Margin Levers Impacting Group I and Group II Competitiveness

Part I – The Past Events of 2011 to Early 2013: Myths and Realities
By Ian Moncrieff, Director, Energy Practice, Kline & Company, Inc.

1.      Introduction

As much as the lubricants industry might wish it otherwise, base stocks production is becoming more commoditized, and it is intertwined inextricably with mainstream refining operations. The vast majority of base stock production occurs in “lube blocks”, which are integrated, both physically and commercially, with their co-located parent fuels refineries. It’s possible to draw an imaginary fence which defines the lube block, separating it conceptually from mainstream refining. Into the lube block may flow a variety of feedstocks (primarily VGO, but also hydrocracker bottoms, vacuum tower bottoms, and hydrogen).  Conversely, intermediate streams not sold directly from the lube block to third parties are returned across the “fence” to the parent refinery, for pool blending or conversion in FCC or coking units.

For Group I plants, because of their lower base oil yield specificity relative to Group II/III plants, and large volumes of byproduct extracts and tars produced, it is important to be constantly aware of the option values of “across-the-imaginary fence” return streams vis-à-vis their external market prices. This is particularly relevant in the case of extracts where the commercial market, though commanding price premiums over internal refinery FCC-driven “marginal values”, continues to decline in volumetric terms. Most Group I producers now route the large majority of extracts to their refinery FCCs. As a result the price advantage of aggregate extract sales over VGO is declining. In the same way, refiners with delayed cokers will adjust the volumes of solvent de-asphalted (SDA) pitch, which is allocated between asphalt blending and coker feed, according to seasonal variations in asphalt market pricing.

We’ve heard a lot in the press, and in major industry forums, about the future of the base stocks industry and, in particular, the evolving competition between Groups I and II. Bulls are prognosticating a rosy recovery, while bears predict a long and painful demise, for Group I plants. This article is an attempt to bring some fundamental insight into the salient events of the recent market collapse. On the way, we will also address some of the “lifesavers” which have been thrown overboard, as potential sources of value creation to enhance base stock production margins, most notably for Group I.

Kline recently launched a monthly cash margin index, which estimates plant net cash margins to U.S. Group II producers (EBITDA before SG&A expense). The first index, published in January, 2014, is shown in Figure 1. While margins in 2011 were very healthy, a profound and undesirable change overcame the base stocks industry in mid-2012, finally reaching its nadir in February, 2013. The underlying causes for the dramatic collapse in base stocks price ratios relative to crude oil can be attributed, among others, to declining base oil capacity utilization, and/or to a fundamental shift in price/cost relationships as the influence of higher-cost Group I supply steadily erodes. To characterize the symptoms of the dramatic drop in margins which took place over that period, let’s dig deeper into the changes in prices and costs which took place in the base stocks industry between 2011 and 1Q, 2013.

First of all, we recognize that not all lube blocks are identical, particularly in Group I plants, where there can be significant variances in yield structure driven by variations in crude slate, feedstock mix, and extraction processes employed. In addition, operating costs are influenced by scale, capacity utilization, and plant maturity. So, while there is no “one-size-fits-all” for Group I plants, let’s choose a “typical” production profile and see how that plant competed with Group II over the past three years. In this comparison, all costs and revenues are expressed in terms of $/Bbl of total feed to the lube block; thus the vacuum unit itself is excluded from the lube block, though VGO and vacuum bottoms produced from that unit which enter base oil processing are accounted for as feed.  In other words, we exclude VDU products which are routed directly to mainstream refinery operations. In the case of Group II, due to the volume gain resulting from VGO hydrocracking, the output of products exceeds the volume of VGO feed supplied (this is a key positive value lever favoring Group II economics over Group I).

2.      Group I vs. Group II Cash Margin Changes

It all depends on your point of view; is the Group I glass half-full or half empty? Well, the answer is both. Let’s make a comparison between a mid-size European Group I solvent plant, with a somewhat larger Group II VGO-hydrocracking complex on the U.S. Gulf Coast, and examine changes in costs, prices and cash margins between 2011 and 1Q, 2013. Over that time period, prices of crude oil, and of mainstream refined products, increased minimally; spot Brent increased by $1.23/Bbl, while a 6:3:2:1 crack spread against Brent rose by some $2.20/Bbl in both the U.S. and N.W. Europe. In addition, the spot market prices of high and low sulfur VGO rose also, by between $4-5/Bbl, while vacuum bottoms values remained essentially static. Thus the events of 2011 to 1Q, 2013 occurred against a backdrop of nominally rising prices of feedstocks and mainstream refined products. To say that the price increases experienced in mainstream refining inputs and outputs didn’t happen in base stocks would be a monumental understatement (Table 1).

The base stock price collapse which occurred over a 9-month period, from mid-2012 to February-2013, has no comparable precedent; there are no analytical pointers or benchmarks to which we can refer to rationalize the inexplicable. We can suggest various physical or psychological influences, such as weaker-than-expected demand in  finished lubricant markets, and the consequent under-utilization in global base stock capacity; the anticipated influence of Chevron’s Pascagoula 2014 start-up (together with other new capacity expected on-stream around the world) looming over the future medium-term market; and the reluctance of buyers to commit in a falling market.  In the end, the bottom was established, at least for some Group I suppliers, by shutdown economics. Margins fell to the degree that smaller, high-cost, or highly export-dependent, Group I plants could no longer cover their variable production costs. As a result, at least four Group I base stock refiners announced planned shutdowns during this time frame.

An illustration of the impact of the base stock market’s weakness on a typical European Group I solvent plant’s cash margins is shown in Figure 2. In Europe, where posted pricing is not formalized, contract business is linked to commercial market indices (such as ICIS or Argus) more commonly than in the U.S. Differences in contemporary market quotes of the various pricing services are usually within small tolerances, though wider variances can exist between them in thin or weak markets. Our model simulates a representative mix of European domestic contract, spot and export business over the past several years.

A complication of Group I margin calculations is that considerably more than half of the product yield has no reliable, publicly-available metric of value. In the case of aromatic extracts, the large majority of gross extract yield is now returned to refinery FCC units, as the external market for DAE is declining rapidly. The feed value of extracts, as a substitute for VGO, can vary with FCC design and operating severity, but would typically command a volume-basis equivalence of some 80-95% of VGO. Pitches and tars produced from solvent de-asphalting are typically routed to cokers or to asphalt blending in the U.S., but have somewhat different optionality in Europe. Delayed coker capacity in Europe (at less than 3% of CDU capacity) is only one-fifth of the coking intensity of U.S. refineries. As a result, excess SDA tar remaining after asphalt blending in Europe is often forced into the fuel oil pool.

In a nutshell, typical European Group I cash margins before corporate SG&A overhead allocations fell from around $13.50/Bbl of feed in 2011 to less than $0.50/Bbl in 1Q, 2013. More than 80% of the reduction in European cash margins was due to the decline in Group I base stock prices. A small glimmer of optimism amidst the doom and gloom was the positive contribution of byproducts; we will return to that topic later. Smaller-than-average Group I plants with higher unit operating expenses, or suppliers who were substantially exposed to the lower netbacks resulting from sales to non-EC export markets, were even more adversely affected. During this period three European Group I producers announced plans to close their facilities, and several others were sailing perilously close to the wind.

And now for the good news (for Group I producers)… Group II was hit even harder.  Since base oil yields from Group II VGO hydrocracking are roughly double those from Group I solvent plants, the collapse in lube prices was felt even more substantially by Group II producers. U.S. Group II margins started from a much greater base of profitability in 2011, and so remained higher than Group I by 1Q, 2013, though the margin gap closed considerably (Figure 3). Inter-Group viscosity-index and related quality premiums also became depressed in the overall collapse in base oil prices. In the U.S., we recognize that essentially no business is transacted at posted prices, though contractual discounts and TVAs off postings are applied to the large majority of transacted business. Price changes for all base stocks are based on Kline’s assessment of “typical” channel-weighted price realizations relative to Group II postings. So, while overall cash margins on European Group I base oil production dropped by some $13/Bbl of feed over that period, U.S. Group II margins fell by an estimated $29/Bbl (with declining base oil prices contributing nearly 90% of that negative margin impact). Leverage can indeed be a double-edged sword!

3.      Myths and Realities

In the attempt to search for some good news for base stock refiners, particularly Group I producers, some have suggested positive value levers that might act to improve margins:

(i) Wax supply will tighten as Group I plants shut down, thereby raising prices of both hard and slack wax;

(ii) Brightstock supply, and possibly heavy neutrals, will also benefit from tightness in supply; and

(iii) It’s good that Group I plants are almost always heavily depreciated.

Let’s take each of those potential Group I value levers and examine them in the context of the same 2011 to 1Q, 2013 time frame:

(i) Wax Pricing – while it is true that slack wax pricing in the U.S. improved over this period by roughly $20/Bbl ($150/MT), this was not the case in Europe. ICIS reported price declines of $30/MT in European slack wax, but a much greater decline in hard wax prices, ranging from $106-118/MT between the low, medium and high melt point grades. In our Group I European margin model, consequently, waxes were the only byproduct whose margin contribution actually declined between 2011 and 1Q, 2013. Moreover, the margin leverage of waxes, positively and negatively, is small. With a slack wax yield on total feed unlikely to exceed 8 vol% (or 5-6% of finished waxes), even a doubling of wax prices would add less than $10/Bbl to Group I margins. We consider that potential market development unlikely, on account of the emerging competition from bio-based, F-T synthesis (GTL-based), and PE waxes.

(ii) Brightstock Pricing – here again recent history has defied the pundits. In the general decline in base stock pricing in our reference period, brightstock was actually the hardest-hit. In the U.S., ExxonMobil’s posted prices, as published in Lube Report, declined by $180/MT for the benchmark SN165 and SN500 solvent neutral grades, but by $323/MT for brightstock. A similar pattern occurred in Europe, with ICIS prices for medium and heavy solvent neutrals declining by some $240/MT, while brightstock fell by $330/MT. Kline accepts the direct impact of Group I plant closures on immediate brightstock supply, but it is less clear what longer-term cause-and-effect responses will be set in motion by them, in supply operations and markets. For example, some combination of enhanced solvent de-asphalting and other process changes at remaining plants, and formulation changes towards more use of heavy neutrals and naphthenics (even high-viscosity Group IV/V synthetics), are likely to dampen the upward price pressure on brightstock prices. Further limits on upward brightstock pricing pressures could result from the general decline in the use of monograde engine oils.

(iii) Depreciation – low net book values, symptomatic of highly-depreciated facilities, are not a positive economic signal. They are evidence of older plants whose ongoing maintenance and other capital improvements have been contained, suggestive of relative inefficiency compared with leading competitors. Moreover, depreciation itself is never bad. When the plant is making money, depreciation provides a tax shield; when it’s losing money it enables larger tax-loss carryovers. Since depreciation is purely an accounting (non-cash) device to defray income taxes, more depreciation is always better than less. The old adage “show me an old plant with a high ROCE, and I’ll show you a plant about to go out of business” still holds true.

4.      Is the Recent Past any Indicator of the Future?

This article is intended to provide some general observations on the salient events of the past two years and, particularly, their impact on the changes in profitability of characteristic Group I and Group II plants in their core markets. Individual producers may perform better, or worse, than these norms depending on their scale, technology, location, cost structure, and market channels. In Part II of this article we will focus not on the past, but on the future.  Are the events of the past two years a significant trough in a cycle which will return the base stocks industry to pre-2012 norms of pricing relationships and profitability? Or are we seeing the early symptoms of a fundamental change in price/cost relationships in the upstream segment of the lubricants industry that will bring margins and returns closer to those experienced in mainstream refining? In Part II of this article we will turn to the future, assessing the prospects for base oil margin recovery and the principal influences which may shape its magnitude and timing. To view this white paper on our website, please visit http://www.klinegroup.com/articles/margin_levers.asp.

 TO BE CONTINUED…

About Kline & Company:
Kline is a worldwide consulting and research firm dedicated to providing the kind of insight and knowledge that helps companies find a clear path to success. Kline Management Consulting provides the optimal size, superior team demographics and team-oriented culture that make engagements a success for our clients. Unmatched in our ability to gather high-value, hard-to-get market and competitive intelligence Kline delivers syndicated and custom research solutions  to support strategic planning for today’s global and local business environment. Building on our 50-plus years in the business and leveraging our worldwide network of offices in the Americas, Europe, Asia and the Middle East, our teams draw upon pragmatic industrial and commercial experience to profoundly understand and interpret global impacts and local perspectives and have the local knowledge and language skills to aid your business decision-making and strategies.  For more information, visit www.KlineGroup.com.

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