A shift in light/heavy differentials: magnifying margins for complex refiners
February 2016 | Tim Fitzgibbon and Anantharaman Shankar
In the second half of 2015, the pricing of residual fuel shifted to a lower pricing relationship versus crude. The shift appears to be demand driven which means it may be fragile and short lived. However, if sustained and coupled with even a modest rise in global crude prices, this could result in a dramatic addition to refiner profitability, especially for high conversion plants.
A shift in residual fuel oil pricing
Residual fuel oil is effectively a byproduct of the refining process, and as such, typically prices at one of two levels reflecting its value in marginal uses. Since 2009 it has been pricing at its higher value (relative to crude oil and other products) because the global market has been tight. However, in late 2015 pricing appears to have shifted to its lower pricing level, suggesting a market moving towards oversupply.
The global resid market balance sees significant shifts over time from both the supply and demand side. Changes in supply come primarily from changes in the global crude slate (i.e. heavier crude generates more resid) and overall refinery utilization (i.e. higher utilization generates more resid). Changes in demand come mainly from changes in overall refining conversion capacity (e.g. coking, RCC, FCC) which consume resid as a feedstock and amongst non-switchable end-use segments (e.g. marine bunker fuel, asphalt, non-switchable oil-fueled power generation) which tend to consume resid even when prices are high.
When the global resid market is tight, resid will price at its value as a conversion feedstock. This higher “conversion” pricing level results in narrow light/heavy differentials and low margins for complex refiners. This has been the state of the market for most of the years since 2009. This tightness was caused by a lightening global crude slate, high investment in new refinery conversion capacity, and high fuel oil demand in Japan for power generation post-Fukushima.
Before 2010, the resid market was in over supply, as high refinery utilization and a heavying global crude slate produced resid in excess of what refinery conversion units and non-switchable end-use segments could absorb. As a result, resid priced at its lower, “substitution” value. In this state, excess fuel oil must find a home by displacing natural gas in power plants that opportunistically switch fuels based on price. This serves as a floor price for resid and results in wide light/heavy differentials, magnifying the margins for complex refiners.
In late 2015, the market appears to have flipped from the higher “conversion” pricing level to the lower “substitution” pricing state for resid. For the last four months of the year, resid prices were more than $5/barrel lower than would be expected if the market were still tight on resid. This switch appears to have gone largely unnoticed by the industry due to very low crude prices, which are somewhat masking the effect on light/heavy differentials.
Lower demand the primary driver
A look at recent trends in the global resid supply demand balance suggest that the primary cause of this shift has been a change in demand rather than supply.
Demand for resid has fallen in a number of key markets. The introduction of tighter marine bunker quality specifications in January 2015 has caused a shift from using resid bunkers to using marine gasoil bunkers. This has added to the regional oversupply of residual fuel oil in Europe and has pushed up exports by around 150 thousand barrels/day over 2014, primarily to Asian markets.
At the same time, demand in Asia has also contracted. China’s slowdown in industrial activity and greater availability of natural gas as a fuel has contributed to a 10% reduction in fuel oil use. Also, loosening crude import restrictions for China’s non-state refiners since July 2015 has allowed many of these “teapots” to switch away from using resid as their primary feedstock. Demand in Japan has also fallen as use of some nuclear capacity has resumed at the expense of fuel oil powered generation.
The growing surplus in Asia initially translated into higher stocks of fuel oil and falling prices. By the end of the year, discretionary switching to fuel became apparent, especially in the Korean power sector.
Outlook and implications
Sustained pricing of resid at its lower “substitution” price mechanism has the potential to be very advantageous for more complex refiners. At this pricing basis, resid prices are about $5/barrel lower than they would otherwise be with crude at around $30/barrel. This adds several dollars per barrel in variable cash margins to refiners running heavy crude through high conversion capacity.
At higher crude prices, the advantage to refiners could be much more pronounced, as the absolute value of crude prices has a strong magnifying effect on the light/heavy differential. If global crude prices were to recover back to the $60/barrel range, coking margins could improve by over $10/barrel. This would add significantly to overall refining profitability and likely more than offset any deterioration of margins from growing oversupply and lower utilization of marginal capacity.
Currently, it is too early to assess if the current state of resid pricing will be sustained. There are a number of drivers that could push the price of resid back to conversion-based pricing in the near to medium term. These include a return to higher industrial-driven growth in China, a stalled return of nuclear plant operations in Japan, and new refinery conversion capacity coming on line. All of these bear close observation over the coming months.
Also, given the short time that prices have been at the lower price mechanism, it is likely that the market remains close to the tipping point between the two mechanisms. Small changes in the resid balance could result in shifts back and forth.
About the authors
Tim Fitzgibbon is a senior industry expert with McKinsey’s Oil and Gas Practice in Houston.
Anantharaman Shankar is a specialist with Energy Insights in McKinsey's Houston office.