Todays base oil environment is marked by a shift away from Group I toward Groups II and III on both the demand and supply sides, said Phadke. Group I is exiting automotive formulations, a process thats already complete in North America and Europe and is continuing inand Asia. This leads to a decline in Group I demand, so vulnerable, high costGroup I plants have and will close down, particularly in North America and Europe.

In anticipation of future quality requirements, new base oil capacities are all Group II or III, Phadke continued, leading to a Group II/III surplus and Group I deficit, particularly a deficit of heavy neutrals and bright stocks. This leads to a substitution push by Groups II/III into Group I applications, particularly in Asia. And the cycle continues, resulting in a steady decline in Group I demand.

This trend clearly operated from 2001 to 2007, said Phadke. In 2001, Group I accounted for 84 percent of the worlds base oil supply. By 2007 it dropped to just 68 percent.

Kline predicts the trend continuing for the next 10 to 15 years, said Phadke. By 2015 Kline expects Group I to account for just 54 percent of global base oil supply, sinking to 51 percent by 2020.

Plant closures are not the only impact of this cycle. It also leads to a reduction in wax supply. With wax demand continuing to be fairly strong, wax prices have increased relative to other feedstocks. And this improves the cost competitiveness of existing Group I plants, Phadke said. It makes these plants look cost competitive.

Another important consequence of the increase in wax prices, he continued, is the increase in the cost of making Group III base stocks using slack wax isomerization. This technique is no longer economically viable, Phadke declared. Wax isomerization destroys value rather than creating value. You make more money selling the slack wax itself. This helps explain why Group III was so tight in Europe in the second half of 2008.

Its very significant, Phadke noted, that in mid-2008 the net material costs of manufacturing Group I dropped below Group II costs. All Group I plants are old and fully depreciated, while most Group II plants are young, with depreciation charges, so Group I plants have a cost advantage right now.

Im not suggesting a Group I renaissance. There are basic problems. Technical demand is declining and that wont go away, said Phadke. But existing Group I plants have a new lease on life thanks to wax pricing, especially for companies with interests in the wax business.

Phadke offered another challenge to the conventional viewpoint that Group II is always cheaper to make. Group II is on the middle of the cost-per-barrel curve for all base oil plants, Phadke contended. Group I wax producers can be more economical.

Excluding outliers, the cash cost to manufacture Group I varies from $97 per barrel to $105 per barrel, he said, a fairly narrow range. Phadke clarified that cash cost is the cost of feedstock offset by credit on byproducts such as wax or asphalt, plus chemicals, utilities, manpower, maintenance, overhead and depreciation.

The more costly slack wax is, the lower the cost per barrel to produce Group I base stocks, said Phadke. Declining Group I supply could bring much higher slack wax prices.

Turning to the outlook for Group I plants, Phadke described three kinds of owners.

First are the companies with base stock supply portfolios of one or more plants for merchant supply. Examples include ExxonMobil and Shell. These owners will continually ask, do we have the right mix of products the market needs today and tomorrow? They will upgrade or shut down Group I plants, based on rational economic factors.

Second are the supply-chain-optimization owners, lube marketers that are backward integrated into base oils to reduce costs. Examples include national oil companies, and independent companies such as Calumet, American Refining Group and H&R Chemische with industrial or private label niches. These owners must upgrade or shut down if their in-house Group I demand falters, but they will continue to make and use Group I as long as possible. For example, they will buy or make Group III to use as a correction fluid, to continue participating in the engine oil market. There is no real threat of closure by these Group I plants.

The third category of owner, said Phadke, is the inherited base stock business, owners of plants acquired along with fuels refineries. These owners have little or no interest in base stocks and specialties. The base stock is just a cash cow. Their concern is whether the base stock plant is the best use of VGO [vacuum gas oil] and other resources. As long, but only as long as the answer is yes, their Group I production will continue.

Kline, based in Little Falls, N.J., has just published Competitive Analysis of the Global Lubricant Base Stock Industry 2009, its in-depth analysis of the manufacturing costs and competitive positions of 102 base stock plants worldwide, including the principal Groups I, II and III paraffinic plants and naphthenic plants. The cost of the complete study is $57,000; portions of the study can also be purchased, such as geographic areas or plant types or individual plant information.

Information about this and other Kline studies is available at www.klinegroup.com.