Positive outlook for short-term refining margins amid Hurricane Harvey capacity losses

September 2017 | Alan Martin, Tim Fitzgibbon, and Patrick Green

Refining has often been seen as the ugly duckling of the oil value chain with cyclical, modest margins and unattractive average returns over the cycle. Recently, however, there have been signs of an improved level of returns. At present, there is much focus on the impact of some unexpected capacity losses in Europe and especially around the Houston area following Hurricane Harvey. Margins across hub markets have gained between $5-10/bbl over the past week, but this will be transient and may be masking the fact that recent underlying trends have been quite favorable and could continue to be so over the next few years.

Strong H1 performance

Refining margins for the first half of 2017 for all configurations and across all hub market locations as shown in Exhibit 1 have been above expectations, surpassing 2016 levels.

Exhibit 1: Complex margins have improved in H1 2017 versus 2016 levels but are still below 2015 average levels

Complex margins have improved in H1 2017 versus 2016 levels but are still below 2015 average levels

1Dubai delivered in Singapore
2Maya delivered to USGC
3Brent delivered to NWE
SOURCE: OilDesk by McKinsey Energy Insights, Platts

This has been reflected in the ongoing announcements of first half results with many players reporting some improvements in their downstream performance.

While there are many factors that have contributed to these improvements, a few fundamentals deserve a specific mention.

  • Demand has pleasantly surprised, with growth in the first half of 2017 exceeding most observers’ anticipated levels. Back in June 2016, the IEA’s Monthly Oil Market report anticipated average 2017 global products demand reaching 97.4 million bpd, an increase of 1.3 million bpd versus 2016. The most recent release in August of this year, which includes first half of 2017 data, now sees average 2017 global products demand at 97.6 million bpd, a growth of 1.5 million bpd (1.6%) versus 2016. It also sees second quarter growth in 2017 staying notably strong at 1.8 million bpd above the same period last year, with both Germany and the US contributing strongly. This would place 2017 as the fourth highest demand growth year in the past decade.

Exhibit 2: Global distillation capacity changes, 2017 vs 2016

Global distillation capacity changes, 2017 vs 2016

1Based on barrels per stream day to reflect maximum capability; availability factors should be subsequently applied to get to barrels per calendar day
SOURCE: OGJ, FACTs, Argus, MITI/Cosmo, Kortes, EPE, EIA, company fact books and websites, McKinsey analysis
  • At the same time, refining capacity expansions and new builds that started up during 2016 were almost completely balanced by refinery capacity reductions, shutdowns, and closures, resulting in an almost flat level of capacity year on year. As shown in Exhibit 2, new refinery start-ups across China, Korea, the Arab Gulf, and the US added just over 0.5 million bpd. Additional smaller debottlenecking type expansions, notably in the US to meet growth in LTO production, took the total new distillation capacity up by just under 0.9 million bpd. However, a raft of shutdowns and capacity reduction across several countries amounted to over 0.7 million and reduced the net gain in distillation capacity to a mere 156,000 bpd. While there have been more conversion capacity additions, the net overall imbalance between the demand growth and the lower refining capacity growth has contributed to higher utilization levels.
  • Various crisis-related situations over the past few years resulted in refining capacity being damaged or shut down across countries such as Syria, Libya, Yemen, Iraq, and Ukraine, with indications that most of this capacity has been slow to be reinstated. Furthermore, operational issues in countries such as Nigeria, Morocco, Venezuela, Brazil, and Mexico have also resulted in lower run rates than historical norms with consequent boosts to utilization levels in hub market locations. While these operational issues are being addressed in many of these countries, it is still unclear how quickly typical industry performance levels can be reinstated.

Each of these factors has contributed to the increased utilization rates seen in hub markets, with some of the countries involved achieving up to 8% higher levels than seen in 2016. Some recent unexpected capacity reductions have also contributed, including:

  • The Shell Pernis loss of 400,000 bpd over the summer from the NWE hub region due to fire damage, as well as the shutdown of the Elefsis refinery in early July due to hydrogen production unit issues.
  • The closure in the past couple of weeks of close to 5 million bpd of capacity in the USGC region as a result of hurricane Harvey, some of which will return to full operation fairly quickly, while others may be more significantly water-damaged and down for more extensive periods.

Reasonable outlook over the next few years

The next couple of years should see higher levels of net capacity additions than last year, but our recent review of refinery construction activity, described in Exhibit 3, indicates that these will still likely be below the peak start-up levels seen in the mid-2000s and that there is risk of delays in commissioning the projects planned to start in 2018. On average, the next three years are likely to see around 1.5 million bpd of new capacity per year.

Exhibit 3: Distillation and conversion capacity will continue to be added at high levels over the next five years

Distillation and conversion capacity will continue to be added at high levels over the next five years

1Includes projects classed as Firm and Probable; forecasts are net of any planned capacity reductions or closures
2Forecast includes 0.5% per annum creep
3Fuel oil destruction defined as 100% coking, 85% FCC, 100% HCU and 38% of thermal processes (derived from LP modeling)
SOURCE: McKinsey Energy Insights refining capacity additions database

Provided demand growth continues at the levels roughly in line with those seen during the past three years, utilization declines will occur but should be modest, and the outlook through 2019 remains quite positive. Furthermore, in 2020 the impact of the Marpol regulations switching ship bunker demand to a set of <0.5% sulfur content fuels will come into play. While there will be options for segregating low sulfur fuel oils and for blending 0.5% sulfur-compliant products, it is expected that this challenge will be at least partially met by an increased demand for Marine Gasoil that will likely further boost hub market utilization levels, product price spreads, and refining margins. Overall, the outlook for this part of the oil business is probably the most optimistic it has been in years.


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About the authors

Patrick Green is a knowledge expert and Alan Martin is a senior expert, both with McKinsey’s Oil and Gas Practice in London. Tim Fitzgibbon is a senior expert with McKinsey's Oil and Gas Practice in Houston, Texas.

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