There is money to be made in European refining after all, but it is not really about the refinery, is it?


Market conditions confront European refiners with a complex set of challenges, and not all of them are well-equipped to survive. Opportune LLP (“Opportune”), a leading international energy consulting firm, examines the complex dynamics of the European market and the long-term outlook for the refining industry in Europe. In the third of a 3-article series, Opportune investigates alternatives to M&A and the rise of asset-backed trading models.

In general, refining operators are assessing their options for each of their plants including:

  • Outright sale, but the number of buyers are limited to trading houses and selected private equity firms;
  • Reconfigurations to increase plant flexibility, take advantage of market opportunities, and produce low sulphur fuels compliant with European regulations;
  • Conversion into storage terminals;
  • Conversion into biofuel plants;
  • Permanent closures.

In a context of increasing oil product flows, the logistical assets of refineries became more valuable than the processing units, and a new asset-backed trading model has emerged to capture market dislocations and arbitrage opportunities. Current trends in the crude oil and product markets are challenging the traditional model of the European refineries while they are creating opportunities for sophisticated traders that “cracked the code”, showing how oil flows and coordinated logistics are the keys to profitability in European refining.

Even so, not all refineries will be seen as an attractive asset-backed trading platform. If it is all about the ability to exploit market disconnects, investors will only benefit from refining assets that offer size and economies of scale, complexity, flexibility of supply, marketing flexibility, integration with the supply chain, good logistics, and access to captive market for refined products.

Opportune believes astute investors have the opportunity to “bargain hunt” and cherry-pick the best refining assets for their midstream and trading portfolios, offering the potential to build profitable asset-backed trading platforms.

However, this is not an opportunity for the faint of heart, as deal closures and success will depend on several conditions related to valuation, limited capex, good configuration and location, potential uplift in profits, favourable labour regulations, and sustainable environmental liabilities.

Alternative options to an outright sale

In a challenging M&A market for refining assets, owners have been considering other alternative options:

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1. Plant reconfiguration

Plant reconfiguration aims at increasing plant flexibility to run a broad variety of crude grades and produce the fuels that are more in demand. This means adding hydrocracker units to convert residual oils in lighter products, but also moving to other processing options to meet the requirements of regional markets for specialty products.

A reconfiguration project can be expensive and the investment decision largely driven by the size of the market opportunity, access to relevant feedstocks, and compliance with regulations in relation to permitting and environment.

2. Conversion into storage terminals

This has been the traditional approach to shutting down refinery operations, minimizing remediation and conversion costs. Current market conditions and the glut in oil supply are making storage assets in trading hubs very appealing; hence, the conversion option is more economically viable than ever.

Historically, conversions to storage terminals acted as a solution of last resort, implemented only when the refinery was unprofitable and reconfiguration unjustified based on material economic benefits.

Key factors for successful conversions into storage terminals include:

  • Location with access to trade flows and profitable inland markets;
  • Good marine facilities in deep waters, beneficial for the access of a broad variety of tankers including VLCCs;
  • Functional logistics with pipeline connections, rail infrastructure, and water transportation;
  • Straight forward permitting;
  • Potential to reduce workforce without prolonged negotiations with trade unions;
  • Conversion processes able to avoid site remediation, and competitive in terms of costs when compared to permanent closure. 

3. Conversion into biofuel plants

Biofuel conversion is a new approach implemented by European IOCs to shut down uncompetitive refineries. Biofuel production represents a new processing option that can reduce carbon emissions, support fossil fuel replacement, address the shortage in biofuels production, and help countries meet the European Union's biofuel targets.

  • ENI invested EUR 100 million in the conversion of its Porto Marghera refinery into a 360,000 tons per year Hydrotreated Vegetable Oils (“HVO”) plant producing green diesel and using its proprietary HVO Ecofining technology;
  • ENI is also in the process of converting the Gela refinery into a 750,000 tons per year HVO plant;
  • Total is investing EUR 200 million to convert its La Mede refinery to manufacture 500,000 tons per year of HVO.

The European Union aims to source 10% of its transport fuels from renewables by 2020 (mostly biodiesel with food crop based or 1st generation biofuels limited to 7%) and several countries are still far away from reaching this target (in 2014 biofuels accounted for just 5.7% of the EU transport fuels).

The number of biofuel conversions will ultimately be limited. There is a potential sustainability problem when the feedstocks comprise food crops (e.g. palm oil). These crops can have higher carbon emissions than fossil fuels when considering land use changes into arable land and the associated loss of trees to produce the crop. This is indeed the challenge for the ENI Porto Marghera project where palm oil is the initial feedstock, although the company announced its intention to use more animal fats, recycled cooking oil, algae oil, and lipids in the future.

Furthermore, the European biofuel market is relatively small and cannot support several largescale conversion projects that would flood the market with biofuels, erode the market share of established players, and drive down margins and plant economics.

In summary, Opportune believes that the biofuel conversion projects that have been implemented so far are small and expensive. They have been used more as a “marketing tool” to improve the social image of the IOCs while shutting down refineries, limiting site restoration costs, reducing headcount (avoiding bad publicity and difficult negotiations with trade unions), and supporting sustainability, rather than as a sound investment to generate long lasting profits.

4. Permanent closure

Permanent closures of European refineries present several challenges that have prevented an efficient and timely rationalization of the sector for decades.

Conversion projects, traditionally into storage terminals and lately also into biofuel plants, reached the same objective while mitigating site restoration costs and job losses:

  • Stringent European environment laws are making the remediation costs prohibitive, and state and/or European Union economic support is currently not available;
  • Strong trade unions, in particular in Southern Europe, deterred IOCs and independent players from entering into tough negotiations that could ruin their social image;
  • Low salvage costs and limited secondary market for refinery units and equipment are not helping. Land value and alternative uses can drive a successful closure project. Although, a sound costbenefit analysis supported by independent reviews and preventive negotiations with local authorities and trade unions are of paramount importance.

In general, Opportune believes refinery closures in Europe have been difficult to implement and we are expecting this will continue to be the case for years to come. Furthermore, permanent closures are unlikely to be supported by government and/or European Union incentives in a context where market imbalances (EU’s long gasoline/short diesel position) are still making fuel security an important topic in the policy agenda.

The rise of the asset-backed trading company model

Trends in the crude oil and refined products markets are challenging the traditional model of European refineries. These trends are also creating opportunities for sophisticated traders that can take advantage of refiners’ natural long position relative to product cracks and logistical capabilities:

  • The large swings in prices, volatility, and demand trends require a proactive presence on the markets, balancing physical activities with trading opportunities;
  • Refiners can leverage on their long exposure, creating additional value by trading around hedging positions;
  • Europe is geographically well suited to become a key logistical clearing hub for refined products. As a result, the logistical assets of refineries could be more valuable than processing units for their significant role in storage and transport;
  • Growth in Middle Eastern and US product exports into Europe will continue to drive additional import logistics-related opportunities.

Since 2012, oil traders have emerged as the main buyers of refining assets with the aim of adding operational flexibility to their portfolios and taking advantage of arbitrage opportunities:

  • The high degree of oil-price volatility has increased both the number and the magnitude of pricing imperfections in the market, thereby increasing trading companies’ scope for engaging in arbitrage;
  • Arbitrage opportunities fall into three main categories: time, location, and product quality.
    • Time: Contango situations in which spot prices are lower than prices for future delivery. This situation creates profitable opportunities for companies with marginal storage capacity. Today’s low short-term interest rates make the economics of financing inventories attractive;
    • Location: Price differentials between locations can create interesting opportunities for players that are able to access relevant logistics and physically reroute oil and oil products. To exploit such opportunities, traders need to control key logistical assets, such as terminals, pipelines, rail, and storage capacity;
    • Quality: Global and regional supply/demand balances for oil grades are constantly changing (e.g. North Sea sweet oil production is declining while new light grades are being produced from U.S. shale oil). This is affecting trade flows, price differentials, and refining netback margins. Refineries closely linked to traders and can react rapidly to these changes have been able to create superior returns.

Many refiners are still not sophisticated enough to take advantage of these market imperfections, and they continue to manage crude inventories as if oil is purely a manufacturing input rather than a financial commodity. The aim to carry the smallest inventory possible, results in leaving a considerable amount of potential value on the table. In addition, some refiners refuse to adapt their crude supplies in response to price optimization opportunities and the evolution of netbacks. Instead, they disregard the linear programming used to determine the optimal crude supply, preferring the use of more familiar grades. 

This situation created an appealing investment case for traders to acquire European refining assets with logistical infrastructure and to benefit from market dislocations that have increased significantly with the recent oil price volatility.

The future of European refineries

In today’s environment, refiners and traders are converging towards an asset-backed trading model— a model that allows the two to achieve benefits not possible alone. The model provides a way to expand revenues, stabilize returns (returns on trading are not directly impacted by the level or direction of oil prices and refining margins), and make companies more responsive to structural and dynamic market opportunities. As such, refiners are shifting their emphasis from marketing to trading, while traders are acquiring refining and logistical assets.

Opportune believes IOCs and refining independent players need to reshape their portfolios and change the configurations of their assets in order to take advantage of such opportunities and shift focus from marketing to trading.

The portfolio rationalization process should be driven by a combination of:

  • Investments to develop an efficient and integrated trading system around key processing facilities with the remaining converted into storage;
  • Divestments of selected assets that can play a role in the midstream and trading systems of global traders and portfolio companies of private equity firms, or fulfill the ambition of distressed investors and emerging companies keen to develop asset-backed trading operations.

Some refineries will be central to the implementation of sophisticated trading systems: these are the ones that have size, complexity, flexibility of supply, marketing flexibility, integration with the supply chain, good logistics, and access to captive market for refined products.

All the others will need to review alternatives and analyze the cost-benefit profile of a conversion project. Current market conditions are making storage assets appealing and storage conversions economically viable, while biofuel conversion projects have been so far small and expensive. Storage assets have been largely used as a “marketing tool” to improve the social image of IOCs while shutting down refineries, limiting site restoration costs, and reducing headcount rather than as a sound investment to generate long lasting profits.