As outlined in Liz Martin’s insightful April 2024 article, refineries often hold greater strategic value for asset-backed traders than for other acquirers or even incumbent owners. This has driven a trend of major trading houses dominating refinery acquisitions, leveraging their ability to monetise inherent optionality.
This piece delves deeper into the commercial intricacies associated with refinery M&A transactions, drawing from recent experiences as commercial advisors.
From valuation dynamics to the evolving biofuel challenges, this discussion unpacks five critical complexity areas:
- Valuation Dynamics: Navigating Shifting Sands
- Role of Balance Sheet: Understanding Balance Sheet and Credit Constraints
- Trading and Asset Optimisation: Unlocking the Optimisation Potential
- Risk Management & Governance: Assessing the Key Risks
- Transitioning to Biofuels: Managing the Unspoken Challenges
Refinery M&A: Commercial Complexities
1. Valuation Dynamics: Navigating Shifting Sands
Valuing a refinery is a multifaceted challenge influenced by competitive positioning, market volatility, and operational inventory valuation.
Asset Competitiveness and Longevity: Buyers should assess the target refinery’s competitiveness against multiple criteria, factoring in the merits of environmental upgrades and potential repurposing for biofuels or other decarbonisation initiatives. This evaluation is critical in forecasting the refinery’s long-term viability within its geographic and regulatory context
Market Volatility and Forward Cracks: Refinery valuations will naturally be influenced by the prevailing forward product cracks (refining margins). In recent times, these margins experienced unprecedented highs due to geopolitical disruptions, notably the Ukraine crisis. However, as markets stabilise, valuations are reverting to pre-crisis norms. Buyers must account for this cyclicality while sellers adjust their expectations accordingly. Overvaluing recent margins without considering longer-term trends could lead to overpayment or stalled negotiations.
Inventory Complexity: A significant portion of the refinery valuation lies in the inventory held within storage tanks and pipeline systems. Assessing what is deemed “normal” operating stocks and then accurately valuing diverse inventory components, from tradeable feedstocks to illiquid intermediaries and tank bottoms, demands deep sector expertise; a complexity underestimated by less experienced acquirers.
2. Role of Balance Sheet: Understanding Balance Sheet and Credit Constraints
Ultimately, acquirers with a robust balance sheet and a broader network of credit lines with financial and physical counterparts can realise higher margins, whereas financially weaker buyers may rely on incumbents or commodity banks for credit, typically at a cost premium.
Hedging and Liquidity Exposure: Acquiring refineries comes with inherent exposure to fixed-price inventory valuations. Credit-constrained buyers face higher hedging costs and potential margin-call pressures during market fluctuations. For instance, during the Ukraine crisis, some refiners with large forward positions in refinery margin and inventory hedges experienced significant liquidity squeezes.
Capital Deployment and Strategic Investments: New owners often inherit refineries handicapped by some years of underinvestment. Stronger financial players can often unlock value through modest investments in infrastructure, such as storage tank and pipeline upgrades or jetty modifications. Moreover, long-term competitiveness may require significant capital for transitioning into biofuels, co-processing waste oils, green hydrogen, and eventually into carbon capture projects.
Storage Plays and Contango Opportunities: Financially capable owners can exploit market contango; profiting from storage plays during favourable pricing conditions, to further enhance margins.
3. Trading and Asset Optimisation: Unlocking the Optimisation Potential
The capability to optimise refinery systems through trading activities varies significantly across operators, influencing the overall value extracted from assets.
Spectrum of Trading Competence: Global trading houses and major oil companies excel in trading and asset optimisation. Conversely, independent refiners are often constrained to relatively small trading teams that lack the required resources and capabilities to maximise value from complex operations.
Cultural and Organisational Barriers: Transitioning to a trading-centric model requires overcoming entrenched operational norms. Resistance from the asset/business managers and mistrust of newly introduced trading teams can impede progress. Strategic shifts necessitate external guidance to align stakeholders and implement best practices.
With the right expertise and resources, acquirers can drive substantial value through entrepreneurial trading and robust optimisation strategies, but only if constraints, be it financial, cultural, or operational, are effectively addressed.
4. Risk Management & Governance: Assessing the Key Risks
Risk management is not merely a compliance exercise but a critical enabler of value creation, particularly for acquirers looking to integrate trading and optimisation activities. Risk management practices within refinery operations vary widely, necessitating thorough due diligence by potential buyers.
Inventory and Margin Hedging: Independent refiners often limit their risk management activities to modest inventory and margin hedging. In contrast, larger operators may engage in discretionary risk-taking across many trading books, requiring sophisticated governance and oversight.
Scalability and Compliance: Acquirers planning to scale trading operations must address compliance and governance gaps proactively, ensuring sustainable growth without undue exposure to regulatory or market risk
Governance and IT Systems: Effective risk management hinges on robust governance structures and fit-for-purpose IT systems. Buyers must evaluate the adequacy of these frameworks, ensuring that all risks are captured, measured, and managed effectively using tools such as Value at Risk (VaR) models and scenario testing.
5. Transitioning to Biofuels: Managing the Unspoken Challenges
The shift to cleaner energy sources, particularly biofuels, is a key focus for modern refineries. However, integrating biofuels into traditional operations presents unique challenges.
Economics Underpinned by Regulation: Biofuels investments, as with many new fuels, require a certain leap of faith that the regulatory policies that underpin the future economics will be sustained and will have the desired effect of creating a sufficient price premium for the lower carbon fuels that justifies the investment. Assessing potential investments should be supported by experienced practitioners that can help develop and challenge market analysis, supported by thorough scenario testing of downside and upside cases.
Feedstock Sourcing: Securing reliable bio-feedstock supplies is a competitive and geographically dispersed endeavour. Leading players like Neste have established regional sourcing teams, leaving new entrants at a disadvantage. Direct sourcing requires significant investments in origination teams in unfamiliar geographies and long-term commitments with emerging projects, adding layers of risk and complexity. The alternative is to source through intermediaries/aggregators and forgo potential margin, which may be preferable until sufficient scale is achieved to justify self-sourcing.
Pre-Treatment Infrastructure: Many bio-feedstocks require pre-treatment to remove impurities before processing. While larger bio-refiners may justify onsite investments in the required plant, others must rely on expensive third-party services, thereby eroding margins
Market Illiquidity: The nascent biofuels markets typically lack the liquidity necessary for effective forward trading and hedging. This exposes refineries to heightened market risk and challenges existing risk management practices, requiring alternative metrics and modelling approaches. Acquirers must be mindful of the requirements for assessing and supplementing the risk management capabilities and processes to address these challenges.
Addressing these challenges requires a strategic approach, balancing investment in capabilities with a realistic assessment of market dynamics, operational constraints and risk management complexity.
Conclusion
The complexities of refinery acquisitions are ever-increasing, driven by market volatility, the evolution of trading practices, and the transition to cleaner fuels and decarbonisation. Successful acquirers are those who can navigate these challenges, leveraging robust financial resources, advancing trading capabilities, and having a forward-looking approach to risk management and sustainability.
Major trading houses remain the dominant players in refinery M&A, thanks to their financial strength and ability to optimise systems. However, institutional and non-traditional investors will still play an important role, particularly when aligned with strategic partners and/or experienced advisors.
At Energex, we take pride in supporting investors and corporate clients through these intricate transactions. The deep trading, optimisation and risk management experience within the Energex team helps our clients to bridge capability and capacity gaps in competitive transaction processes.
Our unique approach, rooted in decades of sector experience and a rigorous due-diligence process, ensures all risks, opportunities, and complexities are thoroughly addressed. With a commitment to delivering actionable insights and robust analytics, we continue to empower stakeholders to make informed, strategic investment decisions in this dynamic sector.
If you would like to understand more about our M&A commercial advisory services, please contact Steve Jones at Energex Partners sjones@energex.partners.