Which of these statements is reliable?
1) Base oil prices follow the ups and downs of crude oil prices.
2) API Group number is a good gauge of base oil quality and value.
3) API Group I base oil refineries cant compete on cost with Group II and III plants, and will have to either upgrade or close down.
All three statements may seem reasonable, in light of whats been said and written about base oils for the past 20 years, concedes refining expert Amy Claxton. But suppliers, investors and buyers need to look beyond these assumptions to the underlying market realities, she urged a recent industry meeting.
For most of the 20th century, Claxton reminded the Independent Lubricant Manufacturers Associations annual meeting in October, base oil prices did trail closely after crude oil, rising and falling in sync with the benchmark crude for each region (West Texas Intermediate in the United States, North Sea Brent in Europe, Tapis in Malaysia, etc.)
Todays base oil prices, however, seem disengaged from crude prices and even each other. Instead, prices for individual viscosity grades and API Groups twitch up and down in time with their own internal clockwork. According to Claxton, this is a signal that API Group I, II and III base oils are settling into separate value streams-each with a distinct pricing mechanism.
To unwind these mechanisms, always begin with the fundamentals of supply and demand, said Claxton, who is the president of MyEnergy Consulting and Training in Hummelstown, Pennsylvania. Supply and demand, over time, is the fundamental price-setting mechanism, whether youre talking about bagels, Bic pens or base oils.
The operative phrase, she emphasized, is over time: You cant just look at how prices move daily or weekly alone. But over time, youll see that every commodity has a price ceiling-the upper limit of what people are willing to pay-and a price floor. The floor is the lowest possible price that a supplier can afford to accept and still stay in business.
When strong demand draws down base oil inventories, an undersupply can occur that creates the conditions for rising prices, until the price ceiling is reached and buyers find it too painful to bear. Likewise, in the face of oversupply, prices can weaken until they sink to the floor. If prices crash through the floor and still dont recover, the highest-cost suppliers will make for the exit. That is why refiners in the U.S. and Europe can be seen trimming back or closing down in the face of sustained losses, Claxton said, although refiners in some economies may continue operating due to governmental price controls.
In the sweep of historic trends, she said, for a long time, crude prices set the floor for base oils because raw material costs are 80 percent or more of a refinerys cost of operation. The other 10 to 20 percent is their operating expense.
Despite the wide fluctuations in crude prices that took place in the 1970s, and the eruptions that have peppered energy markets ever since, we could count on product pricing to follow crude pricing over time. Base oil pricing was particularly easy to follow until the 1980s and early 1990s, because most of the product was fungible; what would be called Group I quality today.
In the early 1990s, the American Petroleum Institute defined the five base oil Groups we know today, just as large volumes of Group II base oil began to gush. Over a relatively short time period in the mid-1990s, North American refiners including Excel Paralubes, ExxonMobil, Motiva and Petro-Canada brought massive Group II plants on line and generated a glut of light and medium grades. In response, most base oil prices fell.
The exception was heavy-viscosity base oils. These denser grades have a slightly higher price floor because they cost more to produce, Claxton pointed out. Heavy grades account for a lower portion of the overall yield, too, so they have always sold for more than the light and medium weights.
Coming to the present era, its evident that prices are no longer tied neatly to crude oil and API Group. Group I bright stock commands the highest price of any slate, the heavy grades earn high margins, and waxes and specialties are highly profitable. Meanwhile, many light and medium Group I and II grades are at parity in price, while Group III barrels are being deeply discounted in some regions due to oversupply and underwhelming demand.
Whats setting the price ceiling now? First, noted Claxton, there are a lot more suppliers and a lot more quality choices. The viscosity index for Group II typically runs from 95 to 119, and yet theyre still all considered to be Group II. Likewise, the Group III base oils that charged into the market over the past decade offer V.I. running from 120 to over 135-but fit under the Group III umbrella.
Supply/demand balances now have to be achieved across each vis grade, each quality level and the quality levels within a specific grade, said Claxton. And rather than having one ceiling and one floor, the base oil market resembles a fun house with multiple ceilings and floors. Price points depend on whether the goal is to make passenger car and heavy-duty engine oils, or everything else such as industrial oils, metalworking fluids or greases.
Behind these new pricing mechanisms is the same old world order, Claxton observed. Supply-versus-demand still applies. But there are more products, more complexity and more quality levels within single markets. Comparing the dynamics of todays Group I refinery to a Group II or Group III refinery is like comparing a Toyota car plant to a toaster factory, she added. It obscures the insights that could be gleaned if each segment were looked at on its own terms. Even within the tiers and layers, the product that enjoys the highest demand and the shortest supply is going to fetch the highest price, she declared.
The API system of classifying base oils into numbered Groups has also given rise to a mistaken belief that Group I represents the lowest tier of quality, Group II is in the middle, and Group III is on top and thus gets the top price. This mentality made it easy for refiners to reach a decision to build a whole bunch of Group II and III capacity, especially in the Middle East and Asia, Claxton noted.
In many cases though, formulations are built around kinematic viscosity, not saturates or viscosity index. Currently were seeing shortfalls in the availability of heavy viscosity grades, in part because so many Group I refineries have closed, while Group II and III units only make light and medium grades. Now we see refiners trying to chase that market, with new bright stock and heavy-vis grades, Claxton observed.
In the real world, she continued, formulators choose base oils to meet the quality they need at their lowest total cost. No one cares if it is Group I, II, III or IV. The formulators dont care, and will blend them together to get the performance they need. They will pay for quality where they need it-for example to make an SAE 0W-8 engine oil-but will not pay for unnecessary quality.
Group I has lost ground to other base oils, but still holds the largest market share, she pointed out. It accounts for 44 percent of global supply, compared with Group II at 34 percent and Group III at 13 percent. Naphthenics have the rest.
This shift in market share is due in part to refinery closings, but new construction also played a role, especially speculative Group III plants that are mismatched with market demand, reminds consultant Geeta Agashe, president of the consulting firm Geeta Agashe & Associates in Cedar Grove, New Jersey. In a seminar last month during the ICIS Pan American Base Oils & Lubricants Conference, she noted that new construction projects in the Middle East are aiming to diversify these economies away from crude oil and towards higher value refined products-with the effects cascading into the base oils market.
Examples include Shell and Qatar Petroleums massive gas-to-liquids plant in Qatar, the Bapco refinery in Bahrain, Abu Dhabis Takreer refinery that opened last year and, next year, Luberefs base oil plant in Saudi Arabia. Every one of these is supplying Group II and/or Group III on a global scale, with more likely to come.
Kuwait, the UAE, Iran and Oman are all adding fuels refining, mostly using hydrocracker bottoms as their feedstock, Agashe said. These producers are building to make fuels, not base oils, but then theyre asking, What else can I make? If they can add value by adding base oil production, theyll do it-even if the base oil market is oversupplied-as long as base oil is at a premium to diesel.
As these low-cost barrels arrive on the merchant market, they may take share away from existing light- and mid-vis base stocks. What plants may be vulnerable to closure, and why, is a strong concern, commented Agashe. The world has 5 million tons a year of base oil overcapacity now, and will add more than 15 new plants by 2020. Some of these may be delayed or slowed down, but if they all come on, it will add 10 million more tons of overcapacity.
Thats bad news for the supply-demand picture, concurred Steve Ames of SBA Consulting in Pepper Pike, Ohio. Over the next five years, he forecasts that lubricant demand will decline 1 to 2 percent a year on average, due to longer drain intervals and higher lubricant efficiency. Not just automotive engine oils, but driveline, industrial and even process oils will see this decline, he told the ICIS Pan American Base Oils conference. Group I will not disappear, he added, because higher-vis grades are now the focal point for Group I plants.
Even so, on a global basis he sees a need to correct the big imbalance between the capacity we have and the demand we have. We could see 1 million to 2 million tons per annum of Group I capacity shutting down or changing to higher quality, he said. He also opined that some 600,000 tons of Group II capacity, in North America and elsewhere, will be repositioned towards making Group III.
This struggle will benefit the best-run Group I suppliers, believes Amy Claxton. In todays environment, the high-cost producers dont have to compete with low-cost producers, she said. They only have to compete with their peers.
In her analysis, these differing slates have led to a structural break in the base oil supply model. What once were overlapping products are now on distinct paths, with their own economic regimes:
Group I has the highest production cost, but also a great value portfolio. Group I plants have the highest operating costs, yes, but also the highest-value byproduct revenue streams, which include bright stock, waxes and more.
Group II can cost less to make, but has fewer vis grades and byproducts to support a high-cost producer. Its stronghold will continue to be light- and mid-grade base stocks for a wide range of automotive and industrial lubes.
Group III is overtechnical, a high-performing product that the finished lubricants market hasnt caught up to yet, in either volume or technical need. Eighty-five percent of Group III today is produced opportunistically from hydrocracker bottoms, Claxton pointed out. These base stocks have the highest V.I. and the highest saturates levels, but only supply the light-vis end of the market. Group III refiners have no bright stock and no 600 Neutral, but they do have excellent ultra-low sulfur diesel as a byproduct.
So today, we have overlapping but different models of competition between producers, asserted Claxton. Refiners are not making the same products-so who cares whether they can compete with the other base oil Groups? Group I only needs to compete with other Group I; Group II only has to contend with other Group II players, and Group IIIs with other Group III.
New technology led to the expectation that Group III is better than Group II, and Group II is better than Group I, she concluded. But the market is the market. Blenders will continue to buy whichever stock they need to achieve the lowest formulated total cost. And you cant compare a Toyota plant with a toaster factory.