Some countries may add new unprofitable capacity for strategic reasons such as security of supply. As a result, mature regions, predominantly within the OECD, are likely to need larger cuts than the global demand trend might imply. Were this to occur, the eventual reduction in capacity needed to balance the market would be that much greater. In such a market, refining margins would most likely be lower than would be the case in a rational market.
Accordingly, we 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. 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. Margin assumptions in particular should be questioned and sensitised over a broad range of values, as they are likely to prove optimistic should oil demand follow the 2D pathway.
An historical analogue can be seen in the early 1980s, when high prices led to a 10% decline in global demand for crude oil between 1979 and 1983 before recovering: global refining capacity fell by 8% in response. Capacity reduction in the OECD was over double this amount. This was a period of significant duress for the refining industry, with international oil companies slashing capital expenditure and closing capacity. In a 2D demand scenario, where oil demand falls at a somewhat slower rate but for a longer, sustained period, we suspect the same might happen again. While strategic interests may keep capacity open for non-economic reasons, the financial cost for doing so is likely to grow increasingly punitive.
New & complex beats old & simple
We emphasise that the results of this report should not be taken as precise forecasts. Components of the refining margin curve we use could well change over time. Also, the behaviour of industry actors is impossible to predict. Aggressive rationalisation might reduce the fall in margin; lack of action could do the opposite. However we consider the results reasonable in terms of a general exploration of the implications of a 2D demand scenario for the refining sector. The industry faces two unenviable choices: “toughing it out” and seeing cash-flows and earnings hit by margin pressure; or taking aggressive action which brings its own on related costs. The pressure is likely to be greater for the weaker players, which will tend to be the owners of sub-scale, low complexity refineries in regions where demand is already mature.