How National Oil Companies are changing the face of the industry. By Stephen George and Mark Routt

A new era of game changing competition in the refining industry is upon us. National Oil Companies (NOCs) are increasingly flexing their commercial muscles in refined oil product markets. The next few years will see new capacity start-ups in Kuwait, Oman, Saudi Arabia and other Middle Eastern and Asian countries. As the Middle East moves to even greater product surpluses, differences in inter-regional margins will narrow and Asian and European competition will intensify.

How can oil companies future-proof their current investments and quickly adjust to a new reality where NOCs will forcibly enter markets traditionally dominated by International Oil Companies (IOCs) and traders? What does a world look like with NOCs becoming a dominant oil product market force?

A globally competitive force
Historically, the traditional oil refining economic model favours building refineries closer to demand than to supply. This is driven by the differential economics of moving feedstocks in bulk on large ‘dirty’ tankers vs moving multiple ‘clean’ products short-haul in more expensive smaller parcels. Logistics issues can also limit trade in crude and products, as port and working capital constraints dictate what can be built close to markets.

However, the model is changing with new export-oriented refineries being built closer to sources of crude oil production. In Saudi Arabia, new Saudi Aramco JV projects have been launched in both the East and West of the country (YASREF, with Sinopec at Yanbu, and SATORP, with Total at Jubail).

Both YASREF and SATORP oil refineries have nameplate capacities of 400,000 bpd (barrels per day) and supply products for domestic consumption and for export. In the UAE, state oil company ADNOC, has expanded its Ruwais capacity with a similar mission by building a 417,000 bpd full conversion oil refinery to be fully commissioned by mid-2018.

While all these projects have defied conventional economic rationale, they have similar drivers that make them attractive to the sponsoring countries. Although they may sacrifice some of the cost advantage of being close to the product demand, they are able to buy crude at the free on board (FOB) price and offset some of the cost of moving products to distant markets. Product freight rates have been historically low for some time due to the glut of tanker capacity. Lower rates have narrowed the cost disadvantage of siting oil refiners further away from product demand, which means they extend the reach of both new exporters and other extra-regional competition.

Finally, although the return on investment for these expensive, newer oil refineries may be lower than hurdle rates for some IOC investors, favourable access to capital, the latest technology design advantages, and the multiplier effect of local economic activity in NOC economies makes these projects positive value generators for NOCs, who can take a longer-term perspective on capital investment than IOC competition. These investments also bear secondary economic dividends by creating skilled employment opportunities for the local, often young, workforce and by diversifying the national economy away from only crude oil production and export.

NOCs are also starting to work around the limitations of regional product markets by expanding their own commercial and trading operations. On the back of their recent project start-ups, both Saudi Aramco and ADNOC are demonstrating new commercial acumen, with Aramco now streamlining its businesses and opening itself for scrutiny ahead of a planned IPO in 2018. Similarly, parts of ADNOC are being privatised and the company is seeking a strategic partner for a new asset-backed trading initiative in the wake of a new commercial approach. Oman Oil Company is reportedly seeking advice on its own IPO and planning the construction of a new 230,000 bpd JV oil refinery in the special economic zone at Duqm on the Arabian Sea coast – far from existing demand centres.

Outside of the Middle East oil exporters, we see signs that others have caught the spirit of this new age. Mexico’s Pemex has been working on major strategic initiatives to revitalise both its upstream and downstream oil and gas sectors. The long work of constitutional reforms has now freed the country from a crippling dependence on domestic ownership, control and content.

However, the evolution of NOCs along more commercial IOC lines, is still hostage to the inertia of the ‘old’ way of doing things. The urge for central control and also for state regulations that do not keep pace with privatisation can create unexpected pitfalls. Pemex has been unable to invest sufficiently because state control of oil product markets, prices, and import/export policy are constraining the NOC’s cash flow. A similar situation exists in Colombia.

Competing against each other, and themselves
With a few notable exceptions, NOCs have largely focused either on their own domestic oil product markets or very clearly defined integrated entries into key export markets, largely in Asia. To date their investments have been principally about securing crude oil export outlets in return for equity in downstream companies and retail concessions. But as NOCs expand their export-oriented capacity, they will increasingly be looking commercially for markets for their own surplus refined products.

India and China are Asia’s two most important product markets, but strategically both are looking to maintain domestic oil refining capacity in balance with growing demand. NOC product exporters are therefore increasingly likely to find themselves competing with IOC majors, traders and eventually themselves as they look to carve out routes to market for their growing surplus of products. Importantly too, Middle East exporters will soon find that their own crude exports to refiners in Asia will put them in competition with their own refined product exports.

Successful transition from an NOC to an IOC-style model is not only dependent upon the downstream entity, but also on the state ceding control. When these transitions occur, then NOCs like Pemex and Petrobras should be able to ‘up their game’ and increase their access to regional markets. But, and it is a large caveat, this depends upon a cultural change in the state regulatory environment.

Redefining competition – NOC-on-NOC
Historically, NOCs have controlled oil product imports by applying a variety of barriers: taxes, subsidies, duties, access to distribution infrastructure and even retail licenses. Many of those obstacles are still in place, but are seen as costly and ineffective. Some Latin American countries that once controlled oil product retail are becoming more liberalised (e.g., Mexico). Others (Peru, Colombia, Venezuela) have been forced to import in spite of persistent economic barriers, because domestic demand growth outpaces domestic supply and oil refining investment. Refined product imports from Middle Eastern NOCs are increasingly seen as the new normal and the clear lines that once characterised a company as either a NOC or IOC are starting to blur.

Today, Aramco is a NOC. In the near future, it will offer shares on various equity markets and effectively transition to an IOC – with the associated public stock market accountability. Colombia’s Ecopetrol, Malaysia’s Petronas and Mexico’s Pemex are NOCs that have become more IOC-like in their actions. Vietnam is not far behind, with another oil refinery planned that will pivot the country into product surplus.

Conversely, we are also seeing signs of state involvement in non-NOC entities. In Canada, the Alberta government is backing the Redwater upgrader project in co-operation with private sector investors. Brazil’s ethanol industry and China’s quasi-public refiners are other examples where state involvement props up private-sector investment.

NOCs are evolving into IOCs, and at the same time states are investing in the IOCs. Conventional classifications are starting to fragment.

As NOCs spread their wings in the competitive space, the potential for NOC-on-NOC competition grows more likely. Signs are starting to emerge as multiple Middle Eastern NOCs target the same Asian oil product demand. Not only are Middle Eastern NOCs going head-to-head against one another for Asian market share, they are also starting to compete against their own JV interests in those same Asian markets. The more commercial NOCs become, the more they must face the realities of competition, even amongst their own stable-mates. With more new projects launching between now and 2022, the market will only become more competitive, and more exports from NOCs means more imports elsewhere.

The transformative development of NOCs from national champions to global competitors reflects a strong desire on the part of the national governments to be the ‘last man standing’ as forecast demand for refined oil products – especially transport fuels – starts to plateau in the 2030s. So as refined product demand dwindles due to increased electrification and use of other fuel alternatives, even while there is adequate global supply of petroleum products, it is not enough to have the resources in the ground. It will be necessary to survive and thrive on thinning refining margins, a higher regulatory burden and a shifting product demand barrel. The long-term income stream from hydrocarbons will remain critical to OPEC and other oil-exporting economies and their competitive repositioning is designed to move them from their role as national champions to a global base load.

To futureproof, Operational Excellence is crucial
The implications of this transition are profound both for NOCs and non-state oil refiners. A more globalised oil products market signals tighter margins, which in turn should drive investments in Operational Excellence and discipline in capital allocation. NOCs, and even IOCs, that don’t respond to these signals will lag their counterparts and limit their options in an increasingly global commodity market. Narrower margins will then constrain new capital investment, and in turn give preference to companies operating either on more commercial lines or that have a private source of capital.

Markets aren’t standing still. Scale and efficiency will become more important in the refining sector after 2020, and oil refiners will have to respond to new challenges including carbon emissions reduction, marine fuel sulphur reductions, and the evolving refined product demand barrel moving away from transport fuels in favour of petrochemicals and renewable alternatives.

As an oil refiner, your market environment will determine your best response to the challenges ahead. NOCs evolve, they will need to focus on full scale business transformation programs to maintain cost competitiveness and optimise capital employed to achieve higher net margins in competition against your peers and highly efficient export refiners.

By setting out a programme of continuous improvement, operational excellence focuses on the areas of your organisation where improvement is required and delivers sustainable performance improvements that deliver real value to your bottom line.

All oil companies looking to future-proof their current investments will need to adjust to a new reality where NOCs will effectively enter markets traditionally dominated by IOCs and traders. Smaller independent oil refiners will need to become more agile, take advantage of a wider slate of opportunity crudes, and develop product flexibility that includes new markets only available through trade and enhanced commercial operations. IOCs must focus on value chain optimisation opportunities, including widening feedstock and product slates, integrating refining with petrochemical production, and potentially producing additional desirable unfinished intermediates at a low total cost to increase overall net profits.

As new forces emerge, all oil refiners need to plan their unique response to the changing shape of more global competition.

Stephen George is Chief Economist – EMEA and APAC, KBC & Mark Routt is Chief Economist – Americas, KBC. KBC, a whollyowned subsidiary of Yokogawa Electric Corporation, is all about excellence in the Energy and Chemical Industry. It makes and keeps its clients world-class through operational excellence and profitability, enabled by the actions of people and application of technology.

KBC has drafted a whitepaper entitled ‘NOC-on Effect: Re-invented National Oil Companies Will Emerge as formidable refining competitors during the 2020s’ which provides further insight.

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