Downstream's Challenges in 2008

Oil executives will be looking back at 2007 as another bumper year for refining and marketing, but concerns have been growing. Worldwide, margins were stronger than ever, driven by new highs in the US and increased resilience in Europe and Asia. However, in this exceedingly positive environment, some refiners have posted very disappointing earnings, raising concerns about their ability to perform in less favorable environments.

In addition, results of heavily localized operators were erratic, with the earnings of US-centric players dropping off sharply in the third quarter when product price increases were unable to keep up with the rapidly rising cost of crude. European refiners were better shielded from this phenomenon but inevitably suffered from the progressively weakening US dollar.

Less encouraging is evidence that costs are becoming more problematic. Operators in many regions are bemoaning a dramatic increase in the cost of refinery upkeep and maintenance, confirming that the fairly modest cost growth of the 80’s and 90’s is now history. This issue will plague operators for the foreseeable future, putting a serious dent in profits. However, on the marketing front, despite a dramatic rise in crude and product prices, margins have withstood significant pressure, proving a boon for players with aggressive retail strategies and significant stakes in marketing assets.

Lack of refining capacity remains a crucial concern among consumers and investors alike. The refining industry remains exceedingly tight, though the startup of key projects in India (Jamnagar), China (Huizhou) and Mexico (Minatitlan), together with smaller projects elsewhere, are likely to ease tensions. PFC Energy expects 1.90 mmb/d of new topping capacity to come online in 2008 – a 2.25% increase – as well as 1.82 mmb/d of new conversion capacity.

There are concerns on how the expected economic slowdown could affect oil product demand. In addition, uncertainty abounds as to the eventual effect of $90-100/bbl crude on elasticity of oil demand. This can only become clear once costs are fully passed on to consumers. In the US, which still accounts for 25% of world oil demand, gasoline expenditures as a percentage of available income are dangerously close to the highs witnessed in 1980-82, which subsequently led to a ten percent drop in demand. However, the world has changed and the US is no longer the only region to focus on when it comes to fuel demand; in fact, since the 80’s oil shock, a significant portion of new demand has come from oil exporting nations, where a rise in crude price can in some cases actually lead to increased consumption. In addition, some two thirds of new demand has come from markets where oil products are heavily subsidized (China, India, Middle-East), and where pricing mechanisms mean that demand is unlikely to collapse, even in a high-price environment.

Consequently, 2008 is shaping up to be a more difficult year. The most likely scenario is one in which margins remain very volatile amidst rising operating costs, potentially leading to substantially weakened earnings. Furthermore, with the age of downstream mergers nearing an end, new players are moving in causing the re-fragmentation of certain markets, particularly in Europe. The emergence of new downstream giants (Reliance, CNPC) deploying markedly different business models will undoubtedly be significant. IOCs can no longer hope to solve a potential decline in their earnings by simply resorting to mergers. Last but not least, with companies needing to maintain stable and healthy downstream cash flows, rising crude prices and maintenance costs will surely require greater management attention.

Key Messages:

2007 was another year offering an extremely positive margin environment; however not all oil companies were able to capture the full benefits of this environment. But throughout 2007, concerns have been rising, among which growing costs, and the possible negative impact on demand of crude prices close to the $100/barrel are the most significant. PFC Energy foresees that 2008 is likely to be a more difficult year for the downstream oil sector in most markets.

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