In order to make European refineries profitable again, further cuts in capacity are necessary. By 2025 they are estimated at 1.35 million barrels per day. Individual refineries that profit from oil refining are at the biggest risk of going under. Lotos’s refinery would join this group, because even high efficiency won’t protect it from refining becoming unprofitable due to the situation on the market. So, when one considers the takeover of Lotos by Orlen from the perspective of changes in the global and European refining industry, it becomes apparent that the transaction safeguards it against a possible shutdown – Adam Czyżewski, PKN Orlen’s chief economist in an interview with BiznesAlert.pl.
BiznesAlert.pl: The refinery market in Europe is consolidating. Why?
Adam Czyżewski, PhD: This trend is rooted in the ongoing globalization of the refining industry, driven by the new huge refineries that are being built in Asia and in the Middle East to enable exports to China, but also to Europe and America. The competitiveness of those facilities was founded on the proximity of cheap oil sources, technological efficiency and production capability that is a few times higher than the potential of the biggest European and American refineries. Europe’s answer to this development was to consolidate its refinery market, which meant the least profitable refineries were either shut down or merged with other facilities. The dropping global demand for oil caused by the recession after the financial crisis and high oil prices, coupled with the opening of the new refineries in the Middle East and Asia revealed the surplus of capacity in the refining industry. Between 2009 and 2014, 54 refineries were closed across the world. They had a total capacity of 5 million barrels per day, out of which 1.8 million was in Europe. However, the concentration of European refineries, thanks to the economies of scale and improved modernization abilities, enhanced their competitiveness on global markets. It needs to be clearly stated that the concentration caused by the growing competition in the world’s refining industry, did not result in increasing the market price of oil. The industry is so big that a single refinery does not impact oil or fuel prices in the global context. The overabundance of potential, which has accompanied the industry since 2009 means that if a new refinery wants to enter the market, it needs to offer competitive fuel prices. This pushes out of the market less profitable facilities and ignites processes that lead to concentration, which improves the efficiency of those refineries that managed to hold ground.
High fuel prices, hiked up by the bonus for risk during the Arab spring, which held until mid 2014, made it possible to develop new extraction technologies, which reversed the situation on the oil market from scarcity to abundance. In mid 2014 oil prices started to drop, and refineries got a cash injection, because the market margins improved, so they started producing more…
… but the coronavirus pandemic arrived to a world with low oil prices…
… and the virus led to another, deep reduction in demand. Currently, we have too many refineries on the market in relation to the expected demand, but despite that new ones are still commissioned in Asia and the Middle East. Globally the scale of this surplus is estimated at 3.8 million barrels a day. In Europe that figure is between 1.7 and 1.8 m barrels per day. This means by 2025, 7 or 8 refineries such as the one owned by Lotos, which in 2019 processed about 200 thousand barrels per day, should go under. That’s the reality of the market. The fact that there are too many refineries and the demand for fuels will drop does not mean that in 15-20 years they won’t be useful. Refineries produce liquid fuels that fuel transport. As long as there are combustion engines in the market, there will be demand for liquid fuels. Refineries also produce the input needed for petrochemical production. Changes in transport and the dynamic growth of the petrochemical industry are altering the demand structure for petroleum products. The demand for diesel is dropping, but the need for petrol and gasoline for the chemical part of refineries is going up. In Europe large companies have in general already consolidated, but in our region the scale of this process has been smaller. The merger of Orlen with Lotos is rather late, but it still makes deep economic sense, and its business rationale is very strong.
Could you lay it out?
The first reason is related to the strategic development of our petrochemical assets. If we want to develop them, we need the raw material. After we cracked down on the grey market on the domestic fuel market, the demand went up over the capacity of the Orlen and Lotos refineries and is fuelled with import. Today, this mostly pertains to the diesel oil, but when we put into operation our petrochemical capacity, the domestic supply scarcity will also appear on the fuel market. By taking over Lotos’s refinery, we secure a stable source of the petrochemical raw material, and at the same time create a stable demand for petroleum production, which is currently missing very much on the market. The refining and petrochemical margin will stay in the company and in Poland, which will increase our investment opportunities.
When talking about business benefits, shared oil purchases also come into play. We will be able to negotiate better prices, improve logistics, offer Orlen’s access to the sea, and optimize the cooperation between the refinery in Gdańsk and the Būtingė port in Lithuania.
Some of the results of this transaction will be determined by the final remedial measures, about which at this stage we cannot say much. The market is familiar with the requirements set by the European Commission. The EC does not impose how we should do this. In return we may receive money, but we may also receive other assets. If in return we receive assets that are more related to margin than refineries or petrol stations, then undoubtedly this may benefit not just the company, but the Polish economy as well. In our view, this makes a lot of sense business-wise. Divesting some of the shares in the fuel market can be turned into a success thanks to appropriate configuration and correct choice of remedial measures.
However, apart from Lotos, Orlen has also already took over Energa. Does such a combination of mergers make sense?
Yes, because the above factors are combined with the requirements of the energy transition, which accelerates the departure from fossil fuels, including transport decarbonization. However, it translates into the drop in demand for fuels, which is already happening. Diesel fuel will be impacted the most by this. Hybrid cars are entering the market and electromobility is growing. The energy industry is being transformed to accommodate more green energy. This is an inevitable process, which requires lots of investments that are easier for larger companies to bear. This pertains both to the size and efficiency of those investments, which are enhanced by joint projects, such as the development of the domestic hydrogen market, an endeavor in which both Lotos and Orlen are currently engaged in. Hydrogen is the fuel that integrates the decarbonization of both transport and the energy sector. It is an energy carrier, that can be used as power storage or fuel, directly or for synthetic fuel production, which may also serve as input for petrochemical production, which in this configuration is called electrochemistry. Therefore, this is an interconnected system that may bring profits, but the key to success is low-emission green energy, which we will be developing at Energa. However, we will still need refineries. Those that will survive, will make profit a little different than today, thanks to high-margin products for the petrochemical industry, green transport and green power industry.
What are the reasons for the „selection of refineries”?
Most of all, it stems from the perspective for the refining market, which at this point does not look too good, because there are too many refineries. Since there are no organizations that could coordinate the process of reducing capacity, such as the OPEC+ group which has done it on the oil market, the reduction is driven by market forces, such as low refining margins or drops in fuel and oil products prices under levels that guarantee production profitability. This process started in the fourth quarter of 2019, and the impact of the pandemic only made it stronger. Currently, it is estimated that the scale of the redundant refining capacity in relation to demand forecasts is 3.8 million barrels per day by 2025. The refining margins will stay low, as long as the production capacity doesn’t drop. Once that adjustment happens, which may take place in the near future (price pressure has been in full swing for over a year now), the refining margins will recover and those refineries that will survive on the market will become profitable again.
Who will be the victim of this selection?
Those entities that will lose financial liquidity. It doesn’t matter whether we are talking about a refinery with the finest technological and logistic conditions, such as the refinery in Gdańsk, if it works at low capacity, it won’t generate profits from fuel sales. Today, the market fuel price is decided by tankers that carry cargo from the Middle East. The facilities in that region combine extraction and refining margins. The extraction margin is at a level of over USD 60 per barrel (because operating costs do not exceed USD 1.5 per barrel). Therefore, the refineries from the Middle East can offer cheaper products than the ones in Europe. The Persian Gulf states do want the price to be high, but they still want to find buyers. The high extraction margin allows them to lower the price to a level that will eliminate refineries that pay over USD 60 per barrel. Orlen’s upstream capabilities are not substantial, but the company does have retail, power and petrochemicals that work well and generate stable money flows that can cover the refineries’ losses caused by macroeconomic factors. Refineries in Europe are already going under, this is happening Scotland, Portugal, and the next in line are the facilities owned by Total and Neste. The US and Australia are seeing the biggest number of bankruptcies. Orlen is able to cover this small margin, but Lotos is not. We are hoping that in the near future the margins will improve and go up. Those who will survive will experience a rebirth.
The opponents of the merger claim that the transaction will undermine competition and increase prices.
That’s not true. Why did BP and Shell argue against this decision and file a motion to the EC to block the transaction? What were they afraid of? Those companies sell fuel on the same market. If we were to increase fuel prices, it would be beneficial for them. They buy fuel from Orlen, but they can import it from abroad as it is possible, but it is more comfortable to buy it from us. Every player on the market has a number of solutions to pick from, which ensures competitiveness. After all, the EC set the requirements to increase competition on the domestic fuel market. We have to meet these conditions, which will be beneficial for consumers, as it will strengthen the market factors (additional entities, import and access to infrastructure) in shaping domestic prices.
Interview by Bartłomiej Sawicki