No revisions in our 5-year forecasts
Over the span of one year which has passed since the publication of the 2014 Integrated Report, we have kept a watchful eye on the developments on the oil market, with regular comments and updates published on our website at (http://ffbk.orlen.com/blog). Those developments gave us an in-depth knowledge of the adjustment process, while the scenarios presented a year ago generally remained unchanged.
Crude prices remained highly volatile during the year, though the average prices were rather low despite a number of uplifts which lasted for even up to two months. Such transient price rises deferred supply adjustments, which drove the subsequent price declines even lower. Persistently low prices stimulated demand, which tripled in 2015 year on year, growing by 1.6m barrels a day (mbd). The supply side split into three areas, differing not only in terms of the scale of activity, but also in terms of the overall nature of their evolution. OPEC countries increased their output for various reasons, which forced non-OPEC players to adopt deeper adjustments. The US onshore producers were forced to make the most extensive adjustments at the earliest stage, yet still later than expected. Efforts to enhance efficiency (seen until mid-2015) and cost cuts designed to offset the price collapse, and the short investment cycle (of around three months) eventually led to a decline in production output, but not before late 2015. For the same reasons, in the case of production from conventional sources, where the investment cycle lasts from three to five years, full effects of postponing and cancelling upstream projects on the back of low crude prices will be known only after several years.
The oil price erosion was deeper than expected, the supply side adjusted itself later than assumed, but the adjustments in the US have been much more extensive than originally planned, while the supply of crude from Iran was resumed sooner than expected, largely in line with the anticipated increase in output by OPEC members. All in all, we expect that the current oversupply of crude oil will be absorbed by the end of 2016, and that subsequent price rises will put an end to the crude price mega-cycle. Initially, rising oil prices will be offset by high stocks and rebounding onshore production in the US. The process of rebuilding onshore production potential and reducing the oil glut may take up from two to three years. Also, in two to three years, the oil market will start to feel shortages of supply from conventional sources in non-OPEC countries. If those two factors constraining growth of supply are combined with record-low oil production reserves in OPEC countries (much less than 2 mbd, compared with the historically secure level of reserves set at 3.5 mbd) and the continuing geopolitical conflicts in the Middle East, we can expect a strong uptrend in crude prices over the course of several years after 2018. This upward trend will be offset by rebounding production output from deferred conventional projects, which will eventually become profitable again; this, however, will take some time.
To sum up, we can uphold our last year’s projections of an increase in crude oil prices over the next five years, which is likely to accelerate significantly beyond 2018 after a slow start.
As current demand projections indicate annual growth of 1–1.3 mbd in the five-year horizon, strong demand will support the return of refining margins back to normal and prevent excessive margin erosion driven by growing oil prices. In conclusion: our mid-term (5-year) forecasts have remained largely unchanged compared with the scenarios presented in our 2014 Integrated Report.
A year ago, it made sense to put a limit on the forecast horizon, given that our knowledge of the new oil market reality was rather limited. With the knowledge we have gained since, we can now take a more forward-looking approach.
Stronger focus on the long-term perspective
Projections for crude prices and product and refining margins are just one of a number of deliverables of scenario analyses, and not even the most important one. The scenarios are not meant to foresee the actual course of events, but rather to prepare the Company for building sustainable growth strategies which will stay up-to-date regardless of the actual developments. A well-organised scenario analysis will help avoid the four ‘deadly sins’ of strategic planning, namely: (i) a tendency to hold on to earlier assumptions no matter what, (ii) optimism dominating over realism, (iii) illusion of control over the course of events, and (iv) attaching too much weight to recent information. Therefore, it is very important to identify the differentiating factors between the scenarios. Each scenario tells a logical story about the crude oil market, which can come true in the future. Taking a purely mathematical approach we may come to a conclusion that those stories are countless. However, building alternative scenarios only makes sense when we can tell several very different stories, which can potentially come to life in the future and change the course of events on the oil market; and their number is much smaller. The key to building such scenarios are the most relevant problems which will determine the future of global oil market and generate alternative solutions, depending on how they are addressed.
It is no secret that crude prices have a major bearing on the financial performance of oil companies; therefore, it is worthwhile to test our strategy’s resilience to any changes in that area. It would seem that ‘dipping’ the proposed projects in the low-price environment and then moving them to the high-price reality is enough to determine the financial effects. There is, however, one major problem: in the long investment horizon (over 15 years in the oil sector), the price trends will not stay flat. The lessons learned after oil crises, and the current mega-cycle of crude prices which is slowly (but surely) coming to an end, have left no doubt: it is not possible to keep high oil prices for a long time because strong adjustments on the demand and supply sides will eventually drive oil prices down. But is this true also for low prices? In that case, opinions vary, because we actually did experience long spells of low oil prices.
The key is to analyse oil market mechanisms and fundamental drivers on the demand and supply side other than price. Since crude oil is just one of the available primary energy sources, demand for oil will depend, to a large extent, on the global demand for energy and the share of other primary energy sources (share of primary energy). Against that background, many market players have asked an important question: is it possible that the current spell of low oil prices heralds the very end of oil as energy source?
The answer depends on whether the world will address a number of major global problems, and how. First of these is the problem of climate protection and degradation of the natural environment. Is the agreement reached at the Climate Change Conference in Paris a real breakthrough? If so, then according to the available scenarios which assume growth of the global energy sector, oil would lose its leading position as transport fuel, and in less than 20 years the global demand for oil would start shrinking. To a large extent, demand for transport services is driven by social changes and demographics. The future demand for oil will strongly depend on whether the new generations entering the labour market over the next 25 years decide to green-light policies which will dramatically change our transport habits. If the answer is ‘yes’, than the projected global demand for oil will start falling much earlier than in scenarios assuming no changes in that area. Those scenarios also take account of global population ageing and the shrinking population in OECD countries. The second question is whether the world in which faster economic growth translates into global leadership, which drives up the number of ‘superpowers’, will eventually end up in global chaos? Confrontation between superpowers would affect global economic development and weaken existing trade links, and the world would develop only in periods between crises. As a result, oil would probably continue as the leading fuel in the transport sector, which would lead to relatively short price cycles in the oil market, driven by high fluctuations in demand and delayed reactions on the supply side. Another major issue, which is a differentiating factor in various scenarios, is the development and roll-out of new technologies. We know that this process is unstoppable, and we know that innovative technologies will eventually change the energy mix; however, a lot depends on the type of technologies developed and the scale and timing of their implementation. According to the scenarios assuming significant technological changes driven by international cooperation and rapport in the area of climate and environmental protection, oil loses in importance much faster in a long-term perspective.
So, let us go back to our question. Is a coincidence of those factors and drivers possible which will keep oil prices low until oil as fuel is pushed out of the transport sector entirely? What would need to happen, step by step, for such a scenario to actually come to life?
1 Based on IHS and International Energy Agency materials.
The next five years
In the World Economic Outlook 2015 report, the International Energy Agency has already tested the likelihood of the scenario whereby oil prices remain low until 2020. The IEA has found that for prices to remain low in the coming years an unlikely coincidence is required of slower economic growth until 2020, marked acceleration in the withdrawal from subsidising fuel consumption in OPEC countries, greater resilience of non-OPEC producers in a low-price environment and above all, determination from the cartel itself to follow the strategy of prioritising market share and low prices. Since low prices prevent oil from being supplanted by other energy resources and even boost demand for it, under this scenario, a stronger demand for oil could only be satisfied through quick investment in expanding the production of cheap oil in the Middle East (a marginal cost of USD 30/b covering the entire cost to find and develop an oil field, and the cost of production). Without such investment and a major increase in production that would push OPEC’s share in oil supply to levels last seen in the 1970s (over 50%), oil prices would have to grow before 2020 to balance the market. The IEA considers the low price scenario to be very unlikely over the next few years.
Oil prices after 2020
Strategic oil projects have a considerably longer horizon and decisions taken in the oil sector are driven by what is expected with regard to the future of crude oil and its prices in 25 years. A quarter of a century is a long time, and a lot can happen over the span of 25 years. It is enough to recall what we thought of the oil market 25 years ago compared to what we know now. Back then, global economy was dominated by two superpowers: the US and the Soviet Union, and China’s GDP was ten times lower than the US GDP (in US dollars as at 2014). The world has only just started looking at climate change. The second United Nations Conference on Environment and Development (the Earth Summit), at which 170 countries adopted the United Nations Framework Convention on Climate Change, was held only in 1992, 20 years after the first Conference held in Stockholm. Crude price was under 25 dollars per barrel, and China’s demand accounted for only 3.5% of global oil consumption. There was a widely shared opinion that oil reserves would be exhausted, which should drive oil prices up in the long term.
Today, China is the world’s second largest economy, with GDP lower than the US GDP by less than 40%, and the country has been on a fast-growth track since joining the WTO, boosting global demand for oil and driving up oil prices to more than 140 dollars per barrel in 2008. In the US, the technology for extracting hydrocarbons directly from the source rock has been developed, and the world has gained access to oil resources on a scale never before imagined. The OPEC cartel, which has controlled oil prices since 1973 (first directly, and since the end of the 1980s, when oil was first traded at a commodity exchange − indirectly), finally lost its leadership. In parallel, the increasing role of climate and environmental protection in energy sector’s strategic decisions is steadily pushing oil out from its last outpost − the transport sector (which consumes more than 65% of the global oil output). Demand for oil in the OECD countries reached its all-time high in 2007, and has been falling since. Outside the OECD, the thirst for oil is still on the rise, driven mainly by demographics and faster economic growth. However, the role of those drivers will diminish and in 15 to 20 years global demand for oil will start to shrink, as oil will be gradually replaced by alternative energy sources.
The scenarios for oil market adopted 25 years ago have proven wrong. It is very likely, if not certain, that the same will happen to today’s long-term scenarios, because there is no way to predict the unpredictable. However, if we focus our scenario analyses on the consequences of the assumptions adopted for key issues and on known adjustment mechanisms, both on the supply side and the demand side, then we are better positioned to discuss the future of oil and its prices.
In the above-mentioned scenario of the European Energy Agency, it will not be possible to keep oil prices below USD 50/b for more than 2 to 3 years; therefore, we can expect an uptrend in prices in a longer term. But how to reconcile this with the expectations that the global demand for oil will grow at a slower rate and even start shrinking in the long term trends?
This apparent contradiction is caused by the fact that to quench the thirst for oil in a long-term horizon, production of crude must exceed the rise in demand several times over. This is caused by the gradual depletion of producing fields. The decline of output from such fields until 2040 will exceed the growth in demand for crude oil and liquid fuels several times. The IEA report presents a New Policies Scenario which predicts how the global energy sector could develop if politicians were determined to implement all their climate policy commitments. According to this ‘green’ scenario, demand for oil and liquid fuels (excluding biofuels) would only increase by 13 mbd (0.5 mbd annually) until 2040, which is well below current market projections. However, just to offset the diminishing output from producing conventional fields until 2040, 43 mbd of oil from new fields would be required. As new deposits are increasingly difficult and expensive to develop, the price of oil must be high enough to ensure profitability at premium cost. But what price are we talking about? In 15 to 20 years, oil prices will probably oscillate between 80 and 100 dollars per barrel (in USD as at 2014, excluding inflation). So what lies ahead?
In the baseline scenario, we assume that all structural changes on the demand side and in technology will occur through evolution, and that there will be no gaps in supply caused by geopolitical disruptions or natural disasters. With those assumptions, oil price will follow an upward trend: after a slow start (due to the need to rebuild production of shale oil in the US), it will rise more rapidly (a delayed effect of reduced upstream investments in conventional fields which needed to be scaled down due to the low oil prices in 2015–2016), only to stabilise at a rather high level in 2025, estimated by the IHS at around 100 USD per barrel (in real terms, excluding inflation). Oil price hikes will be limited by the declining global demand for oil, which will fall after 2025; on the other hand, the oil price will be supported by rising cost of oil production from new, more challenging deposits. In this scenario, the trajectory of oil prices is an S-shaped curve, with the highest uncertainty surrounding the question of long-term crude prices. From the perspective of today’s low-price reality, the 2025 oil price of USD 100 per barrel in real terms (that is, more than USD 120 per barrel including inflation) seems rather high.
But what would happen to oil prices if we assume a breakthrough in the coordination of global climate policies in the near future, a change in social habits and transport models, an increase in expenditure on renewable energy sources, and the emergence of new, effective technologies which could potentially push oil out of the transport sector?As we mentioned above, transport consumes 65% of global oil output. As demand for oil from the current vehicle fleet is very inert (the average life cycle of the transport fleet is 15 years), the rate at which oil is pushed out of the transport sector will be in line with the rate of replacement of the current vehicle fleet with other means of transport and driving units, independent of oil. First, adjustments will be seen in passenger cars, because it is much more difficult to substitute fuels in heavy transport.
Paradoxically, in the scenario assuming the emergence of new technologies, oil price is expected to increase over the next 15 to 20 years faster and more than in the baseline scenario, only to plunge more rapidly and settle at a relatively low level in the long-term horizon (at approximately 50 dollars per barrel in real terms). There are a number of reasons for such price reactions, the main one being the lack of interest (in this particular scenario) in upstream investments (considering that it is not economically viable to invest in ‘declining’ energy sources, even if their price is on the rise) and, as a result, reduced supply in the period when oil is still needed in the transport industry. Rising oil prices do not stimulate supply, but rather accelerate the process whereby oil is eventually pushed out of the transport sector and the global oil demand shrinks significantly and permanently. As the demand plunges, the cost of oil production will decline as well, because resorting to high-priced crude is no longer needed in the low-demand reality.
Looking at the current geopolitical scene, we could easily imagine a scenario in which the main superpowers (the US, China, Japan, the EU, and Russia) fail to agree on the solutions to global problems (such as climate protection or terrorism) and start seeking the answers on their own, often through confrontation. The problems are right on our doorstep, with the on-going disintegration within the EU itself. The likely consequences of those processes include rising global risks, unwillingness to invest, lower global demand, and growth interrupted by crises breaking out around the world. Feedstock and oil price cycles will follow in the wake of cyclical fluctuations in demand; however, those cycles are much shorter, especially compared with the current 15-year mega-cycle which is finally drawing to a close. The previous crude price cycle was triggered by China’s accession to the World Trade Organisation and the opening of Chinese economy to foreign investments and capital inflows. The situation in China is currently normalising, going through the phase of transition similar to that seen before in Poland and many other economies of Central and Eastern Europe. The third scenario assumes confrontation, whereby changes in demand are difficult to predict due to sudden and unforeseeable geopolitical tensions. Unpredictable shifts in demand make it difficult for the supply side to adjust. Given the delayed reaction to oil price shifts on the supply side, the demand and supply change cycles are likely to be unsynchronised, which will result in short price cycles. In may also turn out that, instead of accelerating, the global economy will enter a major slowdown phase in 2018–2019 on the back of certain negative developments (for instance in China). The slowdown will add to the slumps in oil output from conventional non-OPEC sources expected in that period and will put a cap on oil price growth. Low prices combined with uncertain demand projections will scale down upstream investments; as a result, oil supply will turn out to be insufficient to offset production slumps caused by depletion of deposits. Global concerns about insufficient oil supply will eventually drive up oil prices, which will stimulate investments in production; however, their effects may become apparent in the period of weak demand, which will drive oil prices down again.
To conclude, the confrontation scenario assumes disruptions affecting the global economy and the crude market, which will thwart transformation of the crude oil and energy sectors.
The commodity business, which encompasses the energy sector where the ORLEN Group operates, is a margin-based business. In the case of the oil sector, which still accounts for a lion’s share of our activity, the refining margin equals the difference between the product mix market price (average of the market prices of fuels and petroleum products, weighted by the production structure), and the market price of crude. In the above-mentioned scenarios we have discussed crude price movements, leaving the market prices of fuels and petroleum products aside. In the short term, fuel and petroleum product markets operate at their own pace, independent of the crude market. However, as the horizon is extended, interactions between those markets will come into play. Transmission of movements in crude prices into prices of fuels and petroleum products will depend on which factor calls for adjustments: namely, the demand for fuels and petroleum products, or the supply of crude.
Declines in crude prices on the back of a sudden rise in supply will immediately trigger a spike in product margins. Since crude prices will decline due to rising demand, there is no reason why the prices of fuels and petroleum products should change if nothing unexpected happens on the fuels market. However, a rise in product margins will increase returns on crude processing, and refineries will increase their throughput accordingly; and they can actually do it, due to high surplus of the global production potential in the refining sector. However, placing additional supply of fuels on the well-balanced market will require lower fuel prices; as a result, prices of fuel will fall, but with a certain time lag after the decline in crude prices. Higher margins will persist for as long as crude prices continue to fall, and then they will shrink, as fuel prices generally follow crude prices after a certain delay. When a decline in fuel prices draws to a close, product margins will stabilise at ‘natural’ levels set by the least efficient segment of the global refining business which offers the crude processing capacity necessary to satisfy the demand for fuels.
However, the situation is much different when the market is driven by the demand for fuels and petroleum products. If the demand rises faster than expected (just as it did in 2004–2008 due to the situation in China), products prices will rise accordingly, driving up margins and increasing profitability of crude processing, which will boost demand for oil. Since the reaction of the crude production potential is delayed, crude prices will go up and the margin will come back to where it started. In the past, the transmission process was strongly influenced by the OPEC cartel with decisions to increase output or to keep it flat, which had an impact on margins. In the current market reality, when the production potential can be activated within several months, the OPEC lost the ability to influence oil prices and refining margins. However, it can regain it if the US fails to increase the output of oil from non-conventional sources, which can occur in ca. 5 to 10 years in the baseline scenario.
It could also turn out that an increase in crude prices is triggered by rising geopolitical risks, just as in 2011–2014 in the wake of the Arab Spring. The risk premium contained in the price of crude oil is not always easily passed on to the prices of fuels and petroleum products. Therefore, rising risk premium will, first of all, drive down refining margins. As a consequence, due to declining profitability of their production processes, refineries will suffer losses and will be forced to scale down or even suspend production. As the supply of fuels on the market is reduced, their prices go up and margins are restored, at least to a certain extent: they are usually lower than prior to the adjustment, as the refineries which produce at the highest price are eliminated from the market.
Taking account of the transmission mechanisms, the baseline scenario assumes that in 2017–2018 refining margins will fall from the high 2015 levels, in line with the concurrent increase in crude prices. In the following years, as the increase in crude prices accelerates, margins may shrink significantly, especially if crude prices accommodate the geopolitical risk premium (which is currently ignored). In the long-term horizon, margins should rebound to the levels which will guarantee profitability of the global crude processing business.
At this point we should discuss a number of processes initiated in the low-price market reality, which will have an impact on refining margins in North-Western Europe (ARA margins – Amsterdam, Rotterdam, Antwerp). First of all, high refining margins which have persisted since mid-2014 did not solve the basic problem of European refineries, namely their uncompetitive position vis-a-vis American and Middle- and Far-East refineries. What determines the position of European refineries is the scale of their operation and age, as well as their links with the upstream business, which are weaker than in other parts of the world. On top of that, European refineries must cover higher regulatory costs related to climate and environmental protection. The competitive position of American refineries improved to some extent after the release of oil exports from the US, which led to an increase in the price of WTI benchmark oil and a lower differential against the Brent crude. Secondly, low oil prices have brought awareness to the OPEC countries and Russia of the importance of extended value chain in the margin-driven commodity business, which can be achieved by bringing new refineries and petrochemical units on stream. The output of those state-of-the-art units, which are and will continue to be put into operation in the Persian Gulf countries, will be exported overseas to meet the global demand. The Mediterranean region and North-Western Europe would be the natural target markets for those refineries. Higher supply from new, modern refineries integrated with the world’s most cost-effective upstream business will have a heavy bearing on the prices of fuel and petroleum products, which will adversely affect the margins of European refineries. And thirdly, Russia has embarked on a similar quest to extend the value chain, and it will soon offer fuels and petroleum products instead of crude oil. If we add the shrinking demand for fuels and petroleum products in Europe, then it becomes obvious that European refineries are in an extremely difficult position. In the context of weakening demand and competitive margins, irrespective of the crude price scenarios, small independent refineries are always the most vulnerable market players.
Conclusions for the Strategy
The ORLEN Group refineries have built a strong Downstream segment and operate in emerging markets; still, they will find it difficult to compete with refineries backed by a vertically integrated upstream operations. In that case, a decline in refining margins on the back of rising crude prices is accompanied by rising upstream margins, as the gap between market oil price and oil production cost is growing. The net result will depend on how much feedstock is sourced from the Group’s own hydrocarbon assets.
It should be noted that extension of the value chain towards upstream will bring double profits: namely, resilience of the new system to crude price movements and the take-over of production margin (that is, the difference between market oil price and local oil production cost). In order to capture production margins, the ORLEN Group must secure the know-how related not only to crude production, but also the acquisition of appropriate assets.
In this context it should be emphasized that any asset whose price is correlated with the price of crude oil, or is entirely independent of crude prices, may play a role similar to the role played by crude upstream operations. Such assets are related to feedstocks, not only energy feedstocks but also new technologies related to renewable energy sources, which could potentially be used in transport. The first option will be preferred if, in addition to the baseline scenario, we are putting a lot of weight to the confrontation scenario, which will involve the risk of losing margins due to frequent and deep movements in crude prices. The second option should be considered in the context of international collaboration and gradual replacement of oil in the transport sector with other energy sources.