January 2019

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Viewpoint: The NOC-on-effect—Transforming the face of the refining industry

A new era of game-changing competition is about to take over and transform the refining industry as we know it.

A new era of game-changing competition is about to take over and transform the refining industry as we know it. As national oil companies (NOCs) increasingly gain prominence in the refined oil product markets, we will see new capacity startups in Kuwait, Oman, Saudi Arabia and other Middle Eastern and Asian countries. As a result of a move toward greater product surpluses, the Middle East will see interregional margins narrow and Asian and European competition will be enhanced.

Oil companies will soon become accustomed to a new reality, where NOCs emerge within markets previously domineered by traders and international oil companies (IOCs). To future-proof their current investments, oil companies must adapt quickly and embrace this new reality. How will the dominance of NOCs as an oil market force change the industry?

Global competition

Historically, the traditional oil refining economic model favors building refineries (FIG. 1) closer to demand than to supply. This is driven by the differential economics of moving feedstocks in bulk on large “dirty” tankers vs. moving multiple “clean” products short-haul in more expensive, smaller parcels. Logistics issues can also limit trade in crude and products, as port and working capital constraints dictate what can be built close to markets.

FIG. 1. The traditional oil refining economic model favors building refineries closer to demand than to supply. However, the model is changing with new export-oriented refineries being built closer to sources of crude oil production.

However, the model is changing with new export-oriented refineries being built closer to sources of crude oil production. In Saudi Arabia, new Saudi Aramco joint venture (JV) projects have been launched in both the eastern and western regions of the country: YASREF, with Sinopec at Yanbu, and SATORP, with Total at Jubail.

Both YASREF and SATORP oil refineries have nameplate capacities of 400,000 bpd and supply products for both domestic consumption and export. In the UAE, state oil company ADNOC has expanded its Ruwais capacity by building a 417,000-bpd, full-conversion oil refinery.

While these projects have defied conventional economic rationale, they share similar drivers that make them attractive to sponsoring countries. Although they may sacrifice some of the cost advantages of being close to the product demand, they are able to buy crude at the free-on-board (FOB) price and offset some of the cost of moving products to distant markets. Product freight rates have been historically low for some time due to the glut of tanker capacity. Lower rates have narrowed the cost disadvantage of siting oil refiners farther away from product demand, which means they extend the reach of both new exporters and other extra-regional competition.

Finally, although the return on investment (ROI) for these expensive, newer oil refineries may be lower than hurdle rates for some IOC investors, favorable access to capital, the latest technology design advantages and the multiplier effect of local economic activity in NOC economies make these projects positive value generators for NOCs, which can take a longer-term perspective on capital investment than IOC competition. These investments also bear secondary economic dividends by creating skilled employment opportunities for the local, often young, workforce and by diversifying the national economy away from only crude oil production and export.

NOCs are also beginning to work around the limitations of regional product markets by expanding their own commercial and trading operations. On the back of their recent project startups, both Saudi Aramco and ADNOC are demonstrating new commercial acumen, with Aramco now streamlining its businesses and opening itself for scrutiny ahead of a planned IPO. Similarly, parts of ADNOC are being privatized and the company is seeking a strategic partner for a new asset-backed trading initiative in the wake of a new commercial approach. Oman Oil Co. is reportedly seeking advice on its own IPO and planning the construction of a new 230,000-bpd JV oil refinery in the special economic zone at Duqm on the Arabian Sea coast, far from existing demand centers.

Outside of Middle East oil exporters, we see signs that others have caught the spirit of this new age. Mexico’s Pemex has been working on major strategic initiatives to revitalize both its upstream and downstream oil and gas sectors. The long work of constitutional reforms has now freed the country from a crippling dependence on domestic ownership, control and content.

However, the evolution of NOCs along more commercial IOC lines is still hostage to the inertia of the “old” way of doing things. The urge for central control and state regulations that do not keep pace with privatization can create unexpected pitfalls. Pemex has been unable to invest sufficiently because state control of oil product markets, prices and import/export policies are constraining the NOC’s cash flow. A similar situation exists in Colombia.

The battle for dominance

With a few notable exceptions, NOCs have largely focused either on their own domestic oil product markets or very clearly defined integrated entries into key export markets, largely in Asia. To date, their investments have been principally focused on securing crude oil export outlets in return for equity in downstream companies and retail concessions. However, as NOCs expand their export-oriented capacity, they will increasingly be seeking commercial markets for their own surplus refined products.

India and China are Asia’s two most important product markets, but strategically both are looking to maintain domestic oil refining capacity in balance with growing demand. NOC product exporters are, therefore, increasingly likely to find themselves competing with IOC majors, traders and, eventually, themselves as they look to carve out routes to market for their growing surplus of products. Middle East exporters will soon find that their crude exports to refiners in Asia will put them in competition with their own refined product exports.

Successful transition from an NOC to an IOC-style model is not only dependent upon the downstream entity, but also on the state ceding control. When these transitions occur, then NOCs like Pemex and Petrobras should be able to up their game and increase their access to regional markets. However, this largely depends on a cultural change in the state regulatory environment.

Changing how we define competition: NOC-on-NOC

Historically, NOCs have controlled oil product imports by applying a variety of barriers, including taxes, subsidies, duties, access to distribution infrastructure and even retail licenses. Many of those obstacles are still in place but are costly and ineffective. Some Latin American countries that once controlled oil product retail are becoming more liberalized (e.g., Mexico). Others, such as Peru, Colombia and Venezuela, have been forced to import despite persistent economic barriers, as domestic demand growth outpaces domestic supply and oil refining investment. Refined product imports from Middle Eastern NOCs are increasingly seen as the new normal, and the clear lines that once characterized a company as either an NOC or an IOC are starting to blur.

Today, Aramco is an NOC. Soon, it will offer shares on various equity markets and effectively transition to an IOC—with the associated public stock market accountability. Colombia’s Ecopetrol, Malaysia’s Petronas and Mexico’s Pemex are NOCs that have become more IOC-like in their actions. Vietnam is not far behind, with another oil refinery planned that will pivot the country into a product surplus.

Conversely, we are also seeing signs of state involvement in non-NOC entities. In Canada, the Alberta government is backing the Redwater upgrader project in cooperation with private sector investors. Brazil’s ethanol industry and China’s quasi-public refiners are other examples where state involvement props up private sector investment.

NOCs are evolving into IOCs and, at the same time, states are investing in the IOCs. Conventional classifications are beginning to fragment.

As NOCs spread their wings in the competitive space, the potential for NOC-on-NOC competition grows more likely. Signs are emerging as multiple Middle Eastern NOCs target the same Asian oil product demand. Not only are Middle Eastern NOCs going head-to-head against one another for Asian market share, they are also starting to compete against their own JV interests in those same Asian markets. The more commercial NOCs become, the more they must face the realities of competition, even among their own stablemates. With more new projects launching between now and 2022, the market will only become more competitive, and more exports from NOCs means more imports elsewhere.

The transformative development of NOCs from national champions to global competitors reflects a strong desire on the part of national governments to be the “last man standing” as forecast demand for refined oil products, particularly transport fuels, begins to plateau in the 2030s. As refined product demand dwindles due to increased electrification and use of other fuel alternatives—even while an adequate global supply of petroleum products exists—it is not enough to have the resources in the ground; it will be necessary to survive and thrive on thinning refining margins, a higher regulatory burden and a shifting product demand barrel. The long-term income stream from hydrocarbons will remain critical to OPEC and other oil-exporting economies, and their competitive repositioning is designed to move them from their role as national champions to a global base load.

Crucial investment in operational excellence

The implications of this transition are profound, both for NOCs and non-state oil refiners. A more globalized oil products market signals tighter margins, which in turn should drive investments in operational excellence and discipline in capital allocation. NOCs (and even IOCs) that do not respond to these signals will lag their counterparts and limit their options in an increasingly global commodity market. Narrower margins will then constrain new capital investment, in turn giving preference to companies that are operating either on more commercial lines or that have a private source of capital.

Markets are not standing still. Scale and efficiency will become more important in the refining sector after 2020, and oil refiners will need to respond to new challenges, including carbon emissions reduction, marine fuel sulfur reductions, and the evolving refined product demand barrel moving away from transport fuels in favor of petrochemicals and renewable alternatives.

For oil refiners, the market environment will determine their best response to the challenges ahead. As NOCs evolve, they must focus on full-scale business transformation programs to maintain cost competitiveness and optimize capital employed to achieve higher net margins in competition against their peers and highly efficient export refiners.

By setting out a program of continuous improvement, operational excellence focuses on the areas in an organization where improvement is required and delivers sustainable performance improvements that provide real value to the bottom line.

To future-proof their assets, oil companies must adopt a new reality where NOCs will begin to infiltrate markets previously dominated by traders and IOCs. Smaller, independent oil refiners must leverage further opportunity crudes and become more agile, developing flexibility across their products to include new markets only accessible through trade or enhanced commercial operations. Value chain optimization opportunities should be a primary focus for IOCs, with attention paid to integrating refining with petrochemical production, widening feedstock and product slates and creating the potential to produce, at a low cost, additional unfinished intermediates that will boost overall net profit levels.

As the face of the oil refining industry continues to develop, oil refiners must consider their own response to these emerging forces set to change the face of their global competitors. HP

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