Key Themes

Eduard Gracia, principal at A.T. Kearney in Dubai, told delegates the growth rate of automotive and industrial lubricants is closely correlated to global GDP (Gross Domestic Product). Equally, he noted that base oils are 95 percent of mineral origin and their demand is inextricably linked to lubricant demand. The remaining 5 percent of biobased and synthetic base oils are growing faster, but it is going to take a long while before these markets become a major force.

Although Gracia contended that base oil demand is largely driven by GDP, that statement must be qualified by the fact that gains in efficiency have to be taken into account. Every year, the world gains in efficiency with respect to its consumption of lubricants; therefore, to keep demand of base oils constant, you would need GDP growth of about 3 percent just to stay in the same place. If GDP stalls, as it did in 2009 when demand was static, the impact on lubricant demand is incrementally more significant. Demand for base oils will tend to be slow, even if GDP is pushing hard, Gracia added.

As has been widely predicted, organic growth in the base oils market will be modest, and Gracia estimates it at less than 2 percent during the next few years. Asia will be the major source of demand. The expectation is that API Group I demand is going to go down as it tends to be prevalent in developing countries. As a country develops, there is a migration toward Group II and III, as well as naphthenic and synthetics, which is growing.

It remains to be seen what impact the slowing Chinese economy will have on the rest of Asias economic performance, but, if recent reaction is any indicator, its buoyancy is pivotal to regional sentiment. What is clear is that demand has not grown as anticipated on a global basis because of the recession, and overcapacity is now an industry-wide problem.

According to Gracia, the issue traces back to 2006 when demand and capacity were reasonably balanced and plant utilization was high. The expectation was that growth would be balanced between capacity and demand. What actually happened was the onset of the recession, and demand grew much slower than had been predicted.

In fact, capacity has continued to accelerate, with 2015 capacity some 15 percent higher than was forecast in 2007. Yet, there has been little change in demand in the same period. Looking forward, Gracia said demand is likely to grow at a slow pace, but planned capacity additions already in progress are adding potentially burdensome levels of supply with obvious consequences for prices and plant utilization.

On the basis of forecasts by A.T. Kearney, the divergence between capacity and demand in 2020 offers a sobering insight into the future state of the industry, one that is characterized by lower than optimal plant utilization. According to Gracia, one factor causing the imbalance was the expectation that Group I base oils would be phased out, which accelerated additional Group II and III capacity to supply markets in Asia and to some degree the Americas. In contrast, Middle East capacity is small, and Group I is still highly prevalent, with Saudi Arabia and Iran being the main sources of supply.

Capacity additions due to come on stream in 2016 include Luberefs Group II base oil plant in Saudi Arabia and the long-awaited new Group II and III supply from Takreer at their expanded plant in Ruwais, United Arab Emirates. Asia is also expected to add sizeable new Group II and III capacity, as well as new naphthenic supply. Gracia said that to comprehend the logic behind the extra capacity, it is important to understand the relationship between price and costs.

Managing Costs

Because crude oil is the core feedstock of base oils, both prices generally move in tandem, and historically that correlation typically had a two month lag. Gracia said the lag was due to the fact that feedstock spent an average of two months in the system between purchase by the producer and sale in the form of base oils.

However, overcapacity has exerted pressure on producers to be more dynamic, with the result that the lag has all but disappeared. And base oil producers pass most additional profits on to clients. From 2012 onwards, we can see the [price] reaction become more synchronized. When the price of crude went down, the price of lubricants went down almost immediately.

Nevertheless, as crude oil prices fall, the relative weight of feedstock costs decreases, in turn increasing variable operating costs. What is interesting is that when the price of crude goes down, the weight of the feedstock in total cost also goes down. Therefore, local costs such as manufacturing costs become more important.

This is a crucial point and places the Middle East in an advantageous position. Frequently, the Middle East is a tax-free environment and benefits from cheap energy and lower labor costs. Local costs are obviously priced in local currency, and that is where Gracia said the Middle East has a durable edge over many other base oil markets.

What differentiates Gulf currencies like the Saudi riyal and the U.A.E. dirham is that they are pegged to the U.S. dollar. In contrast, the euro and yen have both lost value respective to the dollar as has the Russian ruble. Currencies are important, and we have seen a lot of changes in the parity of different currencies around the world.

Whether currency volatility should be part of an overall strategy moves up on the agenda as producers face squeezed margins. To determine the effect currencies have on margins, Gracia ran a series of models with the results showing that the Middle East has a low sensitivity to currency fluctuations. That stability means plant utilization is likely to remain high for the foreseeable future and ahead of competing producers in Europe, the Americas and Asia.

The first scenario modeled a stronger euro, which worsened capacity utilization in Europe to the benefit producers in the Americas and Asia. If the euro bounced back by around 12.5 percent, you would see utilization in Europe go down because companies would be less competitive. And production would be transferred to the Americas and Asia – interestingly not to the Middle East, Africa or Russia because they are already at capacity.

The second scenario considered a 10 percent devaluation of the euro and showed the opposite effect in terms of gain but still remaining in the same regions. Europe would gain production and take it away from the Americas and Asia but not from the Middle East. Even with a reasonable devaluation of the euro, the Middle East keeps its competitive advantage.

However, Gracia said it was important not to just gage the sensitivity of the Middle East to changes in international currencies, but also to assess the effect of a change in valuation for Middle East currency. The most obvious candidate is the Iranian riyal, which fell dramatically against the U.S. dollar after sanctions were levied and could now appreciate if sanctions are lifted, following the recent nuclear agreement.

According to Gracia, the impact of such an event would be muted, even when a potential 30 percent revaluation of the riyal was modeled. The funny thing is, there are not any major changes because utilization is already high. Even with a 30 percent increase, the region is still very competitive. In other words, regional competitiveness is quite solid in terms of costing.

The competitive edge in the Middle East goes some way to explaining the decision by existing base oil refiners like Luberef and Takreer to expand capacity. The question is how durable the Gulf currency pegs are to the dollar. Pretty safe, it would appear.

Even in previous economic downturns, Gulf States have steadfastly resisted devaluation. Nevertheless, the extent of the current fall in prices has heaped pressure on Saudi finances, with the forward currency market seeming to suggest devaluation. That still looks like a long shot because the government would be very reluctant to create further uncertainty in the market.

Strategic Takeaways

At a global level, Group II and III base oils were expected to grow significantly more than they actually have, and capacity has overshot demand. If demand matches current forecasts, it is going to take years for capacity to catch up. That will have consequences for pricing said Gracia. Base oils will be more synchronized with crude oil than they have been in the past and there will no longer a two month lag.

Producers will also see that operating expenses becomes more important. Drops in oil prices increase the weight of crude in the cost structure. Any savings that can be made in operating expenses will have a much more important impact than it did say two years ago. That, said Gracia, makes exchange rates more relevant to competitiveness.

Even if exchange rates fluctuate by 20 percent in either direction, the Middle East competitive advantage will hold in Gracias opinion, even with the expected appreciation of the Iranian riyal in a post-sanctions environment. Whats more, the amalgam of cost benefits in the region bodes well for the regional base oils market. Due to the cost advantage, capacity will likely continue to migrate to the Middle East with new facilities opening in the region, while others continue to close in Europe and America.