Petroleum Industry Overview


4. Downstream

Refining

The refining of crude oil means its transformation into petroleum products by breaking them down into their components. Petroleum products include:

Refined products

These products are selectively reconfigured into new products such as fuels and lubricants for automotive, ship, and aircraft engines. Refined by-products can also be used in petrochemical processes to form materials such as plastics and foams.

The largest producer of petroleum products in the world is the US, followed by the European Union, China, Russia and India. The global crude refining capacity is forecasted to grow significantly towards 2020, led by China, Southeast Asia, Latin America and the Middle East.

Whereas no new green field refineries have recently been built in the US, existing refineries are being expanded. Most new projects today are announced in Africa, including for example:

Africa’s richest man to invest in greenfield refining to end Nigeria’s fuel deficiency

There are also new and expansion projects in Asia.

Marketing

Petroleum products include: Motor fuels, aviation fuel, lubricants, fuel oil for heating, and fuel oil for power generation, asphalt and propane. These are sold to the end users at the end of the value chain. The motor fuels used to power transportation hold the majority of the market share. The end price of these products in the market usually varies according to the price of crude oil but can also be subsidised by governments through taxes.

Natural gas

Natural gas is an essential component of "petroleum" generally, but it is significantly different in its properties, treatment and development. It is more abundant than oil worldwide and is the preferred hydrocarbon resource today from an environmental standpoint.

Most IOC and major independent companies’ contractors are seeking exportable crude oil. Natural gas discoveries are often relinquished back to the state as "exploration failures". To encourage contractors to develop natural gas discoveries, states often allow them longer retention periods (up to 10 years) before mandatory relinquishment. This allows the domestic market to develop, export options by pipeline or through conversion to LNG to be explored and in some cases aggregation of smaller, non-commercial discoveries into a pooled commercial discovery. As a minimum, the state may require contractors to appraise natural gas discoveries at the State's expense and then relinquish them in condition for the state to develop.

Natural gas produced at the wellhead must first be processed to be of an accepted quality to be taken to market.  The processing of wellhead natural gas can be complex and involves several processes.

Common contaminants contained in natural gas include non-hydrocarbon gases such as water vapour, carbon dioxide, hydrogen sulphide, nitrogen, oxygen, and helium. Natural gas liquids which must also be cleaned out include ethane, propane, and butane (which are the primary heavy hydrocarbons extracted) and other petroleum gases, such as isobutane, pentanes, and normal gasoline. Natural gas that is not within certain specific gravities, pressures, British Thermal Unit (Btu) or water content ranges is likely to cause pipeline deterioration, pipeline rupture and other operational problems.                                  

Natural gas processing

In addition, it is often necessary to install scrubbers and heaters at or near the wellhead. Scrubbers serve primarily to remove sand and other large-particle impurities. The heaters ensure that the temperature of the natural gas does not drop too low and form a hydrate with the water vapour content of the gas stream. These natural gas hydrates are crystalline ice-like solids or semi-solids that can impede the passage of natural gas through valves and pipes.

The figure below shows the typical natural gas processing stages required to achieve pipeline-quality gas.

Generalied Natural Gas Processing Schematic (Source: US Energy Information Administration, Office of Oil & Gas, Natural Gas Division)

The changing role of International Oil companies (IOCs)

International oil companies (IOCs) include the oil & gas “majors”, being the original “seven sisters” of the 1970s:  Exxon, Mobil, Gulf Oil, Texaco, British Petroleum (BP), Shell and Total S.A. Over time, smaller and medium sized oil companies have emerged, with a majority being listed on stock exchanges and alternative markets, and having widespread operations especially in emerging markets. A good example is UK’s Tullow Oil, which has extensive operations in Africa: founded in 1985, it is listed on the London Stock Exchange and had operations in 22 countries as at the end of the 2015 financial year.

Experiments within the oil industry over decades showed that a specialised enterprise with its shareholdings and profit making requirement in a competitive market has provided efficiency among the industry participants.

In today’s sector the state and IOCs have complementary decision making powers. From the early days of oil till 1970s, for about a period of 70 years, IOCs maintained a privileged position vis-à-vis many resource rich states, which frequently lacked the expertise and experience to negotiate effectively with IOCs. However, with the establishment on NOCs and of OPEC as a response to the limitation of states’ rights and powers to influence their own natural resources, the role of IOC in the global markets has changed.

The IOCs: Business model

The IOCs’ typical business model is premised upon 3 pillars: maximising shareholder value; maximising bookable reserves; and minimising costs. However, this business model is widely perceived as failing, caused by various factors, including:

(a) the rise of NOCs since the 1970s, resource nationalisation and the 2nd nationalisation wave of the 2000s (NOCs, especially from OPEC countries, now control majority of the oil & gas reserves and production globally);

(b) industry consensus thinking which led to destructive behaviour, such as multi-billion dollar investment in heavy crude oil refineries, in a market with an increasing light crude slate;

(c) adoption of capital asset pricing model in management strategy, which undervalued risks;

(d) losing IOCs technical and technology edge to service companies through outsourcing. While this was adopted as a strategy to minimise costs, it also meant that NOCs could outsource to service companies, and were not dependent on IOCs. Indeed, the shale gas revolution in the US was led by small and medium sized companies and IOC majors have been late to the party;

(e) global decline in crude oil prices both historically, and post-2014; and

(f) more recently, challenges posed by the green revolution and emissions reductions, which will continue to be seen as a result of emission reduction commitments under the Paris Agreement on Climate Change of 2015, which is likely to lead to stranded assets and unexploited reserves.

IOCs control of global oil

IOCs’ control of global oil in 2013. Adapted from Paul Stevens, “International Oil Companies: The Death of the Old Business Model”, Chatham House, 2016

 

Problems faced by IOCs

All these challenges have been reflected in the stagnation of IOC share values, causing concern for investors.

A summary of problems faced by IOCs’ business model, adapted from Paul Stevens, “International Oil Companies: The Death of the Old Business Model”, Chatham House, 2016

Possible solutions

To weather these challenges in the future, IOCs will need to re-think their business models. Several options have been suggested, including:

1. Mega mergers: such as BP’s acquisition of AMOCO and Arco in 1999, which was intended to increase bookable reserves and minimise costs by reducing duplication. However, mega-mergers are likely to face competition authority scrutiny and should be carefully considered;

2. Diversification away from oil and gas: especially in light of climate change focused emission reduction commitments. IOCs such as BP and Shell are investing in renewables;

3. Investment in the US shale gas revolution: although they would be coming in late, IOCs can take advantage of the rate of bankruptcies being seen in small shale gas companies who were heavily leveraged and are suffering from the rise in interest rates;

4. Reshuffling portfolios: such as reduction of refinery capacity or ConocoPhillips example of splitting upstream and downstream operations;

5. Re-focusing on development of in-house technology: instead of being over-reliant on outsourcing; and

6. Reducing operation in risky locations, and investing in large, long-life, low-cost, expandable, upstream assets in less-risky developed (OECD) countries.