Base oils supplement: After the storm, group I outlook remains cloudy

20 February 2012 00:00  [Source: ICB]

European Group I base oil suppliers endured a turbulent second half of 2011 as prices fell through the floor. But the storm, at least for the time being, appears to have passed, and stronger market sentiment is emerging.

Although the outlook is far from certain, for the first time since mid-2011 Group I prices in western Europe are threatening to increase, while in the Baltic Sea, minor increases have already been realized. A shift in the euro-to-US-dollar exchange rate and ongoing firm crude oil prices are the main catalysts for this shift in pricing sentiment.

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As we head into 2012, demand for Group I base oils is improving, which is also providing some support. This is in stark contrast to the second half of 2011, which saw demand evaporate, suppliers' stocks mount and prices slide by more than $400/tonne (€304/tonne) in some cases. The period was certainly one suppliers would like to forget.

The downgrading of the US sovereign debt and the burgeoning eurozone financial crisis were among the elements which caused economic uncertainty run rife during the second half of last year.

Crude oils prices fluctuated dramatically, and commodity prices felt the pressure. The chart shows how European and Asian base oils price reacted, slipping radically from the middle of the year onwards as demand collapsed with buyers in hiding.

With prices sliding steadily, Asian buyers adopted a cautious approach and arbitrage opportunities for European sellers became scarce. Despite the recent improvement to sentiment, Group I producers' margins remain a concern. As the other graph shows, feedstock vacuum gasoil (VGO) prices saw less of a slide during the second half of 2011, causing base oils suppliers' margins to shrink accordingly.

MARKET DISCUSSION

Healthy profit margins for suppliers in the first half of 2011 postponed talk of the gradual structural shift away from Group I base oils to Group II and Group III. This time last year, it was arguably "business as usual" for Group I suppliers. This is not the case this year, as the recent price slide has brought this issue back to the forefront of market discussion.

If Group I prices do not climb upwards, and assuming feedstock costs remain high, producers have a decision to make: reduce production rates or face squeezed margins. Several Group I producers in Europe have already cut production in recent months in a bid to balance supply and demand.

Last month, a major producer active in both the Baltic and Black Sea markets reported that it was reducing base oils production during January and February because of the narrow spread between base oils prices and VGO prices. It reports it is producing no spot product as there is no economic motivation to do so. Instead, it is reportedly only covering existing commitments.

Europe continues to lag behind in its consumption of Group II and Group III base oils, but the past 12 months have seen some interesting developments regarding the move away from Group I dependency. Group II and Group III are growth areas of the global market, and production developments over recent months support this view.

In October 2011, the Switzerland-based refinery operator Petroplus announced that it intended to suspend this year's turnaround of the base oil complex at the Petit Couronne refinery in France, and instead was considering a reconfiguration of the refinery, which would include a shutdown of the 320,000 tonne/year unit.

At the start of 2012, Petroplus decided to shut down operations at three of its refineries after its lenders froze $1bn (€0.77bn) in credit lines. Petit Couronne has since been safely shut down.

Obviously, shrinking Group I base oils margins are not the sole reason for such developments, but they are part of an environment that shows the position of Group I base oils in Europe changing. "We are still projecting significant shutdowns of Group I production over the next five to 10 years," says Milind Phadke, industry manager for energy at US consultancy Kline & Company. Pressure on suppliers' margins plays a role in this, adds Phadke, as does imbalanced supply/demand.

The largest factor supporting the structural shift away from Group I remains the fact that more sophisticated lubricants are increasingly being demanded by more advanced engines.

Largely because of this, the outlook for Group III base oils remains extremely positive. "It [Group I] is a tough sell at the moment," says a northwest European base oils distributor, adding: "Most of the new formulations are based on Group III."

A different base oils distributor mirrors these sentiments, stating that changing car fleets in Europe have seen demand for Group III base oils increase threefold over the past five years. Leading formulations have less and less Group I elements, states the source.

This issue was highlighted by Brent Lok, manager of base oil marketing and new business development at Chevron, at last year's NPRA International Lubricants and Waxes Meeting, in a presentation called Is Group II The New Group I? Planning for Complexity in a Global Market.

Historically, he said, supply in a region drives the specifications used, Accordingly, he added, Europe has traditionally been dominated by Group I. However, this is being called into question by new specifications and new supply sources, which both point towards Group III and Group II base oils.

Accordingly, premium base oils are being pulled into Europe: Group III from Asia and Group II from the US. Lok concluded that "tightening automotive specifications will see lubricant manufacturers needing to hold all three base oils, so in Europe's case not simply Group I product."

Kline's Phadke also references the structural shift, stressing the importance of this demand creation in the structural changes seen. Globally, Group I supply is declining while new supply is focused on Group II and Group III.

Chevron's 25,000 bbl/day Group II plant at Pascagoula, Mississippi, US, is progressing toward a 2013 completion. This new plant has an eye towards supplying growing European demand, among other areas. Finland's Neste Oil and partner Bahrain Petroleum Company (Bapco) recently inaugurated their 400,000 tonne/year Group III base oils plant located at Bapco's refinery in Sitra, Bahrain.

The plant started commercial production in October last year, with the first export cargo arriving in Europe in December. South Korea's SK Lubricants' joint venture with Spain's oil major Repsol to build a new 630,000 tonne/year Group III base oil plant in Cartagena, Spain, is expected to be on stream in 2014.

Phadke says these new plants will strain European Group I producers, which used to enjoy active exports eastward. Group I producers have limited export markets and have a logistical disadvantage compared with Middle East and Asian plants when catering to Asia, he says.

"These will put more and more pressure on Group I plants. They do export to North Africa and South America but somewhere down the line that is going to be really difficult to do."

When discussing the recent slump in Chinese demand for European Group I product, he adds: "[South] Korean production is ramping up and the capacity within the country [China] has increased for Group II and Group III. There is less desire to use European Group I." Phadke adds that this trend would likely be seen across Asia, not simply in China, because importing locally produced Group II and Group III would eat into imports of European Group I.

Looking ahead, if European Group I base oils prices do rise this will ease suppliers margins and could postpone production decisions over the short term. However, the growing need for Group II and Group III base oils will continue to eat into the Group I base oils market position.

While Group I trade will remain dominant in Europe, certainly over the medium term, further production developments cannot be ruled out in 2012.

• Carl Roache is ICIS senior editor manager for crude products, including base oils, in Europe. He is based in ICIS's offices in London

By: Carl Roache
+44 20 8652 3214

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