Base oils: Oversupply adds to oil prices woes

The slump in crude oil prices has had a direct impact on base oil prices, with falls of between 20% and 30% over the past year. Most analysts expect that an oversupplied market will see base oil prices continue to fall

Until mid-2014, there had been five years of relative stability in oil prices, with crude trading between $105 and $115/bbl for most of that period. So the rapid 60% fall over the past seven months was bound to make business planning – an imprecise exercise at the best of times – extremely difficult.

This applies almost as much to the producers of refined commodities and the manufacturers of a myriad downstream products as it does to the oil companies themselves. It is thus no surprise that base oil producers and their lubricant manufacturing customers enter 2015 in a state of considerable uncertainty.

Oil prices fell sharply to around $45/bbl for Brent in mid-January. That decline is much larger than for non-oil commodity prices and few observers expect anything other than for prices to remain low in 2015 and to rise only marginally in 2016.

Some, including Paul Hodges of International E-Chem, writing in the ICIS Chemicals and the Economy blog, see crude prices heading even lower. “Today it is clear there has been no increase in China’s demand ahead of Lunar New Year, and the West is having a mild winter. So the [oil] price is now highly likely to return to historical levels of $25-$40/bbl,” says Hodges, adding that “this would be good news long-term, as $25/bbl is an ‘affordable’ price for the global economy.”

Things are not much more optimistic in the boardrooms of the oil majors. In an interview with the BBC on 21 January, BP CEO Bob Dudley said oil prices could remain low for up to three years and that BP was now basing its planning on this eventuality.

What does all this mean for base oil producers and their lubricant customers? Where oil is a feedstock, downstream sectors should be major beneficiaries from lower prices, but the equation is not so simple for base oils.

INTERESTING CONSEQUENCES
“Crude price volatility has interesting consequences for base oils,” says Amy Claxton of base oils consultancy My Energy. “Fuel product prices such as diesel, petrol and jet fuel are tightly linked to crude price, and there is a short lead/lag time on price changes. Base oil markets are not as tightly linked to crude oils, however, giving rise to longer lead and lag times for price changes when crude prices rise or fall.”

Furthermore, Claxton says: “In the wake of falling oil prices, corporate capital budgets are generally among the first casualties. As such, refiners’ planned Group II and Group III base oil capital investments will face intense scrutiny and would be likely candidates for deferral.”

However, the interaction of crude prices and their impact on the world economy will have the biggest impact on the base oil sector this year. Jan Hatzius, chief economist of Global Investment Research at Goldman Sachs, says that overall we are looking at a better year for 2015 for the global economy, although there is a lot of divergence between those economies performing well – with the US at the top of the list – and those performing less well, particularly the eurozone and Japan.

“Low oil prices are an important positive for growth,” says Hatzius, but currency declines against the US dollar should also assist non-dollar-pegged countries as it will make them more competitive. “Japan and Europe face a lot more challenges; we expect lower growth numbers – maybe in the 1% range – a lot lower than the US at around 3% for 2015.

“In less developed emerging economies there is a mixed picture. Commodity producers will face a tougher time, whereas commodity importers will benefit,” he adds.

“Our expectation is that China faces a further deceleration in growth, with several years of declining growth rates. We are not looking at a really sharp deceleration, because we do think the authorities still have the ability to manage the slowdown, but we are concerned about a potentially lengthy period of weaker activity.”

WHY THE CRUDE PRICE FALL?
What are the causes of the sharp drop in oil price this time? On the supply side, US shale oil production has consistently exceeded expectations – by as much as 1m bbl/day (equivalent to about 1% of global supply) in 2014. Then there is the unwillingness of Saudi Arabia and other low-cost producers to withhold output in support of OPEC price objectives.

Saudi Arabia has traditionally acted as the cartel’s swing producer, often using its spare capacity to either increase or reduce OPEC’s oil supply and stabilise prices within a desired band. This changed completely in late November 2014 after OPEC failed to agree on production cuts. The OPEC decision to maintain its production level of 30m bbl/day signalled a significant change in the cartel’s policy objectives from targeting an oil price band to maintaining market share.

OPEC’s desired range was set to $100-110/bbl during the early 2010s. OPEC produces about 36m bbl/day, of which 30m bbl/day comes from crude oil (subject to quotas) and 6m bbl/day from liquids (not subject to quotas). Non-OPEC countries produce about 55m bbl/day – significantly more than OPEC, but nevertheless, a decision by OPEC to target market share instead of price was always going to have a major impact on the market.

On the demand side, expectations of global oil demand have been revised downwards on several occasions recently as economic growth disappointed. Between July and December 2014 alone, the projected oil demand for 2015 was revised downwards by 0.8m bbl/day.

Global economic growth in 2015 is expected to remain much weaker than it was during the 2003-08 period when oil prices rose substantially. Further, the World Bank suggests the oil intensity of global GDP has almost halved since the 1970s as a result of increasing energy efficiency and declining oil-intensity of energy consumption.

BENEFITS FROM WEAKER OIL PRICES
The World Bank suggests that a 10% fall in oil prices would raise growth in oil-importing economies by some 0.1-0.5 percentage points, depending on the share of oil imports in GDP. In Brazil, India, Indonesia, South Africa and Turkey, the fall in oil prices will help lower inflation and reduce current account deficits.

The global economy is still struggling to gain momentum as many high-income countries continue to grapple with the legacies of the global financial crisis and emerging economies are less dynamic than in the past.

The International Monetary Fund (IMF) has lowered its forecast for global economic growth for this year and next. The IMF now expects growth of 3.5% this year, compared with the previous estimate of 3.8% that it made last October. The growth forecast for 2016 has also been cut, to 3.7%.

The downgrade to the forecasts comes despite the sharp fall in oil prices, which will be more than offset by negative factors, notably weaker investment. The eurozone is a case in point. The IMF does expect the recovery there to continue, but not strongly. It is estimating growth of 1.2% in the eurozone this year and 1.4% in 2016.

The slowdown in China is a major factor behind the revised forecasts. Chinese government figures show that China’s growth slowed to 7.4% last year, from 7.7% in 2013. Next year, the IMF growth forecast for China is 6.3%, compared with an average of 10% over the three decades up to 2010.

The sharpest downgrade of all is for Russia, which is forecast to see its economy contract by 3% this year and 1% next. That is the result of the fall in oil prices and Western sanctions on Russia because of the situation in Ukraine.

The one major exception to the pattern of lower forecasts is the US, now forecast to grow at 3.6% this year and 3.3% in 2016.

The downward momentum in crude oil prices has had a direct impact on base oil prices, with falls of between 20% and 30% over the past year, depending on grade and region. Most analysts expect base oils prices to continue falling amid an oversupplied market throughout 2015.

Amy Claxton says: “Overall supply and demand play a much bigger and more independent role in base oil pricing compared to fuel product prices. As an example, today’s oversupplied 95 VI base oil market, regardless of crude oil prices, has led to much lower base oil prices. In addition, today’s short-term oversupplied 120 VI market in Asia will also endure sluggish pricing until next-generation engine oils quicken the pace for Group III base oil formulation.”

STABLE LUBRICANT GROWTH
Meanwhile, Ian Moncrieff, director, energy practice at Kline & Company, says the “big bang” in the base oils universe is happening right now. “New capacity is being added much faster than retirements, and margins are under pressure. There is a prospective oversupply in low viscosity stocks and, with Group I trending towards a specialty or niche ‘end-game,’ so Group II is now the price-setting source.”

Moncrieff says global consumption of lubricants has actually been fairly stable over the past 25 years – at between 37m and 39m tonnes/year. But from 2011 through 2017, more than 3 bbl of base oil capacity will be added for every barrel of announced Group I capacity retirements, and, as a result, already weak operating rates will remain low for the next several years, at minimum.

Kline data suggests that global base oil effective capacity utilisation dropped from 100% at the height of the boom in 2007 to below 80% in the recession induced by the global financial crisis of 2008, before rising to 90% in 2010-11 and falling back to around 80% right now. Without demand growth, the incoming capacity will see utilisation rates fall back to 75% for the next decade, it says.

“Base oil prices in all major markets are influenced by the evolving dynamics of supply and demand imbalances at the global level,” says Moncrieff, “and Group I cash margins are at, or even below, cash breakeven under current market conditions, depending on scale and market orientation.

“Margins on spot trade, as well as on lagged postings, are showing a downward cash margin trend,” he adds. “Since June last year, as Brent crude oil has collapsed… VGO [Vacuum Gasoil] and refined products have followed suit quickly. Base oil prices, notably on contract business linked to postings, have weakened also.

“If the freefall in mainstream oil prices is finally halted, we expect to see a slide in contract cash margins as the embedded lag in base oil price adjustments finally catches up with real-time market conditions. Underlying fundamentals continue to be weak, as new capacity has come online.”

Alan Tyler is a freelance journalist with many years’ ­experience covering specialty chemicals and base oils, and was until recently head of ICIS Training