Easwaran Kanason

Co - founder of NrgEdge
Last Updated: May 3, 2019
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Business Trends
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Much has been made of China’s Belt and Road Initiative, the attempt to create a modern Silk Road through an interconnected series of overland and maritime trade and infrastructure routes. Fuelled by China of course. But something similar is happening in the oil world, specifically in the downstream segment. A major country has created and continues to expand a network of interconnected oil refining and petrochemical hubs in key strategic geographically locations, all in the name of establishing a dominant supply chain for its oil.

That country is Saudi Arabia.

Through its state oil firm Saudi Aramco, the Kingdom’s ambitions to push further downstream is not a secret. This goes way back to 2011, when the Arab Spring swept through most of the Middle East. In Saudi Arabia, this was quashed by offering economic sweeteners to its citizens, afforded by oil prices well above US$100/b. The oft-quoted figure is that Saudi Arabia’s attempts to placate its population required US$90/b crude prices to work. That worked fine until oil prices crashed in late 2014, which then exposed another weakness: the major dependence on crude oil for the Kingdom’s fortunes and continued existence.

So a plan was hatched to diversify the economy, which itself has roots in the Arab Spring policies. Saudi Aramco would need to reduce its exposure to upstream and diversify into refining and petrochemicals, with an eye to an eventual (and now confirmed to be delayed) IPO. A series of deals were struck. Saudi Aramco invested to become equal partners in Malaysia’s massive 300 kb/d RAPID refinery. It bought out partner Shell to become the sole owner of American refining subsidiary Motiva and its 600 kb/d Port Arthur facility, the largest in the US. Tie-ups with several Chinese refineries were made, a key move in a market where Saudi Arabia was rapidly losing out to Russia for market share. And Aramco is also part of the giant new 1.2 mmb/d oil refinery planned in India’s Maharashtra state.

All this has been done in the name of securing fixed demand for its oil. In a fast-evolving world where the tide of US light sweet crude is inexorably rising, the battle for market share is heating up. What better way to secure demand than by buying it? Sure, there have been a few instances where Saudi Aramco walked away from potentially large deals – like in Indonesia’s messy refining sector – but over the past month, it has announced even more deals that hint that its expansion is unlikely to stop. Aramco is now officially in ‘talks’ to acquire an up to 25% stake in the Reliance 1.24 mmb/d Jamnagar refinery – one of the most complex refineries in the world - for up to US$10-15 billion. It wants to help build a new refinery for Pakistan by 2024, and has acquired a 17% stake in South Korean refiner Hyundai Oilbank to complement its existing investments in China and Japan. After buying out Shell from Motiva, Aramco is now also looking into taking over Shell’s 50% stake in the 305 kb/d SASREF refinery in the Kingdom’s Jubail City. It is taking over fellow Saudi chemical giant SABIC. It has even started trading LNG…. even though Aramco doesn’t produce a single drop of LNG yet.

Taken together, that’s a portrait of a company aggressively expanding. Aramco’s global refining network was already strong at the end of 2018; by 2023, with these and perhaps even more investment to come, this could be the largest, strongest refining network in the world. A quick back-of-the-envelope calculation shows that if all these investments pan out, Aramco will have access to over 8 mmb/d of global refining capacity. That’s enough to account for half of the Kingdom’s current crude output levels, and a good hedge against the threat of US shale.

 Saudi Aramco’s Downstream Plans

  • Double global refining capacity, from 5 mmb/d to 8-10 mmb/d
  • Double global petrochemicals production by 2020
  • Be a ‘global leader’ in petrochemicals by 2040

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Saudi Aramco Moves Into Russia’s Backyard

International expansions for Saudi Aramco – the largest oil company in the world – are not uncommon. But up to this point, those expansions have followed a certain logic: to create entrenched demand for Saudi crude in the world’s largest consuming markets. But Saudi champion’s latest expansion move defies, or perhaps, changes that logic, as Aramco returns to Europe. And not just any part of Europe, but Eastern Europe – an area of the world dominated by Russia – as Saudi Aramco acquires downstream assets from Poland’s PKN Orlen and signs quite a significant crude supply deal. How is this important? Let us examine.

First, the deal itself and its history. As part of the current Polish government’s plan to strengthen its national ‘crown jewels’ in line with its more nationalistic stance, state energy firm PKN Orlen announced plans to purchase its fellow Polish rival (and also state-owned) Grupa Lotos. The outright purchase fell afoul of EU anti-competition rules, which meant that PKN Orlen had to divest some Lotos assets in order to win approval of the deal. Some of the Lotos assets – including 417 fuel stations – are being sold to Hungary’s MOL, which will also sign a long-term fuel supply agreement with PKN Orlen for the newly-acquired sites, while PKN Orlen will gain fuel retail assets in Hungary and Slovakia as part of the deal. But, more interestingly, PKN Orlen has chosen to sell a 30% stake in the Lotos Gdansk refinery in Poland (with a crude processing capacity of 210,000 bd) to Saudi Aramco, alongside a stake in a fuel logistic subsidiary and jet fuel joint venture supply arrangement between Lotos and BP. In return, PKN Orlen will also sign a long-term contract to purchase between 200,000-337,000 b/d of crude from Aramco, which is an addition to the current contract for 100,000 b/d of Saudi crude that already exists. At a maximum, that figure will cover more than half of Poland’s crude oil requirements, but PKN Orlen has also said that it plans to direct some of that new supply to several of its other refineries elsewhere in Lithuania and the Czech Republic.

For Saudi Aramco, this is very interesting. While Aramco has always been a presence in Europe as a major crude supplier, its expansion plans over the past decade have been focused elsewhere. In the US, where it acquired full ownership of the Motiva joint venture from Shell in 2017. In doing so, it acquired control of Port Arthur, the largest refinery in North America, and has been on a petrochemicals-focused expansion since. In Asia, where Aramco has been busy creating significant nodes for its crude – in China, in India and in Malaysia (to serve the Southeast Asia and facilitate trade). And at home, where the focus has on expanding refining and petrochemical capacity, and strengthen its natural gas position. So this expansion in Europe – a mature market with a low ceiling for growth, even in Eastern Europe, is interesting. Why Poland, and not East or southern Africa? The answer seems fairly obvious: Russia.

The current era of relatively peaceful cooperation between Saudi Arabia and Russia in the oil sphere is recent. Very recent. It was not too long ago that Saudi Arabia and Russia were locked in a crude price war, which had devastating consequences, and ultimately led to the détente through OPEC+ that presaged an unprecedented supply control deal. That was through necessity, as the world faced the far ranging impact of the Covid-19 pandemic. But remove that lens of cooperation, and Saudi Arabia and Russia are actual rivals. With the current supply easing strategy through OPEC+ gradually coming to an end, this could remove the need for the that club (by say 2H 2022). And with Russia not being part of OPEC itself – where Saudi Arabia is the kingpin – cooperation is no longer necessary once the world returns to normality.

So the Polish deal is canny. In a statement, Aramco stated that ‘the investments will widen (our) presence in the European downstream sector and further expand (our) crude imports into Poland, which aligns with PKN Orlen’s strategy of diversifying its energy supplies’. Which hints at the other geopolitical aspect in play. Europe’s major reliance on Russia for its crude and natural gas has been a minefield – see the recent price chaos in the European natural gas markets – and countries that were formally under the Soviet sphere of influence have been trying to wean themselves off reliance from a politically unpredictable neighbour. Poland’s current disillusion with EU membership (at least from the ruling party) are well-documented, but its entanglement with Russia is existential. The Cold War is not more than 30 years gone.

For Saudi Aramco, the move aligns with its desire to optimise export sales from its Red Sea-facing terminals Yanbu, Jeddah, Shuqaiq and Rabigh, which have closer access to Europe through the Suez Canal. It is for the same reason that Aramco’s trading subsidiary ATC recently signed a deal with German refiner/trader Klesch Group for a 3-year supply of 110,000 b/d crude. It would seem that Saudi Arabia is anticipating an eventual end to the OPEC+ era of cooperative and a return to rivalry. And in a rivalry, that means having to make power moves. The PKN Orlen deal is a power move, since it brings Aramco squarely in Russia’s backyard, directly displacing Russian market share. Not just in Poland, but in other markets as well. And with a geopolitical situation that is fragile – see the recent tensions about Russian military build-up at the Ukrainian borders – that plays into Aramco’s hands. European sales make up only a fraction of the daily flotilla of Saudi crude to enters international markets, but even though European consumption is in structural decline, there are still volumes required.

How will Russia react? Politically, it is on the backfoot, but its entrenched positions in Europe allows it to hold plenty of sway. European reservations about the Putin administration and climate change goals do not detract from commercial reality that Europe needs energy now. The debate of the Nord Stream 2 pipeline is proof of that. Russian crude freed up from being directed to Eastern Europe means a surplus to sell elsewhere. Which means that Russia will be looking at deals with other countries and refiners, possibly in markets with Aramco is dominant. That level of tension won’t be seen for a while – these deals takes months and years to complete – but we can certainly expect that agitation to be reflected in upcoming OPEC+ discussions. The club recently endorsed another expected 400,000 b/d of supply easing for January. Reading the tea leaves – of which the PKN Orlen is one – makes it sound like there will not be much more cooperation beyond April, once the supply deal is anticipated to end.

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Market Outlook:

-       Crude price trading range: Brent – US$86-88/b, WTI – US$84-86/b

-       Crude oil benchmarks globally continue their gain streak for a fifth week, as the market bounces back from the lows seen in early December as the threat of the Omicron virus variant fades and signs point to tightening balances on strong consumption

-       This could set the stage for US$100/b oil by midyear – as predicted by several key analysts – as consumption rebounds ahead of summer travel and OPEC+ remains locked into its gradual consumption easing schedule 

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