How Should the World’s Refinery Operators Respond to War in Ukraine?

Flexibility and speed will be critical to maintaining refinery utilization and margins in the face of extreme geopolitical uncertainty.

Russia’s war on Ukraine has shocked the world on every level—humanitarian, diplomatic, and economic. How it will play out has yet to be determined. The response, from those sympathetic to the Ukrainian cause, as well as governments and large sectors of the business world, has been swift and sure.

Among the immediate reactions has been the institution of sanctions on the import and use of Russian oil and other energy products by several countries, along with a much greater number of companies no longer willing to purchase the country’s products. The result: severe disruptions in the flow of Russian oil and gas around the world.

The uncertainty surrounding Russian energy supplies has spread the economic consequences of the conflict across the globe, raising energy prices to new heights and causing real hardship for those struggling to heat their homes and get to work.

As key players in the global energy supply chain, the global oil refinery business has been thrown into turmoil. Although the current refinery margin environment has improved when compared to the period before the invasion,?the current level of geopolitical risk and uncertainty is high, and trade flows of crude oil and natural gas will likely be disrupted for some time. How refinery operators respond will be critical in maintaining flows of their energy products despite the reductions in the flow of Russian crude and natural gas—and, indeed, in ensuring the survival of their operations.

The New Reality

No region’s refineries have been affected as much by the disruption in the supply of Russian crude and other products as has Europe’s. Of the approximately 4.5 million barrels per day that Russia typically exports, half has been going directly to Europe—accounting for more than 35% of the total processed by European refineries annually. Sourcing both the volume and the quality needed will lead to a shift in energy flows, made more difficult by the already tight oil market prior to the invasion.

And it will take time to make the shift, which has the potential to reduce refinery utilization levels. Replacement crudes may not have the same API weight and sulfur content as Russian crudes, further affecting utilization. Exhibit 1 shows the API weight and sulfur content of lost Russian crude and selected replacements; the loss of the large quantities of Urals crude will be especially difficult to replace. Russia also exports substantial volumes of products that are used in US and European refiners for further upgrading, a supply source critical for ensuring optimal operations at high utilization rates.?

Moreover, current reductions in the supply of Russian natural gas, combined with the potential impact on the NordStream 2 gas pipeline and the constant threat from Russia to fully cut off gas supplies to Europe, has led to severe spikes in the price of gas in Europe, to as high as 225 euros per megawatt/hour (around $70 per million BTUs). This too will affect the profitability of European refineries and result in refinery throughput reductions as operators seek to optimize profitability or minimize losses in light of the higher operating cost driven by the price of natural gas.

The impact of the invasion of Ukraine falls on a European refinery industry that has already been facing numerous uphill battles. The high cost of European refinery products and government efforts to reduce the impact of global warming has led to financial losses and significant refinery rationalization there.

Global Effects

The impact of the war will not be limited to European refiners. The threat of the loss of part or all of the 4.5 million BPD that Russia exports globally drove the price of crude to more than $130 per barrel in early March, and it is likely to remain far higher than it was prior to the invasion. All refineries around the world will be faced with this new reality of highly variable and overall increased input costs.

The loss of supplies of Russian crudes will also negatively impact refineries served by freight and charter companies that aren’t able to transport sanctioned crudes. However, with Russian crudes currently trading at steep discounts, refineries that have not banned Russian crudes and continue to have direct access to them are likely to prosper, at least for the time being. This is especially true of those than can export into a global energy products market where crude is still trading at a high premium. The risk these refineries run is a continued escalation in sanctions that may eventually result in the loss of this opportunity as well.

However, it isn’t only the loss of Russian crudes that is impacting refineries worldwide. It’s the loss of intermediate streams such as vacuum gas oils, fuel oil, and atmospheric tower bottoms from Russian simple conversion hydro-skimming refineries. These streams are exported globally, with a significant amount making its way to European and US Gulf Coast refineries to fill spare fluid catalytic cracker, hydrocracker and coking capacity. The impact of the loss of these intermediates is likely to increase the operating costs of these refineries as they scramble to keep these units full, assuming that more expensive feedstocks remain economically viable. ?

On the natural gas front, shipments to Europe of liquified natural gas will significantly increase, resulting in increased pressure on gas prices around the world and further driving up operating costs. In short, every refinery around the world is now faced with the new reality of higher, and highly variable, input costs.

Known Unknowns

Russia’s invasion of Ukraine is also likely to lead to several longer-term impacts. With retail gasoline prices rising well over $5 per gallon in some parts of the US in April, and as high as $10 per gallon in parts of Europe, the appetite for electric vehicles (EVs) is likely to increase. This would further accelerate the transition away from internal combustion engines, decreasing gasoline demand and potentially speeding up the rationalization of refinery capacity.

On the other hand, Russia is the world’s top exporter of nickel, a key component of lithium-ion batteries for EVs. Potential restrictions on imports of Russian nickel has already significantly increased its price; depending on how long the threat of restrictions last, the increased cost will likely raise the price of EVs, slowing the speed of conversion.

Finally, governments are already responding to the drastically rising price of gasoline, and further reactions are likely. Already, US President Joe Biden has announced the release of up to 180 million barrels of crude from the country’s strategic oil reserve, and several US states are considering a reduction in gasoline taxes. Elsewhere, several countries have either put price caps on gasoline or added subsidies to mitigate the impact on consumers. Could the price shocks drive further government intervention, such as the temporary suspension of the Jones Act to allow the movement of gasoline between US ports via foreign-flagged vessels to improve flexibility and lower costs?

Response Time

Every refinery operator, not just those under the most pressure in Europe, must determine how to react in the short term to the current situation, and prepare for the longer-term consequences.

• Operators must respond rapidly and nimbly to the current circumstances. It is critical to quickly develop alternative sources of crude and intermediate oils. This will require a far more rapid assessment and qualification of new crudes than refineries are used to conducting. Some refineries have been hesitant to make moves that could add additional risk to their decision making, But those that manage the turmoil the best will be those who can react and respond in real time, balancing the increased risk that comes with a quick response against the ability to maintain utilization rates economically.
• Refiners that have secured storage and logistics assets are positioned to use these inventories to take advantage of continued price volatility, delivering additional profits on top of base operations.
• The shift away from Russian oil gives refiners the opportunity to consider the emissions intensity of crudes from other sources, setting them up for long-term reductions in their carbon footprint.
• The use of real-time economic optimization models will be critical in maintaining peak utilization in the face of significant price volatility for both crude and products.
• In the current environment, refiners are likely to see increased returns—additional capital that they will need to allocate. Upgrading and further digitization are possibilities, as is an accelerated push into low-carbon fuels. Biofuels, on the other hand, may face headwinds if they are perceived to cut into food production, given the recent record high prices for some food commodities.
• Refineries that struggle to access feedstocks should consider revising their maintenance schedules to move up planned shut down until feedstocks become available; alternatively, it may make sense to defer maintenance in hopes of capturing opportunities on the spot market. ?

The Way Forward

Refinery operators face a highly uncertain future. The impact of Russia’s invasion of Ukraine on the refinery business will be severe, and nowhere more so than in Europe. The immediate effects are already clear; the long-term effects—on supplies of crude and natural gas, on demand for refinery products, on government responses to the war, and on the post-war geopolitical environment—remain unknown. So it’s critical that operators make plans for a variety of contingencies as they sort through their options.

About the authors:

John Florez , Associate Director Oil & Gas, Houston

Clint Follette , Managing Director and Senior Partner, Houston

Alex de Mur , Managing Director and Partner, Madrid

Jamie Webster , Partner and Associate Director, Seattle?