The European refined products market has had one of the worst years on record. Covid-19 has demolished transportation fuel demand leaving large fuel stockpiles across the continent.
Join Elliot Radley, the Editor of the European Products report and Benedict George, reporter on the European Products desk covering diesel and refining as they discuss the current state of the European refining industry and what refiners are doing to stay afloat.
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Elliot: Hello and welcome to Driving Discussions. In this series, we've been discussing the forces that affect road fuels globally. In today’s episode we will be taking a closer look at the state of Europe’s refining industry and how it is facing the challenges presented by Covid-19. My name is Elliot Radley, and I’m the Editor of the European Products Report here at Argus Media and with me today is Benedict George, reporter on the European Products desk covering diesel and refining. Thanks for joining me today Benedict.
Benedict: Thanks for having me.
Elliot: So Benedict, the European product markets have had one of their worst years on record, with recurring lockdown measures all over the continent destroying demand and leaving huge stockpiles which might not be drawn down until well into next year. Gasoline has spent much of the year trading at discounts to crude and diesel refining margins fell to their lowest point of the 21st century so far in the autumn.
This is all clearly very bad news for refiners. Benedict, in what ways are refining companies feeling the pressure?
Benedict: Europe’s refining companies made big losses in the third quarter, which may continue into the winter. BP and ExxonMobil both reported losses in the third quarter. Total reported losses in its refining business in particular. They were joined by Repsol, Eni, Norway’s Equinor, Greece’s Hellenic and Austria’s OMV among others.
One useful sign of the pain refiners are going through is the response of ratings agencies. They have been downgrading a few European refining companies in the last few months. In March, Moody’s downgraded OMV’s outlook from stable to negative and in April Fitch did the same for Turkey’s Tupras.
Some are now facing mountains of debt as a result. Recently, the Greek refiner Motor Oil Hellas, which runs the Corinth refinery, announced it had made a loss of over €100mn in the first three quarters of year and fallen from a net cash position of around €25mn to a net debt position of around €550mn. So that’s an indication of just how deeply this year has hurt the refining industry.
Elliot: So bottom lines have turned red up and down the continent. What kind of damage control have refiners been using to mitigate those losses?
Benedict: The most common thing they’re doing is simply running crude units at lower rates. The latest figures released by Euroilstock, which cover the first 15 members of the EU and Norway, showed utilisation was at around 69pc in October. That’s 10 percentage points lower than in the same month last year. And it’s basically economics 101: when demand and prices are lower, the optimal volume of production is lower.
More interestingly, some refiners have stopped producing altogether temporarily because they have hit technical minimum CDU utilisation of around 60pc and – at that level – their revenue is still not covering their costs. The biggest refinery to completely stop producing is Total’s Donges refinery, the second-largest in France. The others we’ve seen are Galp’s Porto refinery in Portugal and Ina’s Rijeka refinery in Croatia. None of those are expected to restart until next year.
Still more dramatically, some refiners have mothballed units, which means they will be offline for several months at least but possibly much longer. It’s one step short of permanently decommissioning. That’s what Gunvor has done with the Antwerp refinery, which it said could not be profitable in the near future. Cepsa has done the same with a distillation unit at the Huelva refinery in southern Spain and Petroineos the same with a distillation unit and a cracker at the Grangemouth refinery in Scotland. Petroineos has also laid off 200 workers.
Elliot: If all of those companies you listed have been making losses, why haven’t they all stopped producing?
Benedict: The reason is that most of them are doomed to make a loss even if they stop producing.
This is because they have to pay fixed costs, like salaries and so on, even they switch units off. Those costs don’t vary with the rate of production. If their revenue is greater than their variable costs, like the power needed to run a unit, then they might as well claw back some of the fixed costs by continuing to produce.
Variable costs are typically around $2-3/bl, out of total costs of around $5-6/bl for a complex refinery. So those refiners that have switched off production temporarily, they are in such dire straits that they have opted simply to accept their fixed costs in the short term.
Elliot: So that explains why we saw refiners pumping out products over the summer, even though margins were so low, which only served to keep margins low and ensure that they all made a loss in the end.
Can most refiners sustain these kind of losses, with lockdowns still destroying demand and no clear timeline for vaccines to be rolled? Are some of them considering closing operations permanently?
Benedict: Yes, some are considering stopping permanently – but that is a very costly process in the short-term. We have not seen any instances of wholesale decommissioning so far. Companies look at all the possible alternatives before they begin decommissioning. When they are making losses, they start by cutting four kinds of cash outflows: operating costs, dividends, non-essential maintenance work and investment plans. They only consider permanently shutting down when those paths run out.
One popular strategy at the moment is converting traditional refineries to process renewable fuels. This way, companies can close traditional refining capacity while gaining exposure to the growing market for renewables. In many countries, there are state incentives to do this as well.
Total has confirmed it will convert the Grandpuits refinery near Paris to process renewables, Neste is going to co-process renewables at Porvoo and Preem is going to co-process at Lysekil as well. Those conversion projects take a lot of capital expenditure and regulatory oversight, so they are all going to take between months and years to complete.
Having said that, it is very possible that some refineries will fully decommission. We saw it in the aftermath of the 2008 economic crisis, just spread out over a few years as alternative options ran out.
Elliot: Ok. Can we make any calls at this stage about which refineries are in the most financial trouble, and are the most at risk of fully shutting down?
Benedict: It’s hard to be specific about this at the moment.
But we can try to generalise using some underlying facts about refining economics. So, we can say the refineries that are in the most trouble are independent, old, simple and coastal.
Firstly, independent refiners tend to have smaller cash reserves, less flexibility, more debt and so on. Whereas the majors have enough resources that they can afford to make bigger losses for longer without running into a financial brick wall.
Secondly, Europe has a lot of old refineries which have not seen very much investment over the last few decades. As other regions like Asia-Pacific in particular have grown their refining capacity over that time, it has left the older European assets relatively uncompetitive by global standards.
Thirdly, the more complex or specialised a refinery is, the more profitable it naturally tends to be. This is because sophisticated cracker or coker units increase yields of high-value products, and so increase the overall margins that the refinery can earn.
Elliot: Right ok, and of course a complex refinery always has more optionality than a simple one, in that it can choose to switch off secondary units and mimic the operation of a simple refinery, if economics incentivise that.
Benedict: Yes, that’s right. And finally, inland refineries – like those in central Europe for example – can usually dominate those markets and earn higher mark-ups on the products they sell. So, analysts consider that those are relatively safe. Coastal refineries can face stiffer competition from imported products, which limits their margins.
Given all of those factors, one refinery we have our eye on is the Galp Porto refinery. It falls in all of those categories mentioned above and it has now completely halted fuel production for the second time this year because of economic pressures.
Elliot: Are governments likely to rescue refineries from going under? Obviously, it gets a lot of bad press when a big employer like that fails and all those workers get laid off on a certain government’s watch. It’s notoriously difficult to close refineries, which I think is a key reason we see conversions to renewables as a popular route.
Benedict: Yes, we do see some governments stepping in to protect prized assets. And it’s not only out of national pride. For example, the big Sarroch refinery in Sardinia run by Saras plays a key role in power generation for the island and that has meant the Italian state has supported it in the past. So we can probably say that that refinery won’t be shutting down, no matter how poorly it performs.
Elliot: Are we saying the majors are basically safe? You mentioned that some of them reported losses just like the smaller guys. What kind of thing are the majors doing to manage the crisis?
Benedict: Some of the majors are looking to divest their less profitable refining assets.
There are a lot of vultures circling looking for good prices for refining assets at a time like this, because they anticipate the crisis might be depressing values too much, as it were. They talk about ‘low multiples’ – if a buyer has to pay a relatively small price relative to the profit the refinery generates, then they’ve got a ‘low multiple’. Multiples tend to get lower in a crisis like this, but divestment is still preferable to the expensive process of decommissioning because it generates cash rather than using up cash.
So far, Total has agreed to sell its Lindsey refinery in the UK to the fuel retail group Prax and Shell has indicated it will look to sell the Fredericia refinery in Denmark over the next few years.
There are lots of parallels with the period following the 2008 economic crash. We saw a lot of refineries shut down back then and we also saw buyers come into the market and acquire refineries at cut prices. Shell sold the northern German Heide refinery to private equity firm Klesch at that time and sold the Stanlow refinery in the UK to Essar UK, a subsidiary of the Indian conglomerate Essar.
Elliot: Is there any chance this is just blip for European refineries? Is there an angle that says the pandemic is just a freak disaster and maybe everything will go back to normal in six months’ time?
Benedict: The problem is that the European refining industry has been burdened with structural overcapacity for years prior to the pandemic. The majors have been looking at divestments even before the pandemic came along, because its fundamentally not very profitable to run a refinery in Europe these days. The main reason is that imports from regions like Asia-Pacific have become so competitive. And those other regions just keep on building big new refineries.
Oil demand recovered after the 2008 economic crash, but nobody missed the few old European refineries that had been driven out of business along the way. The story will probably be the same with this crisis. There is a fringe of relatively inefficient refineries that Europe simply won’t need, even after demand has recovered.
Elliot: A very interesting overview of the refining landscape in Europe Benedict, thanks very much for your time today. Certainly some difficult decisions ahead for Europe’s refiners, but potentially some great opportunities for those nimble and brave enough to take them. If you enjoyed today’s podcast please be sure to tune in for the other episodes in our series, Driving Discussions. For further information about the European refined products market please visit www.argusmedia.com/oil-products.