2021 AFPM Annual Meeting Virtual Edition: The economics of reliability: Interim report—Global refining
JEFF KRIMMEL, Pinnacle
What is reliability? Most people think reliability is simply a measure of failure, or lack of failure. If something runs for a longer period of time without failing, then it is more reliable than something that runs for less time. However, we believe that reliability is a measure of how often something performs when you want it to.
The basis for our annual and interim quarterly reports is to explore the connection between reliability and economics so that we can understand how these key components of modern society intertwine. In doing so, we begin to see some striking trends and key indicators of opportunity. Our goal for these reports is to challenge key industries in ways we never have before.
Most of the world’s industrial facilities buy and sell commodities. Therefore, they have little impact on the price they pay for their feedstocks or the price they receive for their products. The nature of every commodity is that producers will fill the market with enough product until the margins—or profits—for producing that product drop so that no one will produce more. The balance of supply and demand will, inevitably, separate out the organizations that are very good at running their facilities from those that are not. One of the biggest differences between these two groups is reliability.
Whether discussing jet transportation, power generation, water processing and treatment, chemicals, mining, oil and gas production, refining, automotive manufacturing or agriculture, reliability can mean the difference between excellence and mediocrity, and even profitability vs. bankruptcy.
Pinnacle analysts estimate that operators of complex facilities around the world spend more than over $500 B annually on reliability. Our aim is to view several of these segments in detail and better characterize the role reliability plays in the broader economy.
For decades, lean manufacturing has driven companies and operators to improve runtimes, lower costs and minimize risk for their facilities. While this push has affected multiple sectors, no area has produced as much public data as the refining sector, especially in the U.S. The Energy Information Administration (EIA) has collected and reported refining data for decades, and when combined with international reports from the Organization of the Petroleum Exporting Countries (OPEC), Saudi Arabia, and the International Energy Agency (IEA), among others, the level of information is unparalleled to other sector reporting.
Refining reliability overview—Crack spreads as health indicators. A refiner’s financial performance is largely driven by two variables: the price of raw feedstock (e.g., crude oil) and the price of finished products (e.g., gasoline, diesel and jet fuel). As a result, crack spreads—the difference in price between refined products and chosen inputs—are the most useful indicators of the health of the refining sector.
Importantly, crack spreads do not account for the cost of running the plant. Crack spreads ignore costs for items like the energy to heat and process the feedstock, the people to operate the plant itself, and all the repair, maintenance and ongoing reliability work.
If we are most interested in reliability, then why do we care about crack spreads? Over 80% of the costs for a refinery are its feedstock. Crack spreads help us understand what is left over when we remove a refiner’s single largest cost from its theoretical revenue. This leftover amount is what the refiner uses to cover its remaining costs, with ideally some profit remaining at the end. As crack spreads widen, the refiner has more capital available to invest in its operation or return to its owners. As crack spreads narrow, refiners have less flexibility and must make difficult decisions about how to deploy their limited capital. Crack spreads tell us about the resources available to invest in best-in-class reliability programs, which is our primary area of interest.
Refining financial landscape. FIG. 1 from the U.S. EIA gives us one measure of crack spread from 2006 through September 2020. The blue line shows the spot price for Brent, the international benchmark for light, sweet crude oil. The green lines show the crack spread between reformulated blendstock for oxygenate blending (RBOB)—the primary component of gasoline—and Brent. The solid green line shows the monthly average crack spread. The dashed green line shows the crack spread’s trailing one-year average.
FIG. 1. RBOB and crack spread using monthly average spot prices. (Source: EIA)
FIG. 1 shows the volatility through which refiners have learned to manage their business. Since the beginning of 2006, the smallest monthly average crack spread was $0.01 per gallon ($0.01/gal), while the largest spread was $1.32/gal. Within this window covering nearly 16 years, the crack spread has averaged $0.40/gal. In comparison, the 2020 average was $0.29/gal, a 25% drop from the historical norm. If we use consumer price index data to account for the time value of money, the average crack spread from 2006 to the present increases to $0.46/gal. In constant dollar terms, the 2020 spread was then at a 35% discount to the historical average, which explains a large fraction of the prevailing distress across the global refining sector.
We can see some interesting patterns in this data set. Starting around 2010, aggressive development of U.S. conventional oil and gas plays brought excess supply to the market. This supply glut eventually caused the crude oil price collapse of 2014. Demand, on the other hand, did not experience a similar shock, which kept product prices from collapsing as aggressively as crude oil prices did. As a result, crack spreads climbed through 2015. Over the course of a year or so, refined product prices reset to the lower oil price regime, which caused crack spreads to return to their normalized level around $0.40/gal, where they remained from 2017–2019.
As noted previously, the 2020 crack spread average was about 35% below historical levels when measured in constant dollar terms. The initial decline was triggered by a rapid deterioration in refined product consumption, driven by government lockdowns in response to the COVID-19 pandemic. Refined product consumption has only weakly recovered as government restrictions persist, combined with (at least temporarily) changed travel preferences among the general population. As a result, crack spreads saw continuous pressure throughout 2020, with the most vulnerable refineries experiencing negative margins.
The news is not all bad for refiners. Capacity reductions will accelerate the pace with which the market normalizes. As of December 2020, Pinnacle analysts estimate that 2 MMbpd of refining capacity are out of the market vs. the beginning of 2019. Therefore, the market should reach a healthy balance of consumption and production in 2021. Assuming this to be the case, Pinnacle analysts are forecasting an upward trend in refining margins through 2025.
Anticipated trends in the refining industry: The refining market will improve, but will still face challenges. Looking at global reliability spend patterns, the refining market will improve, but will still face challenges. Regulatory pressures will keep growing, placing a lid on potential future margin expansion, and slowing upstream production growth will buoy feedstock prices and compress margins (FIG. 2). In the U.S., natural gas prices are edging higher, which may reduce one of the U.S. refining sector’s largest structural advantages: the cost of energy. These pressures may be offset by announcements by companies who say they are exiting refining, but we do not anticipate this to have an impact for several years.
FIG. 2. Profitability [earnings before interest, taxes, depreciation and amortization (EBITDA)] vs. utilization by global region.
Operational improvements are coming. In the face of adverse market forces, companies are pushing harder than they have in decades to make operational improvements while simultaneously cutting costs. At the same time, virtually every major oil and gas company is investing heavily in strategic improvements, especially digital transformation. We estimate that the energy industry—including exploration and production, midstream operations and downstream facilities—are planning to spend $20 B over the next five years on these projects alone. While several challenges exist in achieving operating improvement, particularly in digital infrastructure, the potential for such improvement and cost optimization is substantial.
The pace of change is accelerating. For the first time in modern history, oil and gas majors began to diverge dramatically in their forecast of energy markets in 2020. Environmental, social and governance (ESG) pressure has been a dominant topic for the past few years, and when it comes to refining, that pressure continues to mount. A difficult economic environment in 2020 forced virtually every refiner to make massive cuts in spending, and sparked questions as to the stability of some of the facilities. In an industry with a tradition of very slow changes, future leaders will most likely achieve and maintain that position due to the pace at which they evolve and focus, in part, on improved reliability.
Takeaway. We estimate that global refiners spend more than $50 B annually on reliability-focused activities, primarily between routine maintenance efforts and turnaround programs. It’s also estimated that between 10%–30% of this spend is wasted, meaning it does not improve reliability. In fact, in some instances, we believe some of this spend may actually have a detrimental impact on performance, weighing even further against profitability. In this sense, suboptimal approaches to reliability cost refiners between $5 B/yr and $15 B/yr worldwide.
Refineries looking to minimize risk and maximize profits should focus on optimizing reliability spend and performance by:
- Developing consistent, quantitative systems for evaluating system performance
- Integrating reliability data from a range of sources and assets into single-system models to ensure the critical inputs and influences are identified
- Ensuring personnel are adapting their work processes and utilizing these systems effectively to leverage their capabilities
- Pushing past traditional decision processes or practices to uncover new opportunities and solutions.
While these suggestions sound simple, they have proven challenging for many refiners. Across the board, those that are doing all four of these appear to have both a lower risk profile and a more profitable result, validating the premise that reliability is one of the leading indicators of optimal operation.
To read the full report, please visit www.pinnaclereliability.com.
About the author:
JEFF KRIMMEL is Director of Market and Data Analysis at Pinnacle. He has extensive analytical experience in the commercial and market intelligence domains. Before joining Pinnacle, Dr. Krimmel was the Director of Pricing and Market Research at Key Energy Services. Prior to his work at Key, he held various data-driven positions in pricing and profitability, strategic marketing, and new product research and development at Baker Hughes. Dr. Krimmel earned his PhD in mechanical engineering from Caltech, where he used computational approaches to study the use of shockwaves in biomedical applications.
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