There has been much ado made about the winners and losers of the global COVID-19 pandemic and the subsequent lockdowns. Cluttering the pages of the Financial Times and The Economist, have been tales of rising stars in the technology space such as Tesla Inc., who not only enjoyed a 650% increase in their stock price but also for the first time in its 19 year history turned a profit, who were lauded for their ingenuity and tenacity to weather the economic turbulence. Concurrently, others who were not so fortunate like Chinese property developer Evergrande (which saw its share value fall by 95%) were pitied for their financial imprudence and misfortune. Many would have also believed that the energy sector had garnered a similar sort of attention, especially considering the current role energy prices play in the record rate of inflation that we, globally, are facing. However, I contend that we, in our obsession with the outlandish, have ignored nuanced developments elsewhere along the energy supply chain, in particular, the oil refinery and oil tanker industries.
Ailing Refinery Industry
An oil refinery is an industrial plant that transforms or refines crude oil into usable products such as gasoline, diesel, and jet fuel. Like many others before, the year 2019 was a lacklustre year for the industry. The international benchmark Brent Crude Oil prices hovered around $64 a barrel throughout the year, remaining suppressed due to heightened US production for domestic consumption and significant Chinese economic slowdown leaving an excess of oil in the market languishing in refinery storage facilities across Singapore, Saudi Arabia, and Russia. So, when international lockdowns struck in early 2020, the refineries were not in the healthiest of positions to handle such a shock.
Over the course of nine months, beginning with one of the sharpest drops in global stock market history, the refinery industry faced a totalising exogenous demand shock in the form of international travel bans, curtailed social events and diminished road traffic.
This shock, oppressed demand with reductions of over 9%, tailing that trend, production experienced a 6.6% contraction, further glutting the oil markets, causing oil prices to fall as low as $9 a barrel but averaging $42 a barrel (a fall of over 34%) for the year. Market contractions are not good, but as the previous graph shows, refineries reduced production to nearly match demand, so why were oil prices so low and how is this different from other business cycle downturns?
Recall that by the end of 2019, storage facilities were already brimming with oil. So, despite production and consumption tracking one another there was an out-sized amount of oil sloshing around global markets intensifying the price plunge. This caused significant revenue reductions, for global and national refineries, and the lowest profit margins, industry-wide, in 20 years.
Another point to note: refining millions of barrels of oil a day can be an expensive enterprise, worsened still by the fact that a large portion of these costs are upfront capital expenditures. Such is the case that unless refineries are operating at minimum, 80% production capacity, it is simply unaffordable to operate them and most owners in that situation either convert the refinery into a storage facility or exit the market entirely, and that is exactly what happened. Of the top ten oil refining countries, who represent 62% of global production, three have closed a portion of their refining capability indefinitely with a further 9 countries, not in the top ten, permanently shutting down greater than 15% of their production capacity.
Invigorated Tanker Market
A product (or clean) oil tanker is a ship designed for the bulk transportation of oil products, from refinery stations to consumers. Similar to the refinery industry, the product oil tankers were not in great form in 2019. With lowered levels of international consumption, demand for transportation of oil products was found lacking in the form of reduced volume transportation. This only sustained the financial under-performance of clean tankers, in comparison to other sections of the energy sector, that has been characteristic of the industry since 2015.
What came as a surprise, however, was the reversal of fate for industry players in 2020. One would have envisioned that with halted demand for oil product transport, reflected in the respective fall of 11.3% and 8.3% in world imports and exports of oil products in 2020, that product tankers would have had to endure deepened financial difficulty, but that was not the case.
As the above graph shows, on the five major clean tanker routes transport prices were essentially unchanged or even increased with the Middle East to the Far East route displaying rises of 14.5%. So, how did this come about?
Contangos, or the situation where current (or spot) oil prices are lower than predicted future oil prices, are the main culprit for the improved favour that clean tankers basked in. With the cascading crude oil -and hence product oil- prices, traders in the industry anticipated that future prices would be higher. Additionally, onshore storage facilities at/near refineries, at the time, were already scarce. Armed with this knowledge, traders furiously began to charter product tankers as floating storage spaces; for as long as the cost of storing the oil was not greater than the expected margin between spot and future prices, these traders were content to just wait for prices to increase.
The use of product tankers as temporary storage facilities is not a new phenomenon and also prominently featured during the recession of the late 2000s. What makes this instance unique is how long it was sustained. For months, as opposed to a few weeks, product tankers, especially those who transported oil along the routes with less traffic, just had their tankers soaking up revenue which had doubled in a week. Consequently, the fall in tanker supply meant that whatever product oil was transported could be serviced by a shrinking pool of tankers, shoring up spot rates for tankers.
The reverberations of this fascinating dynamic that occurred in 2020 will be felt for years to come, in forms I’m sure we have yet to fully comprehend. Nevertheless, I will attempt to detail two such consequences of that strange period on our current day.
The limited refinery production capacity coupled with the increased cost to transporting oil has caused frictions in the current provision of oil products through a self-sustaining price inflation spiral. When demand for oil products returned to pre-pandemic levels in 2021, as production was slow to catch up, the price of oil shot up, increasing demand for (and price of) gas, a close substitute. As gas is also an input to the production for product oils, this only further delayed oil production sending both the price of oil and gas ever-higher fuelling food price inflation and threatening energy poverty across the globe.
An unanticipated result of this development is Russia has been able to secure considerable financing of its war against Ukraine through the sale of oil and gas to at first Europe, but now, India and China as the price of oil and gas remains elevated.
On a more positive note, the energy insecurity has brought the green energy transition to the forefront of policy discussions. Not because relying more on renewable sources of energy is better for the environment, but because it contributes to energy independence and reduces geopolitical risk. If nations are able, through the production of sustainable domestic energy, to temper their reliance on foreign sources of energy they’re better able to not just prevent dizzying energy price inflation but also confront belligerent governments in a robust manner.
The addition of the COVID-19 pandemic to the growing list of Black Swan events, whilst spurring on the decline of the oil refinery industry and gifting product oil traders the opportunity to buy a barrel of oil (containing 158 litres) for the price of a Boojum burrito, is something to remember, I think a lot of good will ultimately come from it.
Although currently, we are suffering under serious economic and business environment instability, the pandemic and I am not sure we have overcome much of the chaos that has come from its immediate consequences, the opportunity for the long term re-orientation of our economic and commercial practices to be more aligned with our vision of what the world should be like is a reason to be optimistic.