Peak Demand in Three Years: How “2D” Is Disrupting the Oil Refining Sector

David Fessler By David Fessler
Energy and Infrastructure Strategist, The Oxford Club

Oil & Gas

Imagine if a quarter of today’s demand for global oil refining capacity vanished…

What would that do to the world’s biggest refiners?

The least profitable ones would go out of business. But every refiner on Earth would feel the pinch in a big way.

The rollout of electric vehicles, as well as higher fuel efficiency in internal combustion engine vehicles, is leading us to this situation – and it’s a catastrophic one for oil refiners.

Don’t think it’s possible? Trust me: It’s inevitable.

EVs are selling like gangbusters, and there’s no indication that it’s going to change.

So if you own any stocks in the oil sector, you might want to read on.

The “2D” Scenario: Oil’s Doomsday

Here’s the scenario that could spell disaster for oil companies: It’s called the “2D” (or “2-degree”) scenario.

If countries around the world limit global warming to 2 degrees Celsius by 2035 (which all countries in the world, with the exception of the U.S., have committed to achieving, per the Paris climate agreement), crude oil demand would peak in 2020. Then, over the next 15 years, demand would decline by 23%.

As demand falls, it follows that refinery output must also fall.

Under this scenario, marginal refineries will give up rather than bleed cash. This will have a profound effect on the refining industry.

Refiners that manage to stay in business will see shrinking margins. The study estimates a $3.50 loss per barrel by 2035.

Refiners will notice this on their balance sheets. In fact, some already have. One study looked at 492 oil refineries that account for 94% of the world’s crude refining capacity.

It turns out that 21% of refineries are already in the red.

Just like unprofitable coal-fired power-generation plants, refineries are often old, unprofitable or barely profitable operations.

The ones with the oldest facilities are most at risk.

The Most Exposed Refiners

According to the study, Total SA (NYSE: TOT) and Eni SpA (NYSE: E) are the two refiners most at risk.

Under the 2D scenario, both Total and Eni could see a 70% to 80% shortfall in earnings by 2035.

Meanwhile, industry giants like Chevron (NYSE: CVX) and Royal Dutch Shell (NYSE: RDS.A) could see a 60% to 70% drop in earnings, while BP (NYSE: BP) and Exxon Mobil (NYSE: XOM) could see a 40% to 50% drop in earnings…

That pretty much covers all of the major publicly traded refiners.

A key point here is that the drop in crude demand is far more harmful to the refining sector than it is to upstream producers. That’s because an overcapacity in refining can be addressed only by closing refinery operations.

Upstream producers can simply produce less. In other words, those companies’ margins will be much less affected by demand reduction.

On the other hand, the companies that refine oil into combustible gasoline, diesel and jet fuel will feel the pinch. Transport fuels translate to 70% of an average refiner’s profitability. This is the segment most susceptible to demand destruction under the 2D scenario.

On most major oil companies’ balance sheets, refineries account for 25% of assets.

They are also worth many billions of dollars and generate billions in strategic profits.

Déjà Vu for Major Oil Companies

It’s my opinion that major oil companies are seriously underestimating the growth of EVs. They could easily make up 33% of new vehicle sales by 2035.

But the destruction of the demand for crude brought on by EVs won’t be the first time oil majors have seen this…

Back in 1979, a spike in the price of crude resulted in a 17% plunge in demand from Organisation for Economic Co-operation and Development member countries.

As a result, 18% of refining capacity closed in OECD countries. Worldwide, demand dropped 10%, and roughly 8% of refining capacity closed.

Maybe they can take the lessons from that experience and avoid total catastrophe…

But here’s the essential point for investors…

No new refinery capacity is necessary to meet future demand under the 2D scenario; I see no compelling reason to invest in refiners at this point.

From here, margins are going to be squeezed and profits reduced.

There are much better places to invest in the energy sector.

Good investing,

Dave

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