Mirko Rubeis* Falling oil prices have deeply affected the oil and gas upstream (exploration and production), with many projects shelved or put on hold globally. For much of the downstream sector though, the current environment also provided cheaper feedstock (crude oil) and a sudden stimulus to demand. In line with this, over the past few months, the plunge in oil prices has helped temporarily improve refining margins across Europe and Asia. In fact, it assisted in the erosion of some of the supply advantages enjoyed so far by US refiners. Different factors have supported this: firstly, the slower production growth of US shale oil and the removal of some infrastructure bottlenecks narrowed the price differential between WTI and Brent, a key advantage of US refiners. A stronger dollar further contributed to the reduction of the competitive position of US players. This doesn't mean that US refiners will be lagging behind anytime soon; these companies will continue to hold a competitive edge, particularly given their gas and energy costs, which are lower than their competitions' in Europe and Asia. Overall, sinking oil prices have indisputably served as a shot in the arm for the downstream sector in the short term. The fundamental challenges for the refining industry, however, remain. The global refining market is set to remain oversupplied in the coming years and this overflow could only be alleviated if low prices persist – as this would, in turn, substantially boost economic activity – and a large portion of planned refining projects are cancelled. Even in the case of persisting low crude oil prices, several questions exist on the degree to which demand could significantly increase in the medium or long term. Efficiency and substitution (biofuels, natural gas, and electric vehicles) may limit the demand growth upside. Furthermore, in many Asian countries fuel prices remain regulated (subsidized) and the impact of lower oil prices on demand could not be immediate – or if these countries decide to take the opportunity to remove the subsidies when oil prices are low (to limit price increases when subsidies are lifted, and therefore mitigate public malcontent - i.e. what India and Indonesia have just done) prices could even increase, adversely impacting the demand (particularly when oil prices rise again). Based on this, we expect that refining margins will remain under pressure for the medium and long- term, largely due to overcapacity and relatively slow demand growth. In the Middle East, refiners have reaped significant benefits from the temporary overall improvement in margins. For GCC countries that have invested heavily in the downstream sector (such as Saudi Arabia), higher downstream margins have provided partial relief from the drop in crude oil revenue. Despite the fact that most national oil companies (NOCs) in the region are integrated along the value chain – and more rigorous capital discipline is being exercised not only upstream but also downstream – no major refining projects have been shelved to date. This is also because, prior to the sharp slump in oil prices, numerous mega-projects were already in advanced stages of development or close to completion. With two world-class refineries (SATORP and YASREF) starting operations in Saudi Arabia and the expansion of the UAE's Ruwais Refinery being completed (among other projects), the Middle East has emerged as a formidable global player in the refining sector and a key exporter of refined products, particularly diesel. This increased exposure to an oversupplied refining sector (to which Middle East contributed significantly) requires Middle Eastern players to step up the game and improve their ability to compete more aggressively in the market in order to extract value from their new, large, and complex but costly assets. Scale, supply advantage and location may not be the only attributes sufficient to ensure satisfactory returns anymore. We identified four key opportunities for Middle Eastern downstream players: • Focus on operational excellence • Build strong trading capabilities • Expand internationally • Advocate for subsidies reduction/removal on refined products In the first place, Middle Eastern players need to focus on operational excellence. Despite being a topic of conversation amongst Middle Eastern refining managers for years, operational efficiency in the region still lags behind international best practices. Limited pressure on reducing personnel (due to the role of NOC employers), subsidized gas/energy, and security of supply considerations often prevailing over bottom line focus, are among the reasons for the efficiency gaps that still persist in the region. In our experience supporting over 30 worldwide IOC, NOC and independent refineries, a systematic profit improvement program can result in 1-2 $/bbl margin improvement, acting on technical levers such gross margin optimization, energy management, maintenance, auxiliary operations; as well as on 'soft' levers such as organization and culture to 'hardwire' in the employees certain desired behaviors, required to make the change and the gains sustainable over time. Once the manufacturing efficiency is improved, Middle Eastern players should also improve the way in which they market their products. Particularly in today's volatile market environment, Middle East's O&G companies should consider strengthening their trading capabilities and making additional investments in logistics assets in markets spanning Asia, Africa, and Europe. This could help them efficiently dispose of the growing export product volumes coming from their domestic assets, as well as securing the products needed for their domestic markets. A strong trading arm could make the argument for complete domestic self-sufficiency across all products less compelling, and provide an alternative to further large grassroots domestic refining investments, often designed primarily to satisfy local demand. The configuration and scale needed to make these assets economically viable often results in mega-complexes that rely on large export volumes to sustain their economics. This trend is precisely what contributed to the current refining glut. Future refinery investments in the Middle East should be uniquely driven by economics and profitability, rather than security of supply considerations (which is obsolete in an increasingly liquid refined products market anyway). In the current environment, a further opportunity for Middle Eastern producers is to increase their presence in international refineries. In fact, in addition to causing a steep fall in oil prices, the oversupply of crude has triggered a fierce battle for market share among crude oil producers. As a result of this ‘war', owning interests in international refineries – a strategy pursued in the past by countries such as Saudi Arabia, Kuwait, and the UAE, for different reasons – has now become a strategic advantage. Investments in refining assets in key markets help secure the placement of volumes and curb the need to slash crude official selling prices (OSP) to defend market share. This is a clear example of value from integration, questioned in the past years of high oil price and low refining margins. Last but not least, today's low-oil-price environment presents an opportune moment to eliminate or reduce subsidies on refined products – a major burden on the region's government budgets and oil downstream companies' P&Ls. The UAE has set the example and the hope is that other countries will follow. * The writer is Principal at The Boston Consulting Group Middle East
