Think back only a few years to 2015 – oil prices were at similar levels to today. The oil majors’ upstream financial performance was poor, but their downstream businesses saved the day for overall corporate results.
The benefits of the integrated business model were widely extolled as the collapse in crude prices shifted value to their downstream activities.
Today, the market fears a global recession. The U.S. yield curve has inverted on multiple occasions over recent months - the interest rate associated with U.S. short-term debt is higher than that of long-term debt, which is unusual. In the past, this phenomenon has been observed 12 to 18 months prior to most U.S. recessions.
The adage “history doesn’t repeat, it rhymes” means a global recession is not inevitable, particularly as recent actions by the U.S. Federal Reserve and the European Central Bank have re-established a more typical yield curve profile.
A global recession is certainly not Wood Mackenzie’s base case outlook, but if one did transpire, does the integrated business model of the oil majors insulate them from the impact of lower oil prices?
The circumstances of the oil price collapse in 2015 and 2016 are quite different from the current situation.
Back then, oil prices collapsed as OPEC elected to compete for market share. U.S. tight oil supply growth had been rising rapidly, leveraging low-cost finance and an equity market focused on volume, rather than value, growth.
Chain reaction: the integrated model was seen as key to success, but how does it hold up in a low ... [+]
OPEC’s change of behavior was to stem that tide. The fall in oil prices from supplier competition spurred demand growth in developed countries, as it encouraged discretionary driving. This was particularly evident in the U.S. as gasoline demand grew sharply.
In plain terms, the SUV came back out of the garage for the daily commute, as gasoline prices had halved from 2014 levels. The phenomenon of falling crude oil prices, prompting higher demand for refined products, was a key driver in the higher profitability of the refining and petrochemical businesses of the oil majors.
At one point, Brent crude oil was priced at U.S.$50 per barrel; with gasoline at the refinery gate earning a premium of U.S.$25 per barrel over Brent (compared to its normal levels over just under U.S.$10 per barrel for the preceding 10-year period).
Traditionally, global oil demand has grown by over 1 million barrels per day each calendar year, largely due to growth in the emerging world lifting household incomes. These higher incomes lead to growing numbers of passenger cars and the higher consumption of various goods and services – all of which require more energy usage, much of which is supplied by refined products.
Growth in mature regions, such as North America, Europe and Japan, is much smaller and often declining, as vehicle fuel efficiency standards continue to improve.
Under the scenario of a global recession, annual oil demand growth will likely be very weak – of the order of only a few hundred thousand barrels per day. This will likely lead to materially weaker oil prices, as upstream supply growth is anticipated to be greater than demand growth for our base case outlook. This is due to the large, conventional upstream projects in Brazil, Norway and Guyana being completed within the next one to two years.
Without deeper production cuts by OPEC, oil prices could fall to levels needs to stop further U.S. tight oil drilling. This is at prices at least US$10 per barrel below current levels.
So, with oil prices below U.S.$50 per barrel, will the refining and chemical sectors save the day?
Sadly not, as significant capacity additions are scheduled for the refining and petrochemical sector.
We are expecting almost 3 million barrels per day of refining capacity to be added globally in the next few years. With a global recession, falling demand in Europe and the U.S., combined with limited demand growth in the Middle East and Asia, means refinery utilization will fall. This is associated with weak refining margins, so refining will not ride to the rescue.
Global petrochemicals are in a worse position, as we are already expecting margins to continue to decline due to the over-supply. The only savior will be those with chemical assets in the U.S., where margins are expected to improve as polymer capacity additions provides access to global markets and with it, a boost in earnings. However, if the world is in a global recession, this boost will be small.
Even the contribution from fuels marketing will be hit, but due to lower volumes sold across company-owned forecourts. Unit margins tend to remain stable, so those integrated oil majors with wholly-owned sites will not be hit as hard.
The message is clear – the downstream business provides a hedge to earnings when the crude price collapse is supply-side driven. When it’s a fall in demand, the earnings along the entire chain are squeezed, so integrated value chains will be challenged by the threat of a global recession.
