Crude oil, refining and base oils - whats’ going on?

20 February 2012 00:00  [Source: ICB]

© Rex Features

Lubricants and base oils represent only about 1% of global oil demand, but they have had an outsized influence on the development of the world petroleum industry. In the early days of the oil industry, lubricants were one of the most important products, and availability of high-quality lubricants spurred advances in automotive technology and, ultimately, fuels demand.

Since the mid-1990s, base oil production technology has been at the forefront of technical innovation in refining, and base oil capacity is now expanding at unprecedented rates. However, base oils and lubricants remain a small part of the total refining picture and base oil prices and economics are still inextricably tied to crude oil and refined products.

With a few notable exceptions, base oils are produced in facilities that are integrated with refineries producing fuels and other refined products. The feedstocks that move into base oil production have alternative destinations in fuels operations and many of the by-products of base oil production move back to the fuels side for processing and blending.

As a result, base oil production must compete with fuels production for feedstocks, considering the value of both base oils and by-products. This feedstock competition is the most important mechanism that links base oil refining economics to fuels-refining economics, tying base oil prices to crude oil and refined products.

In addition to the competition for feedstocks, the cost structure of base oil plants also ties base oil economics to fuels and refined products. Most of the variable operating costs for base oil plants are tied to fuel and electric power prices, which have strong links to crude oil and refined products. These base oil variable costs combine with the fixed costs of operation to yield the total plant operating cost.

Most European base oil plants are integrated into fuels-producing refineries and the region acts as the world's swing supplier to the export market. Because of that role, European solvent Group I plants can be considered the incremental source of base oil production to the global industry.

The diagram below presents the estimated cost of base oil production for a Mediterranean solvent refining plant processing vacuum gasoil (VGO) to produce solvent neutral oils. The value of the by-products (primarily extract and slack wax) has been subtracted from the cost of VGO feedstock, which is plotted as the net feedstock cost.

By 2011, the total cost of production was more than triple the levels that prevailed from the late 1990s through the early 2000s. Crude oil and refined product prices began to increase rapidly in 2004, reaching a peak in 2008 and then falling sharply with the global recession in 2009-2010. In 2011, however, the global economic recovery supported higher prices, surpassing the 2008 peak on an annual average basis. The impact of higher energy costs can be clearly seen in the increased variable operating costs. The diagram also presents historical prices for European export-mode prices for 150N base oil (sourced from ICIS).

Historical base oil prices closely follow the estimated incremental cost for the European producer. Refining costs certainly appear to be the primary driver for Group I base oil prices in this key price-setting market, with the overall level of crude oil and refined product prices the most important influence.

In 2011, crude oil prices remained remarkably strong in spite of continuing economic uncertainty and the ongoing Eurozone crisis. Asian and Middle Eastern demand growth remained strong, and the supply disruption caused by the Libyan political transition contributed to a tight market.

In addition to these short-term concerns, longer-term fundamentals support a sustained high crude oil price environment.

Over the past several decades, oil use has become more and more concentrated in the transportation and petrochemical sectors. In these sectors, refined products are not easily substituted, and the available substitutes are generally priced high. Oil use in lower-value sectors such as electric power generation, in which oil has low-cost and abundant substitutes, will continue to shrink. As a result, the structure of oil consumption will support higher prices than historical levels, even while these higher prices encourage continued improvement in consumption efficiency.

Analysis of the industry's costs to find, develop and produce new reserves shows that costs have risen rapidly in recent years thanks to increasing reliance on hostile environments, such as deepwater or Arctic areas, and high-cost supplies, such as synthetic crudes from oil sands. Upstream capital costs have remained high, with limited impact seen from the 2009-10 recession.

WHAT'S WRONG WITH WTI?

WTI (West Texas Intermediate) and Dated Brent are the most actively traded crude oils in the financial markets, and so have global importance. However, WTI is also tied to its physical location and local factors determine its value relative to other international benchmarks. Starting in early 2011, the price of WTI appeared to disconnect from the international market. The WTI-Brent differential, which had averaged close to zero, dropped to discounts of $10/bbl and more, hitting lows of about $30/bbl in late summer. Surplus crude supply in the US mid-continent had developed because of expanded Canadian supplies and rapid growth in domestic crude production from the Bakken shale formation in North Dakota.

With no pipeline capacity to relieve the surplus, WTI prices were pushed down to levels below rail freight costs and then below trucking freight costs. The announcement of new crude pipeline projects in late 2011 appeared to change the market psychology, and the WTI discount moved up to roughly $10/barrel, consistent with trucking costs.

The WTI price discount is expected to remain close to trucking costs in the near term, but then to move up to rail cost- and pipeline levels as new transportation capacity develops. The timing of these movements will depend on the dynamic between production capacity growth and transportation system improvements, but it appears likely that WTI will come into closer parity with the inter­national market within the next two years.

HOW IS REFINNG ADAPTING?

While the absolute level of crude oil prices is the most important determinant of base oil prices, developments in the global refining ­industry are the major influence on base oil capacity expansion. Crude supply, product demand, and product trade changes are all ­influencing refining investment patterns, with significant impacts on base oil investment.

The growth in North American crude oil production, from the Canadian oil sands, as well as the Bakken and other shale formations, is creating a significant competitive advantage for US refiners. The shale boom has also ­increased natural gas supply, lowering operating costs for US refiners. Based on these advantages, US refiners have expanded diesel ­exports, and sharply lowered gasoline imports. These changing trade patterns have affected all refining centers that have traditionally served the US market, such as the Hovensa refinery in the US Virgin Islands, which has recently announced plans to cease operations.

European refiners have also been affected, resulting in financial pressures and closures. At the time of writing, the Petit Couronne refinery in France, owned by Switzerland-based Petroplus, has ceased operating, affecting both fuels operations and its base oil production facilities.

As pressures grow, more European refineries are expected to close. Those with base oils are not immune from the pressure, and their base oil production will likely cease along with fuels production. Those that can extract maximum value from waxes and specialty products will be advantaged, but even their survival is not assured.

While the outlook for refining is bleak in the Atlantic Basin, the East of Suez region is experiencing a boom. Buoyed by robust demand growth, many large expansions are slated for the Middle East and Asia. Moves to upgrade product quality and to respond to rapid global growth in diesel demand are encouraging significant growth in hydrocracking.

Group II and Group III base oil projects provide an attractive path to increase the value of hydrocracking investments. More than 5.0m tonnes/year of new Group II and III projects (excluding the Shell Pearl Gas-to-Liquids project) are expected to start up by 2015, most of which are integrated with fuels operations. This new capacity will put further pressure on European Group I producers, and will turn the Middle East into a significant net exporter of base oils.

WHAT DOES IT MEAN FOR BASE OIL?

These regional and global developments mean that the pace of change in base oil supply is accelerating rapidly. The coming wave of capacity expansion means that new suppliers will be producing new products, and expanding from their traditional supply areas to new markets. As Group II and III supplies and consumption expand, less-competitive Group I producers will continue to shut down, and even the most competitive will face economic pressures.

For base oil purchasers, it will be a time of changing supply relationships, formulations, and competitive realities. Base oil suppliers will face real marketing challenges, and will need to develop and deepen customer relationships. Base oils will remain a small contributor to the volume of world petroleum demand, but will remain a large contributor to petroleum's value to producers and consumers.

• Blake Eskew is senior vice president and Geoff Houlton a vice president at Purvin & Gertz, based in Houston, Texas. Go to www.purvingertz.com for more information

Author: Blake Eskew

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