Downstream organisations with exposure to logistics and marketing (including retail marketing) have typically seen higher earnings than pure independent/merchant refiners. The importance of vertical integration was clearly seen in 2015 – 2016 when oil prices fell to multi-year lows. Vertically integrated downstream companies – those with marketing channels, as well as midstream operations – fared better during this downturn than the pure-play merchant refiner selling at the rack. Marketers saw strong margin uplift through their branded channels and midstream operations provided ratable income.
For most oil refiners and chemical producers, the need to improve margins and remain competitive has never been greater. While the concept of integrating crude refining with petrochemicals manufacturing is not new, it is becoming an important growth strategy as a means for increasing revenues and serving as a hedge against sustained, long-term or flat oil prices, but will it create value in the long-term?
Can margin uplift come from elsewhere?
Before diving into the benefits of vertical integration between refiners and petrochemicals, it is worth briefly examining how refiners have tried to get margin uplift over the last decade. Several examples come to mind. First, let us discuss biofuels and their use in gasoline. Through regulations pushing for cleaner fuels, coupled with the banning of methyl tert-butyl ether, refiners turned to corn-based ethanol for blends of higher octanes. Refiners locked in on higher octanes to secure a higher profit over regular grades of gasoline. They could have invested in ethanol production themselves. Rather, they invested in specialised railcars and networks for transportation and formed long-term supply contracts with producers. The combination persisted until market conditions dictated that it was no longer a sole competitive advantage.
Another example to get margin uplift was based on finding cheaper crude through the crude-by-rail craze. Domestically discounted crudes were shipped on railcars to help refiners lock in cheaper supplies, as compared with overseas crudes being imported. Again, refiners invested in infrastructure (people, process and technology) to support the movement and take advantage of the economic environment. As public pressure pushed for more costly regulations and deeply discounted crudes levelled out against foreign alternatives, enthusiasm for utilising this business strategy subsided. Only refiners that built sound technical infrastructure as an extension of their workforce and processes were able to persist. Others that ramped up too quickly and solved the problem by throwing people and money at it found themselves hurting with higher costs and a lack of understanding as to why and how they got there.
Now, with the International Maritime Organization (IMO) 2020 ruling that the marine sector will have to reduce sulfur emissions by over 80% through cleaner bunker fuels, refiners are again looking for margin. This time, investments were made, and capital deployed to upgrade facilities in order to process crude to produce on-spec, low-sulfur bunker fuel products. Again, time will tell how ‘sticky’ the competitive advantage will be for ‘first movers’ and how the market levels out. Currently, low-sulfur bunker fuels command higher prices. Like the previous crude-by-rail craze, the organisations that thrive will have to go beyond a few cursory steps to solving the problem. Success will come for those that carry the capital investment into their supply chain and expand their customer base sensibly to lock in long-term contracts. This market dislocation, created by regulation, will move back to equilibrium over time. So, companies that extend their internal capabilities beyond initial capital investments stand to benefit at improving the length of time in which they can enjoy a competitive advantage over their peers.
Why petrochemicals integration?
Knowing that refiners must continue to innovate and evolve, petrochemicals integration is the next evolution for most. Petrochemicals integration offers refiners optionality with an ability to ‘toggle’ between production of refined fuels and/or chemicals. It also provides access to fast-growing chemicals markets, as well as a natural hedge against weakening demand growth for gasoline and diesel. The integration of fuels and chemicals production will likely impact the economics of the downstream industry and it could leave less integrated players unable to respond to changing market trends.
Over the next decade, oil may be the next big thing in petrochemicals. This is a change from the 2010s, when billions of dollars flowed into the US to build crackers and downstream petrochemical plants to process low-cost shale gas into ethylene and propylene and their derivatives. This shift is being driven by a bleak market outlook for oil and refined fuel demand, which is expected to decline by 2030. Electrification and policy uncertainty are just some of the factors cutting into demand forecasts for both oil and refined products demand growth.
Another natural reason for pursuing vertical integration focuses on the supply chain aspects. The petrochemicals industry sources its feedstocks from refiners. Essentially, the feedstocks from refiners are processed further in petrochemical plants to produce everything from plastics, synthetic rubber, pharmaceuticals, additives and adhesives (to name a few). So, where there are synergies in processes and locations, it makes sense to form a tighter bond and connection between two parts of the supply chain in order to drive down costs. Economies of scale is important to survive.
Downstream vertical integration ‘hot spots’
Much of the activity in petrochemicals capability within oil refining operations is occurring in China. ExxonMobil has practiced direct crude cracking technology in Singapore since 2014 and may build another such unit in China. Several facilities under construction in China will transform roughly 40% of its oil into paraxylene, a valuable chemical building block to manufacture plastics, fibres, films and as an additive in gasoline. Elsewhere, front-end engineering and design work is underway by a joint venture between Saudi Aramco and SABIC for another crude oil-to-chemicals facility in Saudi Arabia that could potentially start up within the next decade.
In the US, recent examples include Motiva Enterprises’ acquisition of Flint Hills Resources’ chemical plant adjacent to its Port Arthur, Texas oil refinery last year, which signals a value chain integration play. The acquisition for Motiva is smart as it can now extend its product line to customers. The Flint Hills plant includes an ethane cracker, which has the capacity to process NGL ethane into 620 000 tpy of ethylene, the building block of most plastics. Another unit at the plant can produce 340 000 tpy of propylene, another key ingredient for plastics.
How to make it successful?
Integration is not enough to ensure that the new business strategy will be successful. Refiners can take lessons from the past and other industries in order to make sure that they are obtaining optimum value from their acquisitions.
First, cultures must align, such as with the idea that petrochemicals have an ‘equal seat’ and are not just thought of as a ‘bolt-on.’ Petrochemical marketing, customers, pricing and markets differ from traditional refining. Organisations must align and cultures must neatly fold into each other so that all are mutually incented to get the most out of the original economic advantages that drove the merger. Conscious efforts must be made not to stifle one side or pit sides against each other. Conscious change management must be employed at all levels in order to ease anxiety and promote mutual cultural values, ideals and goals for the new organisation.
Second, holistically, the newly-formed entities must examine their customers and get to know them better. Movements are afoot within energy to focus on ‘knowing your customers’. There are many facets to this movement (which is already commonplace within the financial services sector). Knowing your customer is about understanding buyer values for your new customers. Petrochemical markets and contracts are different than wholesale fuel contracts. Investments need to be made in channels in order to seize on lucrative deals. Having an increased presence and economy of scale can certainly help in negotiations for gaining entry into new accounts or driving deeper into existing ones. Therefore, newly-formed entities need insight into their customers in order to realise this benefit.
Third, the information flow between organisations must be unencumbered. No longer is there a focus on one or two similar business units. Now, there is an entirely separate business that needs to be integrated. Inventory reporting must be revamped. Financials need to flow seamlessly. Systems that did not use to feed into a centralised warehouse need to be tuned to do so. Beyond the basics of normal transactions and ‘blocking and tackling’, companies need to develop insight into the data. Integrated commercial groups would be well-served to understand their customers. What is the customer price elasticity? Can other products be bundled to the customer (as they might be integrated as well)? Is there a lower-cost model for the customers? During the integration, can separate customer bases be assured that the same level of service and quality will be maintained and (ultimately) improved? Without efficient flow of information and data, companies can only react to issues, not plan effectively.
Lastly, value chain optimisation leveraging digital technologies will be essential to realising the value of integrated solutions. Chemicals demand is projected to grow 4% to 5% annually, while refined fuels demand growth is projected to be only one third of that. Therefore, it is critical for integrated organisations to deploy improved capabilities for demand forecasting, sales and operations planning, and product planning to ensure that the highest value products reach the highest value customers. Inventory optimisation will continue to be a critical component to managing working capital and ensuring customer fill rates, as well as managing logistical bottlenecks often seen with railcar movements. Can refiners that embraced ‘crude-by-rail’ a few years ago adapt lessons (both good and bad) from the past in order to avoid mistakes? It is incumbent to build off the people, processes and technology infrastructure that may exist in order to weave in a new business into the supply chain.
While digital transformation can mean many things to many organisations, the strong ones that want to maintain a healthy competitive advantage will seamlessly integrate Internet of Things (IoT) and artificial intelligence (AI) enabled technologies as extensions of their workforce and processes. These ‘learning supply chains’ will incorporate feedback loops for continuing to drive key metrics in near real-time to optimise customer deliveries, supply chain costs, inventories and production. They will be the ones that prudently look for opportunities to reflect upon their current operations and strive for continual improvement. What does the future hold?
Time will tell with respect to success and failures of such vertical integrations and the ability for refiners to evolve and enjoy a competitive advantage. Expanding one’s business or altering the supply to affect costs is one thing. To pull off a merger successfully is something else entirely. Both companies need to be steadfast in their resolve to create clear joint strategies that encompass the new business and permeate down through the organisation with policies and procedures. And, they must not forget the ever-present need for tighter integration of systems and processes to ensure lasting success that is mutually beneficial for all parties.
Written by Matt Flanagan and Patrick Long, Opportune LLP.
Read the article online at: https://www.hydrocarbonengineering.com/special-reports/14042020/rethinking-the-value-chain/