Within the integrated space, we are currently witnessing a number of firms increasingly moving investment away from downstream operations. While not suggesting that the integrated model is dead, it certainly indicates that management believes returns will not revisit historical levels. Instead of ending integration completely, we expect companies to reduce investment and opportunistically shed capacity in the coming years in an effort to improve returns.
Refining operations have, on average, generated lower returns than exploration and production operations. However, the recent recession and subsequent drop in refining profitability brought to light the new reality for refining, particularly in developed economies. High oil prices, combined with an economic recession, may have permanently impaired demand for refined products. Gasoline demand is especially affected by the recent strides in fuel efficiency and hybrid technology. As a result, refining capacity in North America and Europe far exceeds demand. In addition, low cost export oriented refineries in Asia and the Middle East offer additional supply pressures. These factors add up to an uncertain future for refiners.
In order to address the new environment, most integrated firms are either divesting refining assets, or reducing downstream investment. For the most part, we view these actions favourably, given that we hold a negative long-term outlook for refining. However, depending on a company's asset base, completely ridding itself of the downstream component does not necessarily make sense. We see companies such as ExxonMobil (XOM), Royal Dutch Shell (RDSB) and Chevron (CVX) as maintaining competitive advantages in its downstream operations, either through high levels of integration between upstream, refining and chemicals, or by owning assets well-positioned to serve growth markets. We also see chemical manufacturing as becoming a more valuable asset for integrated firms as natural gas production increases in the coming years. Here's a look at the activity we see occurring on our coverage list:
