Viewpoint: Europe base oils face oversupply

The European market will prove vulnerable to global structural changes as Group I base oil producers maintain output levels and are slow to upgrade units.

The global base oil market faces unprecedented change in the coming years with rising premium base oil capacity, higher specification requirements for engine oils and the implementation of the International Maritime Organisation's (IMO) 2020 sulphur cap.

Group I prices face downward pressure in 2019 amid falling demand as more buyers switch to premium-grade Group II and Group III base oils. Spot Group I volumes could get a further boost in 2019 from a drop in supplies committed to term contracts compared with 2018. Producers attracted less demand for 2019 term supplies during negotiations at the end of 2018, although some negotiations have continued into 2019.

Many blenders lock in a large share of their requirements with term contracts. But these supplies have reflected an increase in volumes of Group II and Group III base oils in place of Group I. The availability of larger spot volumes is likely to cushion prices against higher-than-expected demand, unplanned maintenance or rising feedstock costs.

Scheduled plant maintenance should curb some spot availability during the peak demand season in the first half of 2019. Maintenance schedules are still being finalised. But several turnarounds in the Mediterranean region are already due to take place in the first half of 2019.

Portuguese refiner Galp 110,000 b/d Oporto facility will shut down in March for a month's maintenance work. The shutdown follows a 10-week shutdown in late 2018 for maintenance work. The earlier shutdown provided little upward price support because of weaker demand and sufficient market availability. Algerian state-owned Sonatrach's 170,000 b/d Augusta refinery will undergo six to eight weeks maintenance starting in the first quarter. The facility is home to the largest base oil unit in Europe, with a nameplate capacity of 782,000t/yr. In Russia, partial maintenance is scheduled to take place at Gazpromneft's Omsk Group I base oil plant from early March.

Persistent surplus supply could limit producers' leverage to raise European prices in response to higher feedstock costs, in the same way it did last year. Crude prices rose in the third quarter of 2018 to their highest levels since 2014. With producers unable to raise prices in response, base oil margins slumped. Some producers trimmed run-rates in response. A slump in crude prices during the fourth quarter of 2018 then triggered a sharp rebound in base oil margins, although they remained historically low. Any moves to cut output in 2019 in response to weaker margins should add price support.

Group I producers will prioritise keeping domestic prices firm by clearing surplus volumes through the export market. Such a move would impact the spread between domestic and export prices. A similar strategy in 2018 prompted a widening of the domestic-export spread from less than $50/t in the first quarter of that year to close to or above $100/t by the end of the year.

But overseas demand from more typical outlets like Turkey, India, the Mideast Gulf and Africa has been slowing. The trend reflects the uncompetitive price of European exports versus those markets' domestic supplies, and versus exports to those markets from other regions.

A repercussion of Turkey's economic crisis was sharply lower demand for Group I SN 150 and SN 500 supplies from Europe. European Group I base oil prices were also uncompetitive versus US Group II supplies and Asia-Pacific Group II/III base oils into India, Mideast Gulf and Africa. That trend has already extended into the start of 2019 and shows signs of extending longer. The prospect of the start-up of new capacity in the Asia-Pacific region and a relatively light round of global plant maintenance in 2019 is likely to sustain plentiful availability to move to other markets this year.

Bright stock was an outlier in 2018, mostly because of strong overseas demand from Egypt. EGPC's 115,000 t/yr Group I unit at the Alexandria refinery that was taken off line in October 2017 will restart in the first quarter of 2019. The resumption of supplies from that plant will follow shortly after the start-up of Luberef's additional 80,000 t/yr of new bright stock capacity in the Mideast Gulf in late 2018.

The Group II base oil market faces the prospect of pressure from rising supply. But tighter engine oil regulations and fuel efficiency requirements by European Automobile Manufacturers' Association (ACEA) are driving demand that will help to absorb this availability.

Falling prices in US and Asia-Pacific markets in late 2018 prompted a surge in discounted Group II exports from those markets to Europe. These added to a wave of supplies already moving to Europe from those markets. Asia-Pacific base oil exports to Europe exceeded 400,000t in 2018. US Group II exports to Europe rose to more than 850,000t in the first 10 months of last year.

Commercial sales of Group II base oils from ExxonMobil's new 1mn t/yr plant at Rotterdam are due to begin in first-quarter 2019. The new plant will quadruple current regional production capacity. Regional demand would need to increase sharply to absorb this combination of new regional supply and rising imports. One way to speed up demand growth would be a narrowing of the spread between Group I and Group II prices to encourage a switch to the premium-grade product in lubricant formulations.

Group II base oil prices were steady throughout 2018, prompting a steady widening of their premium to Group I prices. Their firm prices reflected rising demand for the product as blenders readied for implementation of the ACEA 2016 engine oil sequences at the end of last year.

The sequences outline a minimum standard for engine oils in Europe. Regular updates of those sequences include increasingly stringent testing and higher pass thresholds to ensure that engine oil formulations can withstand higher temperatures in combustion engines, increased use of biofuels and the push for fuel efficiency and economy. Formulations using Group I base oils increasingly struggle to fulfill those requirements. That difficulty in meeting these minimum requirements is set to gather pace as ACEA releases even tighter rules over the coming years.

Rising demand and steady supply helped to support Group II prices. This is in contrast to the slowing demand and plentiful supply that put growing pressure on Group I base oil prices from mid-2018. The result was an increasingly wide price spread between the two groups as their fundamentals disconnected.

Group II light-grade prices ended 2018 at a premium of more than $180/t to domestic SN 150 prices. That was up from an already high premium of around $100/t at the start of the year. Group II heavy-grade prices ended the year at a premium of more than $250/t to Group I SN 500, up from a $140/t premium at the start of the year. The trend reflected the growing structural disconnect between the two markets and the growing danger of linking Group II base oil supply contracts to published Group I base oil prices.

Group III prices are likely to remain mixed throughout 2019 as a result of diverging market fundamentals for base oils with and without original engine manufacturer (OEM) approvals.

The European market faced an increasingly regular and growing flow of Group III supplies from Russia and the Mideast Gulf in 2018. This rising supply of base oils without approvals kept spot prices in a narrow range throughout the year, especially for 4cst base oils. These supplies are likely to impact the Group III market in a similar way in 2019.

Prices for these unapproved supplies were competitive against supplies with approvals. They were also increasingly competitive versus Group II supplies. This prompted some blenders to turn to these supplies instead of using Group II base oils.

Group III prices rose strongly in late 2017 and early 2018 ahead of a raft of global Group III plant maintenance from March. Prices then trended lower after supplies normalised following the completion of that maintenance. But prices for Group III base oils with OEM approvals held increasingly firm relative to supplies with no or limited approvals. The result was a widening spread between supplies with and without approvals to as much as $250-280/t by year-end.

The Group III market faces a lighter round of global plant maintenance in 2019, compared with last year. South Korea's S-Oil will undergo planned maintenance at Onsan in March. But it has been stockpiling supplies at its European storage to cover term demand. Tatneft will also have maintenance at Nizhnekamsk in March, which will impact supplies of light grades for export.

European blenders have a growing number of supply options Group for I, II and III base oils in 2019. Global supply will add to downward price pressure for all three groups and mitigate impact of regional or global shorts. Price competition between groups and suppliers will be a key driver in the evolution of the European market as it switches from Group I to Group I/III base oils.