The past two years saw a series of unprecedented events disrupting demand and supply patterns and leading to an extremely tight global oil market in 2022. After a sharp collapse in oil demand due to the COVID-19 pandemic, a stronger-than-expected demand rebound came at a time when the refining industry was aggressively trimming its asset footprint. In addition, the invasion of Ukraine and subsequent sanctions on Russian crude and product exports added to global market tightness already under way and pushed crude and product prices to new highs by March 2022 (see sidebar, “Disclaimer on Ukraine”). These factors will continue to be the main drivers of market conditions in the next few years.
Drivers affecting refining margins in the near term
While there are many uncertainties that influence refining margins from both the supply and demand perspective, the four biggest drivers are the impact of Russian sanctions on global supply, Chinese policy toward refined product exports, the outlook for global-oil-demand growth, and the outlook for capacity growth from new refining projects.
Sanctions on Russian crude and product exports
The impact of Western sanctions and the price cap on Russian crude and product exports are still playing out, but early signs indicate that product exports may be harder to reroute than crude, potentially adding upward pressure on overall oil prices and refining margins in the near term.1
At the end of 2022, Russian seaborne crude exports grew to 3.8 million barrels per day (MMbd) (0.7 above MMbd over 2021 levels), thanks to a growing fleet of non-Western financed and insured ships that has helped Russia reroute its crude to China and India.
Refined product exports from Russia show a similar story—diesel exports held firm overall but shifted to the Middle East, North Africa, and Turkey by the end of 2022, with some volumes ultimately heading for storage rather than final consumption.1
Compared to crude, product exports are generally more difficult to reroute, either due to a lack of buyers (as Russian crude buyers are often major refined product exporters themselves) or due to the smaller number of product tankers available. As a result, a growing volume of Russian exports is actually stored in trading hubs or at sea and contributing to an overall tighter product market.2
In our near-term outlook, we expect a slight reduction in Russian product supply consistent with growing volumes in storage. The main contribution to market tightness and volatility is still driven by high costs of rerouting and uncertainty.
Shifts in China’s product export policy: Squeezing supply
Perhaps the more unexpected driver of the recent supply tightness in oil markets has been a change in Chinese policy over refined product export quotas. In the second half of 2021, China began tightening the refined product export quotas it sets for its domestic refiners, cutting total 2021 quotas by 37 percent versus 2020.1 This is part of its longer-term policy to reduce “exported emissions” from running imported crude through typically more inefficient, marginal refining capacity.
The reduction in Chinese product exports has had a material impact on the market, adding to concerns of supply tightness. In late December, the government significantly backed off its product export restrictions, likely due to weaker than historical fuel demand and historically high diesel export margins.2 However, we anticipate lower exports in the future in line with the government’s long term policy stance, though sudden changes in policy in one period could pressure margins, albeit temporarily.
Near-term demand outlook
The biggest uncertainty for refiners is the outlook for demand, which will depend on the magnitude of any global economic slowdown and the pace of its recovery over the next few years.
The near-term demand outlook is built out of McKinsey’s economic scenarios explained in the article, “2023, a testing year: Will the macro-scenario range narrow or widen?” Our reference case demand scenario is based on the B1 scenario in that article—a “soft landing” scenario in which structural balance is achieved in two to five years and the world enters a new era of global cooperation.
In the B1 scenario, the conflict in Ukraine is contained and further sanctions are avoided. Policy makers create incentives to boost public and private sector investments that help resolve near-term energy supply-demand imbalances within two to five years. However, monetary policy is insufficient to avoid a recession and inflation remains above central banks’ targets.
A more prolonged recession, lower fiscal support, and tighter monetary policy (consistent with scenario C2, for example) could result in an initial demand contraction followed by a recovery to slightly above 2019 levels.
Based on the high and low range of our economic scenarios, global oil demand could grow by 0.3 to 5 MMbd by 2025 versus 2019 .1
Refining capacity growth
Globally, a new wave of greenfield projects is coming online over the next few years, mostly in Africa, Latin America, and the Middle East, bringing some relief to tight market balances. Between 2023 to 2027, we expect an additional 4.4 MMbd of new distillation capacity to come online, intended to reduce local product shorts in specific markets (in Africa), integrating into petrochemicals (China), or upgrading local crude into higher value products (Middle East).
At the same time, companies, particularly in Europe, OECD Asia, and the United States, are continuing to rationalize older, less competitive capacity, often converting to biofuels. As of early 2023, we anticipate an additional 1.5 MMbd of announced shutdowns and conversions, spread across mostly Europe, Japan, and the United States.1
Net capacity growth will therefore likely increase by 2.9 MMbd from 2023 to 2025 versus 3.0 MMbd of refined product demand growth in the B1 scenario, keeping a perilous balance by 2025.2 With the large volume of capacity closures in the last few years following the COVID-19 pandemic, there is also a greater risk of new delays from cost inflation and supply chain issues or unplanned outages having a bigger than expected impact on refining margins.
Market tightness and margins above historical average
This near-term outlook for market fundamentals suggests tight market conditions seen in 2022 soften slightly through the next two to three years, but the supply and demand balance still remains tighter than history.
Based on outlooks for hub utilization, USGC cracking margins averages $19 per barrel of crude oil (bbl) between 2022 and 2025 versus a historical average of $7 per bbl from 2015 to 2019.1
The implication is that refiners could continue to enjoy higher than historical margins, although with a lot of uncertainty and volatility.
Implications for refiners
This market outlook should translate into significantly high cash flows in the near term. However, we expect refiners will continue to face long-term uncertainty due to the energy transition. In this higher and increasingly volatile margin environment, refiners will need to balance between capturing high margins from the current environment and using these cash flows to prepare for a more challenging long-term environment.
To capture the high upside potential in the near term, refiners could find opportunities to boost overall operational efficiency and utilization, including capital-expenditure investments that were previously uneconomic in lower margin conditions. Other areas of potential opportunity in the short term include improvements in turnaround planning, execution to minimize downtime, and tactical optimization including changing feed slate and product slate.
To strengthen their competitive positions on the refining supply curve in preparation for greater volatility in commodity prices and margins, refiners could also consider opportunities to reduce costs without compromising safety and reliability. These include the reduction of energy consumption costs through efficient cogeneration of steam and power, improving operating efficiency through process digitization, and leveraging predictive maintenance to reduce maintenance costs.
Various drivers will affect refining margins in the near term, but the greatest uncertainty is demand outlook and significant volatility. By focusing on the two levers mentioned above, players can use this as an opportunity to reposition to become more resilient in a potentially challenging long-term environment.