Listen: UK oil refining struggles in the age of energy transition

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Nick Coleman: Hello, and welcome to the commodities focused podcast by S&P Global Commodity Insights. The latest in our series on UK energy policy examines oil refining and whether it has a future in the UK against the backdrop of intense competition and energy transition pressures. I am Nick Coleman. I'm a senior editor for oil news in the S&P Global Commodity Insights news team. In this series, I aim to bring together experts from across Commodity Insights to talk about energy security in the run-up to the UK general election, and some of the pressures and choices facing the sectors ranging from North Sea oil and gas to power generation and renewables. We started with an episode on the North Sea industry and its many woes and now turn to oil refining, perhaps looking for a more hopeful story. It's a sector that gets less media attention, but as the UK heads for an expected change of government with Conservative defeat predicted, the industry comprising six refineries dotted around the country and numerous ports and logistics hubs is looking for answers on a range of issues.

These include competition from large overseas refineries, the switch to electric vehicles and sustainability targets in aviation. One refinery, Grangemouth, in Scotland, marks its 100th anniversary with an axe hanging over it. Its closure is scheduled for 2025. So, I'm joined to discuss these issues and more by Rebeka Foley, senior analyst covering the European refining sector, Robert Perkins, who heads downstream oil news in the region, and Kelly Norways, a downstream news reporter who focuses on the UK. I'd like to start off by just having a little look at the UK's refineries. This is potentially a bit of a historical moment, the closure of Grangemouth Refinery, and is it all doom and gloom for UK refining?

Rebeka Foley: Yes, it's been an interesting development this announced transformation of the Grangemouth Refinery as Petroineos have labeled it. Last year they announced that they'd be converting the refinery into a product import terminal no later than May 2025. It's an interesting development. This is a 100-year-old refinery and the main source of fuels to Scotland and many parts of the north of England. And really it's symptomatic of a wider trend that we've seen across the UK's refining sector. There's been a string of closures in recent years which saw similar conversions across Coryton, Milford Haven, Teesside, Billingham. So, really it's a sign of the increasing threats of competition on the global scale.

When Petroineos announced this decision they cited global market pressures, which presumably a reference to some of these large scale refineries that we're seeing come online in Latin America, in the Middle East. Recently we've had Dangote come on in Nigeria. So, it's looking like an increasingly challenging environment in the conventional refined product space for many of these producers. And then, alongside that shift, we've also seen some of the conventional oil majors start to shed assets in the UK energy space. So, in 2020 TotalEnergies sold their smaller Lindsey Refinery to Prax. So, it's something where you've started to see perhaps an early wave of consolidation, which could indicate larger shifts that we're seeing on the UK level.

Nick Coleman: So, presumably when these slightly smaller companies come in and buy a refinery, they're not doing it because they want to run it into the ground. They must have some hope that it has a future. I wanted to follow up, actually, one refinery that hasn't been sold is Fawley operated by ExxonMobil, and I believe they're actually investing, correct me if I'm wrong, I think they've been investing in new diesel production capacity so that on the face of it might suggest a more optimistic story. Am I wrong about that?

Rebeka Foley: They have. In many ways the UK is in a really interesting position, because we've already seen a dislocation between our domestic oil demand and the way that refineries are geared to supply oil products. So, from the 2000s into the mid 2010s, there was a gradual shift in fuel demand from conventional petrol or gasoline towards diesel, which has been increasingly at odds with the production of our refineries. Basically, you've seen the UK evolve into having this growing diesel deficit, which Fawley is looking to plug with that development. So, to put some numbers on that at the moment, diesel accounts for the vast majority of the UK's demand on the refined product side, so that's 38% of UK oil demand is accounted for by diesel versus gasoline is only 18%. Whereas, on the refining side of things, most of our refineries are geared towards gasoline output with FCCs and high light end production.

And actually, interestingly, Grangemouth is the only refinery in the UK which has a hydrocracker geared towards diesel production. So, what Fawley is trying to do, what ExxonMobil is trying to do makes sense there, is trying to play in that short term short that we're going to see develop increasingly more so over the years. Obviously, you've not got Russian product coming into the UK anymore. You're looking at increasing challenges when it comes to energy security on the diesel side of things. So, as you mentioned, what they've done is they've made this billion dollar investment into expanding that capacity and they've promised that that should decrease diesel imports by a quarter according to their own projections. So, it's an interesting play, because we are already at peak diesel according to our estimates, and we'll start to see that increasingly fall off as you have new policy leaders come in like the UK's ban on internal combustion engines, which is now coming in 2035. So, really they're trying to capitalize on that short-term opportunity while also investing in clean energies at the same time.

Nick Coleman: Pardon my ignorance, if I thought diesel went out of fashion a long time ago as people started worrying about the pollution effects of diesel in our big cities, in our streets, why is diesel still so much in demand even as you say, it might be starting to drop off now?

Robert Perkins: Obviously, diesel is the main demand fuel driver for heavy transport rather than passenger cars, which it makes up the bulk of heavy goods transport, diesel and heavy use in industry as well. So, it makes a significant chunk of the demand picture. And it's worth pointing out that, that feeds through to demand and export market flows into the UK. Half of all UK-defined product goes into the market, domestic market that is, and about 40 is exported. And the exports is largely gasoline, as in most of Europe, the UK's is long gasoline due to the configuration and the plants and the reasons that Kelly's pointed, out over the switch, the dieselization of the passenger car fleet over the last 20, 30 years, and we're a net importer of jet and diesel. And as Kelly points out is, this has become a pressing issue now.

We don't have Russian product coming into the UK directly at least, and it's created a bit of a bounce in refining margins for the sector as you as the broader European refining picture recovers. So, I think that's something to point out. I think it's also worth pointing out that, although we can point to general trends in the margins and the profits the refiners are making, it's very specific dependent on where your refinery is placed. If you speak to anyone in the refining industry, they'll say, look, any one plant their margins and their profits depend on their advantage locations, whether or not, for example, they're close to a deep water port that has access to different cheaper crude streams, whether or not they have connections to pipelines to key demand centers such as airports, those kinds of things. So, it's difficult to generalize on which refineries are making sustainable profit or not going forward.

Rebeka Foley: Just to jump in there, something else that potentially is worth mentioning is that you've seen a lot of these refineries sorely lacking investment and it makes sense that some of the larger, better integrated refineries such as Fawley, would present a good opportunity to modernize that hydrotreating unit that you mentioned is being invested in at the moment, that will have SAF and renewable diesel capacity. So, there's an opportunity for ExxonMobil to play in both of those spaces. They're developing these longer term fuels while also being able to sell into these higher margins at the moment, and that contrasts to older refineries, like Grangemouth where Petroineos themselves have said that continuing to run operations beyond spring next year could cost another £40 million. So, where there is an opportunity to modernize these larger, more integrated refineries, there's certainly a strong investment case there.

Nick Coleman: So, a slightly mixed picture of generally quite small UK refineries struggling to compete against some of the really mammoth large refineries, export refineries around the world in places like India. I think India in the last 10 years built some really enormous refineries that just completely dwarf UK ones. But, as you say, maybe there's some local advantages as well. I think, am I right in thinking there's a direct pipeline between Stanlow Refinery and Manchester Airport, for example? So, that's a market right there that isn't ever going to go away for Stanlow Refinery.

Rebeka Foley: Yeah, and Fawley has done the same investing in its pipeline infrastructure to the London airports. Really, jet is one of the refined products that's looking at some of these longer timelines before you start seeing a shift away just because it is a naturally stickier product. So, you've definitely seen those kind of infrastructure plays as well.

Nick Coleman: So, jet fuel might be a advantaged product for these UK refineries. But, I just wanted to step back a little bit because we've heard in the last two and a half years a lot of talk about energy security, politicians worrying about our energy security in this country, and that goes from the gas that heats our homes to the crude oil to Rob, you mentioned diesel already. So, I'm not sure that we were taking much Russian crude oil before the full scale invasion of Ukraine, but it's certainly true that Europe relied on Russian diesel. So, what's been the adaptation process, and is there a threat that continues of perhaps, a shortage of diesel for this country or for our European neighbors?

Rebeka Foley: I might jump in there. So, of course, there was a lot of uncertainty in the lead up to the sanctions against Russian imports for all refined products that went into effect in February of 2023, and we really saw the market rebalance. A lot of people thought that, oh, Europe has a large diesel short, how is it going to cover Russian lost product? But, we really saw the market reshuffle and Europe get those barrels from other places, mainly the U.S., Middle East, India, and coverage of course, from the domestic market across Europe. If you look at a margin perspective that really gave a boost to margins, encourage refineries to ramp up runs, certainly from a rationalization perspective that put that whole talk pretty much on the back burner for a little bit. We dubbed this era at S&P, the platinum age of refining, where we had a lot of talk about closures before the pandemic and during the pandemic, of course, where we lost about 600,000 barrels a day in Europe of refining capacity.

And that discussion quickly turned to risk premiums and cashing in on strong margins. But, certainly in terms of closures, it remains a question of the survival of the fittest really. In Europe, of course, you could say generally that a refinery's survival is dependent on local market demand and integration with petrochemicals, higher complexity as we mentioned, and the boost to diesel cracks and that rush to cover Russian product in Europe has subsided. We've certainly seen that on the pricing side, and certainly in sentiment we are expecting Atlantic Basin balances to soften now that we're coming out of this rush to cover those lost barrels. So, certainly a return to a focus on what's ahead.

Nick Coleman: So, I don't think any of you are going to say that the UK is literally in danger of running out of diesel. I think I saw statistics just to your point, Rebeka, there that U.S. imports into Europe of diesel and gas oil in April I think we're at a six-year high, and I think for the time being, we can always rely on the United States probably as an import source, but politicians might be thinking also about the jobs in the refining sector that are quite important to try and preserve those jobs. And we've also had Brexit, of course, and if you listen to some people in the refining sector, that has thrown up a few problems for UK refining. I think getting the skilled workers to maintain the refineries, I think that was actually quite an integrated kind of employment network that spans European borders with craftspeople moving around different countries because they weren't going to be employed all year round in one country. Any other aspects of Brexit that might still be lingering problems that spring to mind?

Rebeka Foley: I suppose it's any policy dislocation that you see between the UK and European Union, which could potentially pose a threat if you're looking at elements like differential carbon pricing, for example, if you're thinking about clean fuels production or even conventional refined products production, that's going to change the decision around investments, whether that's going to the UK or Europe. I think in many ways the problems that the UK faces are common across Europe, but there are several areas in which it potentially faces slightly more acute issue when it comes to investment.

So, some examples that jump to mind are when it comes to the carbon border adjustment mechanism that the UK is bringing in, for example, that's currently set to come in 2027, that's a year after the European Union, so potentially have a year there where there's a risk of losing market share to the European Union where you're seeing refiners compensated for higher carbon costs that they have to pay under the emissions trading scheme. And also, if you're looking at things like sustainable aviation fuel mandates, you've got slight differences between the UK and European Union. The UK has opted to limit the use of conventional HEFA produced sustainable aviation fuel, for example, which is currently the main commercially viable pathway to producing that green jet fuel. So, I think it's where you're seeing those differences in policy and those nuances that you might have a risk of losing market share.

Nick Coleman: So, the UK has, for example, a lower carbon price that the refineries have to pay to offset their emissions, and in a worst case scenario you could see them penalized by the EU carbon adjustment mechanism. Is that a real possibility?

Rebeka Foley: Well, in reality, I think you're likely to see policymakers try and align those two policies, but yes, it certainly is the case that even in just the carbon pricing alone, you've seen differences between the UK system and the European system work to the detriment of UK refineries. And according to the lobby group, Fuels UK, the cost of running a refinery in the UK has been 10% higher than its European competitors. So, you are certainly starting to see those types of decisions around operating costs potentially become a thorn inside of UK producers.

Nick Coleman: Are those operating costs, just to clarify, emissions charges, why would it be more expensive to run a refinery here?

Rebeka Foley: So, I think the main reason for that discrepancy has been due to taxation, but you've also had periods where the UK emissions trading scheme has priced above the European equivalent, and then also periods of differential energy costs. Obviously, if you have Europe implement its carbon border adjustment mechanism in 2026, you then see that as another source of potential upside for operating costs in the UK if that charge is then levied at the border.

Nick Coleman: I wanted to just also, aviation. I wanted to just come back to that. It was mentioned earlier in the podcast, but I hadn't realized that apparently the UK is Europe's largest aviation market thanks to these wonderful airports we have like Luton and Heathrow and Manchester. Firstly, that should be an opportunity for UK refineries one might think, and you might have some more comments on that Rebeka, but there's also the question of SAF. SAF has been in the headlines recently, these ambitious targets that the UK has to introduce sustainable aviation fuel made from, well you can tell me, is used cooking oil, perhaps hydrogen? Where are we with these ambitious targets declared by the Conservative government, I think?

Rebeka Foley: At the moment the majority, as you say, is produced using vegetable or waste oils like used cooking oil. It's an area that the UK is looking to ambitiously grow similar to Europe through blending mandates for airlines. So, last month we had clarification around the UK policy, which is mandating 2% of all aviation fuel to be sustainable aviation fuel blends that increases to 10% in 2030, which is a punchier target than the European equivalent at 6%. So, essentially that's hoping to provide offtake certainty to these producers to incentivize increased sustainable aviation fuel production. As I say, the majority of that is happening using waste oils at the moment, but that's something that the UK government is trying to shift. I touched on earlier the fact that they've implemented a cap on the HEFA pathway or HEFA produced sustainable aviation fuel, which is hydroprocessed esters and fatty acids.

So, that's the pathway that's converting existing oils into this sustainable aviation alternative and accounts for about 90% of current production. The reason that the UK government has sought to cap that, and they're capping HEFA produced sustainable aviation fuel at 71% in 2030 reducing to 35% in 2040. The reason that they're capping that is because they're trying to incentivize more scalable solutions, so power to liquids, Fischer-Tropsch are some other examples, which basically unlock economies of scale, whereas the existing production is limited to what you can aggregate from fast food outlets, from kitchens, sources of these second life oils. So, that's a policy pivot that they're trying to implement to incentivize these new nascent technologies which we're not currently seeing. It's an interesting move and it's quite specific to the UK. We've not seen an equivalent elsewhere in Europe and the U.S. So, how that plays out will be interesting.

There's been some pushback from producers, for instance, Petroineos have said that it's been active in saying that it's a policy barrier to looking at the biorefinery development in Grangemouth, and the reason is because this is the only commercially viable way of producing the sustainable aviation fuel at the moment. There's not been a cap on renewable diesel produced from the HEFA pathway, but you don't have as longer term demand certainty as you do for sustainable aviation fuel when you've got the likes of electrification potentially threatening that bio offtake. So, it's an interesting policy decision that we've had from the UK in that respect.

Robert Perkins: I think there's also connections here with the energy security implications that you point out, Nick, with the UK. We've got to remind ourselves that the UK, as you said, we're a huge demand center for jet fuel. In the last few years alone we've been importing something like 80% of our jet fuel needs. So, it's not about where these demand supply centers are coming from in the UK, it's about supply lines to the rest of the world and where we're going to get the SAF from. The SAF mandates themselves on total jet demand, they're not on the production of SAF, although everyone would like to be producing SAF given the margins you can get potentially. It all depends, like a lot of these biofuel products on the government incentives and tax breaks allowing you to invest and upgrade and convert your existing refining assets to produce these advanced biofuels. So, we are interconnected, but jet is a good example where as demand for SAF fuel starts to balloon in the coming years, we could well become even more increasingly independent on importing that from elsewhere rather than filling it from domestic supply.

Nick Coleman: Thank you, Rob. I was going to mention, just correct me if I'm wrong, but I saw another government target, which is that there should be five SAF plants under construction in the UK by 2025. I assume that's still valid, but as far as I can tell, it's the Humber refinery, another actually American owned refinery that I forgot to mention earlier, I believe does produce SAF. But, coming back to your point, Rob, I would assume it's much cheaper to produce a bog-standard kind of SAF in the United States when you've got enormous quantities of things like rapeseed or other organic products that can go into jet fuel. Am I wrong or is that a fair assessment?

Robert Perkins: I think that's right. Rebeka may have more to say on this, but I think you're right. Essentially it's the feedstock issue. When you start talking about biofuels, the cost of feedstock, accessing them, having sustainable supplies of them, it feeds through so directly in terms of the profitability, it's a very different economic picture for refiners, whether it's from old school palm oil or used cooking oils, to e-fuels using carbon dioxide and hydrogen, these are very costly processors. And I think it's worth pointing out on the broader European picture, many people in the industry are very quick to point out that we are so far behind already in terms of the SAF plants that have been given FID from where we should be, where our targets should be in 2030, that we are well behind that. So, there could be a reckoning there in terms of the supply demand picture for those clean fuels in the coming years.

Rebeka Foley: And you mentioned the U.S., I think it's hard to underestimate the influence of the Inflation Reduction Act in incentivizing investment over there. They've obviously taken a slightly different approach to Europe, which has favored mandates to incentivize demand, but actually those incentives have been huge in pulling over some of that investment.

Nick Coleman: Great. I think perhaps it would be remiss, I think, not to talk about electric vehicles, and the various bans have been announced by governments around Europe, including the UK, to put an embargo on selling new conventional internal combustion engine cars. And final thoughts perhaps from all of you on these ICE car bans? Because, we know that cars only account for a portion of oil consumption, but nonetheless, they are kind of emblematic of the whole energy transition debate.

Rebeka Foley: Certainly from a demand perspective, if we look at, of course, the push away from diesel cars from Dieselgate, and that's certainly given away to more uptake of gasoline-powered cars in the passenger car fleet in Europe, and of course, these shares differ by country, but generally gasoline demand has benefited from that. But, if we zoom out, we expect gas oil demand to have already peaked in Europe actually in 2022, and gasoline demand is expected to peak in 2025, and that's around the same for the UK, 2024 for diesel. It's certainly interesting to watch from a refining perspective how refiners will adapt to these changing trends and transport fuels demand and the challenges ahead that they'll face.

Robert Perkins: I think that's good to point out. The UK's fuel consumption in the transport sector alone, even before the pandemic and acceleration and pick up in EV sales was declining on average about 1% a year. So, that was already the direction of travel and that suddenly accelerated with booming electric car sales. I think it's important to put in perspective as well, these are not huge numbers so far. I think S&P Global Commodity Insights estimated in 2020 that a UK phase out of ICE cars would displace around 60,000 barrels a day of road fuels over 10 years by 2030. So, that gives you a flavor. These are not huge numbers, and often they're eclipsed by the sheer impact of fuel efficiency movers as the car park, as the number of cars on the road become more efficient, they turn over. Often the impact on fuel fuel demand outstrips the impact of electric cars over the medium term at least. I think that's something that was happening, and that EVs is definitely accelerating that.

Rebeka Foley: At risk of putting a negative spin on things. I suppose one thing worth flagging is that you have seen moving goalposts in the past with these policy decisions. The internal combustion ban, which is now set for 2035, was originally intended to be brought in by 2030. So, there is always the risk that you do see these policies potentially redesigned or shifted as well. So, a lot of these projections are obviously contingent on that being brought into effect, but that will remain the basis of those projections, whether those are implemented.

Nick Coleman: It sounds a bit of a nightmare for the manager of a UK refinery, but I suppose agility and having to adapt to changing political circumstances has probably always been the name of the game to some extent. Thank you all. It's been great to have these insights. We've covered a lot of ground. This commodities focus episode was produced by Felix Fernandez in London, and for more insights related to energy security, check out our interactive digital report to the Energy Security Sentinel. Follow the link in the description. Thanks again for listening.