Begin at the Middle

The oil price crash between 2014-2016 proved to be an exceptionally profitable time for the middlemen, exacerbating the trend for more investment by traders in the upstream and downstream sectors.

Oil producers in Africa struggled to adapt to the “lower-for-longer” price environment, though crude prices held relatively steady since the end of 2016. But the story is a very different one for traders, who posted record profits in 2015 and strong profits still in 2016. Vitol earned a net income of $1.6 billion in 2015, a 15 percent increase over the previous year. In its unaudited results from 2016, the profits jumped even higher, posting a net income of $2 billion that year. Gunvor recorded an all-time high of $1.25 billion in 2015 and Trafigura netted $1.7 billion.

For the turbulent period starting in 2014 provided the perfect opportunity to reap record profits.

Making lemonade

Successful oil trading is dependent in large part on volatility. After a trader buys crude oil for a certain value, the product is then shipped and sold, hopefully at a profit, to an end user, such as a refinery. In times of volatile prices, more precisely in times of contango — when the future price of a commodity is higher than the spot rice — traders can wait out low prices by keeping their cargo at sea or in storage areas, enabling them to get the most bang for their buck. In a highly visual example, in 2016 hundreds of oil tankers carrying millions of barrels of crude sat idle for weeks off the coast of Singapore, waiting for their moment to move the cargo at a profit. As the oil price has stabilized, however, the market is moving into a period of backwardation — when the future price of a commodity trades below the spot price — making the “cash and carry” trade less attractive.

Cash-strapped governments and companies often cannot afford to hold on to their oil to wait for better prices. To the contrary, African oil producing nations often “mortgage” their oil future by engaging in pre-financing deals with oil traders.

Also, oil demand varies in different regions of the world, allowing traders to ship vast quantities of crude and redirect shipments from one place to another and maximize profits in the logistics value chain. The sheer volumes of crude — some traders transport more than 6 million barrels per day — means the smallest margins have a major impact on a company’s accounts.

Finally, the impact of geopolitics on commodity prices can greatly influence the local prices of oil. Vitol, the largest independent trader in the world, has made itself known here — in being able to reach war torn areas like Gaddafi’s Libya or the Kurdish region of Iraq.

Beyond the core

Many trading companies have become cash-rich, and, in contrast to their historical business practices, they have begun to branch out from the core of their business through vertical and horizontal integration. They have opened financial trading divisions, a “paper” version of their actual work. They have invested in downstream distribution, buying and expanding networks of fuel stations to distribute crude to the consumer. These companies have also acquired their own refineries, using their ability to blend different types of crude to adapt to the refineries’ needs, the cost of different oils and the needs of their different receiving markets, such as Gunvor with three refineries in Europe.

For example, in 2011 Vitol and an investment firm Helios Investments purchased 80 percent of Vivo Energy, a fuel distributing company owned by Shell covering 16 African markets. In late 2016, Shell announced the sale of the remaining 20 percent  of Vivo to Vitol and Helios, making the two companies full owners of Vivo, with 50 percent equity each. In December 2016, Vitol emerged, with Chinese oil company Sinopec, as a final contender in a bid to buy 75 percent of Chevron’s South African subsidiary, which includes a Cape Town refinery and more than 800 retail stations in South Africa and Botswana, though the bid was eventually granted to Sinopec.

The significance of these investments and this interest in downstream distribution in the African continent is considerable. BP projects Africa’s energy demand to grow by 88 percent between 2014 and 2035, from 8 percent to 15 percent of the global market share. The opportunities for growth are immense for trading companies, which compete to supply a fuel distribution market that moved over 3.7 million barrels per day in 2014. Angola and Nigeria, whose combined production tops that level, should be able to provide for the local market. But they can’t.

Unrefined Africa

Africa produces over three times the amount of oil it consumes, and yet it remains a net importer of fuel at a considerable cost to national budgets because of a lack of refining capacity.

Throughout the continent, there are only 46 refineries and many are under-used, with low actual capacity, and they are often poorly maintained. As a comparison, there are over 140 refineries in the United States, which contains a population of 320 million people, compared to Africa’s 1.2 billion.

Most of the refineries in Africa are also located north of the Sahara, in more developed markets. Sub-Saharan Africa is then left with only one choice — importing fuel. Nigeria, the continent’s biggest crude oil producer, spends around $20 million per day on fuel imports.

The lack of capacity comes from many issues, including insecurity, political instability, a lack of technical capacity, and difficulty securing the immense capital needed to build these projects. Additionally, it would be difficult for a new entrant to be able to compete with more streamlined economies in well-established refining centers in Asia and the West.

Refineries are particularly sensitive to economies of scale, and for a refining project to be successful in Africa, many critics argue it must be a big one, with a capacity of about 300,000-500,000 barrels per day. The costs top $4 billion, with smaller refineries struggling to compete with cheaper imports from the U.S. and elsewhere.

Refineries on the coast struggle the most to compete, as the surrounding markets are easily accessible to potentially cheaper traded oil from abroad. Larger refineries in land-locked countries may be competitive, as the difficulty of importing petroleum products from the coast via poor roads makes imported fuels more expensive. Uganda is planning to build its first refinery and awarded the contract to RT Global Resources in 2015, but the Russian company has since backed out of the project. The government is seeking new bids.  The refinery, which should have come online in 2016, and is not expected to come online until at least 2020.

This leaves many African nations in a difficult position, as imports, not refining, continue to supply their energy needs. While this is not good news for many African countries, it is good news for the traders, who will continue to ship crude oil from African shores to be refined, perhaps in their own refineries, and bring the refined products back to Africa to their own fuel stations in African nations.

Going upstream

The traders’ expansions haven’t stopped at the downstream. Over the last few years, trading companies have been acquiring assets upstream as well, particularly in Africa.

Glencore, the only major trading company to go public, bought a small Canadian oil and gas exploration company, Caracal, in 2014. Caracal’s operations were located in Chad, considered one of the most challenging markets in the world. But trading companies, particularly the big four privately owned companies — Trafigura, Vitol, Gunvor and Mercuria Energy —  are well known for their ability to operate in such environments.

Vitol has been in the upstream market in Ghana since 2006, selling part of its equity and operating rights in the Offshore Cape Three Points Block to Italian oil giant ENI in 2009. In October 2016, the Ghana government approved a $7-billion investment plan that should see the block’s resources, estimated at 1.5 tcf and 500 million barrels of crude oil, start to come online in 2018. The gas will most likely be used to power Ghana’s power generation matrix, while the oil will be destined for export. With a 37.78 percent stake in the block, Vitol assures in this way an entry into the natural gas distribution market in Ghana, and an assured supply of crude oil at production prices for continued distribution to the global market.

These deals demonstrate a growing trend — though little publicized, trading companies have been acquiring upstream assets for years. And the period of low oil prices made these acquisitions even easier for traders.

The lower-for-longer era saw many major oil producers reducing asset exposures by focusing on guaranteed upstream investments, and opened the door for cash-rich trading companies to further their exposure in the upstream market. Africa, as the most underexplored oil and gas continent on the planet, seems to be attracting growing attention. In a new development for such a technically complex industry, the middleman is now also placing bets on the upstream and downstream sectors.