Carbon comment

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Macro & FICC Research Published: 2021 05 05 15 55

Carbon comment

EU refineries in the line of fire X3

EU refineries has had a tough time for a long time. Then came Covid 19 with collapsing refinery margins.

Add on a large increase in global refining capacity to make it worse. Lastly add a huge increase in the EU carbon price. We think there is a significant risk that EU refineries will not revive much above a

throughput of 7.1 m bl/d and its free EUA allocation as EU and global oil product demand revives. EU might instead end up importing up to 4 m bl/d of oil products from other regions. This is high carbon prices at work in global competition. Pain at the marginal refined barrel for EU refineries. A carbon border tax is probably needed.

It has been tough for European refineries for a long time. In general, they are quite old and with a fairly low level of complexity. They are working head to head in fierce competition on the margin in the global refinery marketplace. Over the latest years their competitive position has become tougher and tougher along with the rise of modern, high complexity refineries which have come online in Asia and the Middle East. And yet more refineries are coming online in the coming years with capacity to increase more than the projected growth in product demand. Thus older refineries will necessarily be forced to run at lower utilization levels or close all together at different places around the world. Depressed refinery margins is the natural mechanism to force older refineries out of operation.

Global refinery capacity additions were 1.7 m bl/d in 2020 and is set to expand by another 3.0 m bl/d in 2021 and then by 1.5 m bl/d in 2022 according to a report by BNEF on global refining (Aug 2020). A lot of this expansion is in China and it is growing significantly faster than domestic product demand. The

consequence is increasing oil products exports from China resulting in depression of refinery margins elsewhere in the world. For example in Europe.

The Covid 19 crisis has of course exacerbated the situation further. Global demand for refined oil products collapsed last year. The US EIA estimates that oil product demand was 9 m bl/d lower on average in 2020 than in 2019 and that in May 2021 it is still 3.6 m bl/d below May 2019. That implies a comparable surplus of global refinery capacity resulting in a collapse in global refinery margins.

But when you add carbon costs to this picture it becomes very, very serious for the European refinery sector which is operating head to head with global competitors without such carbon costs.

There are 75 refineries in EU plus 2 in Norway. Their total refining capacity stood at 658.6 million tons of oil equivalents per year in 2018 according to FuelsEurope. At the normally used conversion of 7.33 boe/toe it equates to a daily average capacity of 13.2 m bl/d. Refineries in Europe in general operated at an average utilization rate of 87% in 2017. If we assume the same was true in EU + Norway it implies an average throughput of 11.5 m bl/d out of the 13.2 m bl/d capacity that year. These refineries emitted 117.5 m ton CO2e in 2017 according to EU ETS emission statistics for the refinery sector. Doing backward calculations this implies that EU refineries emitted 28 kg CO2e per barrel of oil processed in 2017.

In global refining the CO2e emissions per barrel of refined oil is in the range of 10 – 70 kg CO2e with a volume weighted global average of 41 kg CO2e/bl. Our proxy calculated emissions by EU refineries of 28 kg CO2e per barrel of crude oil refined is thus below the global average at 41 kg. This may be due to several causes. One is that the EU refineries are simpler and thus processes the crude less and thus consumes less energy and emits less CO2 in the refining process than complex refineries do. The other is that EU refineries in general have a lighter crude diet (light, sweet) versus the global average refinery crude diet which is medium sour crude which requires more energy to process. The last reason may be due to the EU ETS system by itself. EU refineries have after all been part of the emission trading system since 2005 and might have taken measures to reduce emissions over the years and the EU refineries with highest carbon emission intensities might have closed down.

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The 28 kg/bl is still significant since refineries in the global market place do not have the same kind of added carbon cost as EU refineries. If we assume 28 kg CO2e emissions per barrel refined in the EU then we get the following added emission costs for EU refineries for each marginally barrel refined.

If the CO2 price is EUR 10/ton (USD 12/ton) then the added marginal carbon cost of refining in the EU is USD 0.35/bl of refined crude oil. At a CO2 price of EUR 49/ton (price at the time of writing) the added marginal cost of carbon in EU refining is instead USD 1.7/bl refined crude. And if the CO2 price moves to EUR 75/ton as we think it will already in Q3 21 the EU refineries will get a negative hit on the refining margin of USD 2.5/bl.

This might seem like a minor added cost but it is most definitely not. From Jan 2017 to Dec 2019 the 50- percentile EU refinery only earned a gross refining margin of USD 3.26/bl. That is the value of products produced minus the cost of the crude oil processed. I.e. it is the gross margin income before opex and capex costs.

The capex cost for EU refineries is probably not all that high since they in general are quite old. I.e. they have paid down most of the capital which was spent to build them.

Opex costs however are still there and are usually increasing by age as more and more maintenance is required per each day of processing operation. Globally the refinery opex costs have estimates in the range of USD 3 – 14/bl of processed crude.

High complexity refineries typically have higher opex costs due to extensive processing. The upside though is that almost all of the oil products they produce are high value products which lifts their gross refining margin.

Opex for complex refineries are typically assumed to be in the range of USD 5 6/bl of crude processed but can easily be up to USD 10 14/bl.

We don’t know the average opex cost for EU refineries. But they might be in the range of USD 3 6/bl given that they in general are considered to be of lower complexity. Let’s however for the sake of simplicity assume that average the opex cost for EU refineries is only USD 3/bl. The truth is probably to the upside of this number.

The 50 percentile refinery in EU had a gross refining margin of USD 3.26/bl from 2017 to 2019. Subtracting the opex of USD 3/bl leaves a net margin of only USD 0.26/bl before other costs. During those three years the 50 percentile refinery in EU was thus barely breaking even. And that is before we take the carbon cost into account.

With 28 kg CO2e however the average, added marginal carbon cost of refining in the EU was USD 0.5/bl during these three years. Right now though that added marginal cost of carbon for EU refineries stands at USD 1.7/bl.

We are here specifically saying “marginal barrel” and “marginal cost”. This is because EU refineries receive about 70% of the EUAs they needed for free in 2019. One can thus discuss whether the carbon cost of the 30% EUAs they need to buy is divided by all barrels refined or whether they are spread out only on the 30%

of barrels refined with no free allowances. We’ll here assume that they make marginal refining decisions on what they’ll earn or loose on the marginal barrel above the 70% free allocation line.

EU refineries spent roughly EUR 200 million per year to purchase the EUA allowances they needed for their refining from 2014 to 2017. In 2018 it shot up to EUR 532 million and in 2019 to EUR 856 million along with lower free allocations and rising carbon prices. If EU refineries in 2022 are to refine as many barrels as they did in 2019 and the EUA price is EUR 50/ton then we estimate that they’ll have to pay EUR 2,046 million in EUA purchases that year. If so it will equate to an average added cost of carbon for all barrels refined of USD 0.6/bl. Again this is significant given an average gross margin of USD 3.26/bl from 2017 to 2019 with an assumed minimum opex of USD 3/bl to be subtracted from that.

Most likely however the refineries will make some kind of marginal economic decision here for all barrels processed above the free allocation limit.

Let’s assume that the gross refinery margin for the 50 percentile refinery in EU moves back to the 2017 to 2019 level of USD 3.26/bl as global oil demand recovers in H2 21 and 2022. It will however probably not be as good as that due the strong increase in new refining capacity globally. Assume further that the EUA price is

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EUR 50/ton in 2022 and that the free allocation continues to decline by 2.8% per year as it has done on average from 2015 to 2019. This would yield a free allocation of only 72.4 million tons of EUAs in 2022 versus 78.9 million free EUAs in 2019. In 2019 the EU refineries emitted 113.3 million tons of CO2.

These assumptions would lead us to conclude that EU refineries could only refine 7.1 m bl/d of crude under the free allocation of EUAs in 2022. In comparison they refined an average of 11.1 m bl/d in 2019.

For the 4 m bl/d from 7.1 to 11.1 m bl/d the 50 percentile refinery in EU in 2022 would have the following marginal economics:

Net margin = Gross margin – opex – carbon = USD 3.26/bl – USD 3.0/bl – USD 1.7/bl = - USD 1.4/bl.

The net margin would fall to minus USD 3.1/bl if the EUA price instead was to rise to EUR 100/ton as this would yield a an added marginal cost of carbon of USD 3.4/bl.

This has several consequences.

One is that as European and global oil demand revives in H2 21 and in 2022 along with rising vaccination rates around the world the gross refining margins are likely to rise globally as well as in the EU. The 30%

marginally refined barrel in EU is however still likely to be strictly negative due to the now much higher carbon cost of the marginal barrel for EU refineries. There is thus a very high risk that EU refineries are stuck at a refinery throughput of only 7.1 – 7.3 m bl/d as this is how far the free EUA allocation can allow them to go amid intense competition versus international players without a carbon cost.

Rising EU oil product demand would then not be covered by rising EU refining but instead lead to a massive inflow of oil products from international competitors. Not the least from all the new refineries in Asia. We are here talking of oil product imports to the EU in the magnitude of up to 4 m bl/d as EU refineries risk being economically stuck at a throughput of only 7.1 - 7.3 m bl/d vs a normal of 11.1 m bl/d.

This bring us to the second point which is carbon leakage and a carbon border tax. Point one above is obviously not a desirable outcome as it yields no real CO2 reduction. Instead crude oil will travel on long sea journeys before finished oil products are transported all the way back to EU again from Asia. The reason for why EU refineries receives 70% EUA their needs for free is exactly because the sector is highly exposed to international competitors without a carbon cost. But when we look at the marginal economics here we see that this is far from good enough. A much higher CO2 price is totally burning the marginal economics for EU refineries in their competition versus global pairs without a carbon cost burden.

We think that this is likely to accelerate the discussion and the necessary implementation of a carbon border tax. If the EU is going to have a carbon price of EUR 50 - 75 - 100/ton then it will need a fending border tax around it.

It is probably much better for EU refineries if we get a proper carbon border tax while instead they get zero allocations for free. The current half-way measure is probably no good at all.

The 50% percentile EU refinery earned a gross refining margin of USD 3.26/bl of refined crude oil before opex and carbon costs.

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Source: SEB, Bloomberg

Carbon costs however makes a large bit into this gross refinery margin. Not so much from 2017 to 2019 but increasingly so for 2020 and 2021. But we are talking marginal refined barrel here because the sector typically gets some 70% of its EUA needs allocated for free. Thus for 2020 and 2021 the EU refinery throughput might have been so low that the sector might not have needed to purchase any EUAs at all.

Graph shows 30 day moving average.

If we also subtract a minimum of USD 3/bl in opex as well as different levels of carbon costs for EUAs we get the following graph for the refining of the marginal barrel in EU.

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EU refineries receive a large share of EUAs for free. Some 70% of the EUAs they need they have gotten allocated for free with the argument that they are in fierce global competition with refineries which do not have a carbon cost. In 2020 and 2021 the EU refineries have probably not needed to purchase any EUAs in the open market due to very low refinery throughput. Or at least very few

If we convert emissions to the processing of million of barrels per day in the EU refineries assuming 28 kg CO2e per barrel refined we get the following graph. Thus if EU refineries are to process the same amount of crude oil in 2022 as they did in 2019 (about 11.1 m bl/d) then they will need to purchase 41 million tons worth of EUAs to cover the marginal 4 m bl/d of processing not covered by free EUAs. But if they do they processing of these 4 m bl/d of marginal refining will all be totally loss making. It would yield the 50 percentile refinery in the EU a loss of USD 4/bl for each barrel processed above the free allocation bracket. High risk here that we won't see EU refineries rebound their processing along with reviving EU and global oil product demand.

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But if EU refineries do run at 11.1 m bl/d average refining in 2022 and the EUA price is EUR 50/ton then they will likely need to purchase EUR 2,046 million worth of EUAs

Bjarne Schieldrop bjarne.schieldrop@seb.no

47 9248 9230