May 2021

Trends and Resources

Business Trends: The economics of reliability—An interim report on the global refining industry

What is reliability? Most people think reliability is simply a measure of failure, or lack of failure. If something runs for a longer period without failing, then it is more reliable than something that runs for less time. However, reliability is a measure of how often something performs when you want it to.

Krimmel, J., Pinnacle

What is reliability? Most people think reliability is simply a measure of failure, or lack of failure. If something runs for a longer period without failing, then it is more reliable than something that runs for less time. However, reliability is a measure of how often something performs when you want it to.

The basis for the author’s company’s annual and interim quarterly reports are to explore the connection between reliability and economics so that we can understand how these key components of modern society intertwine. In doing so, we begin to see some striking trends and key indicators of opportunity. The goal of these reports is to challenge key industries in ways never seen before.

Most of the world’s industrial facilities buy and sell commodities. Therefore, they have little impact on the price they pay for their feedstocks or the price they receive for their products. The nature of every commodity is that producers will fill the market with enough product until the margins—or profits—for producing that product decrease to a level that no one will produce more. Inevitably, the balance of supply and demand will separate organizations that are very good at running their facilities from those that are not. One of the biggest differences between these two groups is reliability.

Whether discussing jet transportation, power generation, water processing and treatment, chemicals, mining, oil and gas production, refining, automotive manufacturing or agriculture, reliability can mean the difference between excellence and mediocrity, and even profitability vs. bankruptcy.

The author’s company’s analysts estimate operators of complex facilities around the world spend more than $500 B/yr on reliability. The author’s goal is to view several of these segments in detail and better characterize the role reliability plays in the broader economy.

For decades, lean manufacturing has driven companies and operators to improve runtimes, lower costs and minimize risk for their facilities. While this push has affected multiple sectors, no area has produced as much public data as the refining sector, especially in the U.S. The U.S. Energy Information Administration (EIA) has collected and reported refining data for decades and, when combined with international reports from the Organization of the Petroleum Exporting Countries (OPEC) and the International Energy Agency (IEA), among others, the level of information is unparalleled to other reporting sectors.

Refining reliability overview: Crack spreads as health indicators

A refiner’s financial performance is largely driven by two variables: the price of raw feedstock (e.g., crude oil) and the price of finished products (e.g., gasoline, diesel and jet fuel). As a result, crack spreads—the difference in price between refined products and chosen inputs—are the most useful indicators of the health of the refining sector.

Crack spreads do not account for the cost of running the plant. Crack spreads ignore costs for items such as the energy to heat and process the feedstock, the people to operate the plant and all repair, maintenance and ongoing reliability work.

If we are mostly interested in reliability, then why do we care about crack spreads? More than 80% of the costs for a refinery are its feedstock. Crack spreads help us understand what is left over when we remove a refiner’s single largest cost from its theoretical revenue. This leftover amount is what the refiner uses to cover its remaining costs, with ideally some profit remaining at the end. As crack spreads widen, the refiner has more capital available to invest in its operation or return to its owners. As crack spreads narrow, refiners have less flexibility and must make difficult decisions about how to deploy their limited capital. Crack spreads inform about the resources available to invest in best-in-class reliability programs, which is the primary area of interest.

Refining financial landscape

One measure of crack spreads is shown in FIG. 1. The blue line shows the spot price for Brent—the international benchmark for light, sweet crude oil. The green lines show the crack spread between reformulated blendstock for oxygenate blending (RBOB)—the primary component of gasoline—and Brent. The solid green line shows the monthly average crack spread. The dashed green line shows the crack spread’s trailing 1-yr average.

FIG. 1. RBOB and crack spreads, January 2006–September 2020. Source: U.S. EIA.
FIG. 1. RBOB and crack spreads, January 2006–September 2020. Source: U.S. EIA.

FIG. 1. shows the volatility through which refiners have learned to manage their business. Since the beginning of 2006, the smallest monthly average crack spread was $0.01/gal, while the largest spread was $1.32/gal. In this 16-yr analysis, the crack spread has averaged $0.40/gal. In comparison, the 2020 year-to-date average is $0.30/gal, a 25% decline from the historical norm. If we use consumer price index data to account for the time value of money, the average crack spread from 2006 to the present increased to $0.46/gal. In constant dollar terms, the 2020 year-to-date spread is then at a 35% discount to the historical average, which explains a large fraction of the prevailing distress across the global refining sector.

Interesting patterns are apparent in this dataset. Starting around 2010, aggressive development of U.S. conventional oil and gas plays brought excess supply to the market. This supply glut eventually caused the crude oil price collapse of 2014. Conversely, demand did not experience a similar shock, which kept product prices from collapsing as aggressively as crude oil prices. As a result, crack spreads increased through 2015. Over the course of a year, refined product prices reset to the lower oil price regime, which caused crack spreads to return to their normalized level of around $0.40/gal, where they remained from 2017 through 2019.

As noted previously, the 2020 year-to-date crack spread average is approximately 35% below historical levels when measured in constant dollar terms. The initial decline was triggered by a rapid deterioration in refined product consumption, driven by government lockdowns as a result to the COVID-19 pandemic. Refined product consumption has only weakly recovered as government restrictions persist, combined with (at least temporarily) changed travel preferences among the general population. As a result, crack spreads have witnessed continuous pressure throughout the year, with the most vulnerable refineries experiencing negative margins.

However, the news is not all bad for refiners. Capacity reductions will accelerate the pace with which the market normalizes. As of December 2020, the author’s company’s analysts estimate that 2 MMbpd of refining capacity is out of the market vs. the beginning of 2019. Therefore, the market should reach a healthy balance of consumption and production this year. Assuming this to be the case, analysts are forecasting an upward trend in refining margins through 2025.

Anticipated trends in the refining industry

Looking at global reliability spending patterns, the refining market will improve but will still face challenges. Regulatory pressures will keep growing, placing a lid on potential future margin expansion, and slowing upstream production growth will buoy feedstock prices and compress margins. In the U.S., natural gas prices are edging higher, which may reduce one of the U.S. refining sector’s largest structural advantages—the cost of energy. These pressures may be offset by announcements by companies like BP and Shell that say they are exiting refining, but this is not anticipated to have an impact for several years.

Operational improvements are coming

In the face of adverse market forces, companies are pushing harder than they have in decades to make operational improvements, while simultaneously cutting costs. At the same time, virtually every major oil and gas company is investing heavily in strategic improvements, especially digital transformation. The author’s company estimates that the energy industry—including exploration and production, midstream operations and downstream facilities—plans to spend $20 B over the next 5 yr on these projects alone. While several challenges exist in achieving operating improvement, especially in digital infrastructure, there is substantial potential for this improvement and cost optimization.

The pace of change is accelerating

For the first time in modern history, oil and gas majors began to diverge dramatically in their forecast of energy markets in 2020. Environmental, social and governance (ESG) pressures have been a dominant topic for the past few years. Within the refining industry, ESG pressures continue to mount. A difficult economic environment in 2020 forced virtually every refiner to make massive cuts in spending and sparked questions as to the stability of some of the facilities. In an industry with a tradition of very slow changes, the future leaders will most likely achieve that position due to the pace at which they evolve and focus, in part, on improved reliability.

Takeaways

The author’s company estimates that global refiners spend more than $50 B/yr on reliability-focused activities, primarily on routine maintenance efforts and turnaround programs. It is also estimated that between 10% and 30% of this investment is wasted, meaning it does not improve reliability. In some instances, this spending may have a detrimental impact on performance, weighing even further against profitability. In this sense, suboptimal approaches to reliability costs refiners around the world between $5 B/yr–$15 B/yr.

To optimize reliability, spending and reliable performance to minimize risks and maximize profits, a refinery can do four things. These include:

  1. Develop consistent, quantitative systems for evaluating system performance
  2. Integrate reliability data from a range of sources and assets into single-system models to ensure critical inputs and influences are identified
  3. Ensure personnel are adopting their work processes and utilizing these systems effectively to leverage their capabilities
  4. Push past traditional decision processes or practices to uncover new opportunities and solutions.

While these suggestions sound simple, they have proven challenging for many refiners. Across the board, those that are doing all four of these appear to have both a lower risk profile and a higher profitability result, validating the premise that reliability is one of the leading indicators of profitable operations. HP

The Author

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