European refining margins have fallen 60 percent since last year, and changing market conditions will put even more pressure on them in the next few years. The industry has opted to reduce throughput instead of closing facilities to account for weak profitability, but this is a temporary fix that won’t last for long, argues Citi analyst Mukhtar Garadaghi. “We see rationalization as the industry’s only viable long-term solution,” says Garadaghi. “15 percent of European refining capacity is unprofitable.”

European refineries facing issues

The first problem is that refining capacity has boomed, and Europe simply hasn’t been able to compete on price. Russian distillate exports to Europe have climbed 60 percent and are set to grow over the next four years, while Saudi Arabia will add 1.2 million barrels a day in refining capacity in the same time frame—making a net exporter of both diesel and gasoline.

European diesel import to eur by source

European markets increasing supply

Even worse, one of Europe’s most reliable markets is ramping up its own supply and displacing European imports. Shale oil in the U.S. is driving growth in domestic output, and while fracking is politically controversial (and the possibility of restrictive regulation is very real), at the moment it has given U.S. refineries a competitive advantage. “We expect the advantaged U.S. producers to continue benefiting from the abundance of cheap sweet crudes and further squeeze their less efficient European peers,” writes Garadaghi.

US gas imports declining

European refineries positions

European refineries could improve their position by closing 15 percent of capacity, but political and labor issues make this course of action complicated, especially since the closures would probably need to be in Greece and Italy—both of which are still struggling to recover. Garadaghi doesn’t see any sign that oil industry leaders are prepared to make the necessary changes to protect their long-term interests, even though he thinks the course of action should be clear.

oil refinery cost curve

Hardest hit markets

“We see the Greek and Italian markets as hardest-hit in the coming years through a function of weak domestic demand and the rise in Middle East imports,” he writes. “We highlight Eni SpA (ADR) (NYSE:E) (BIT:E), ERG S.p.A (BIT:ERG) (OTCMKTS:ERGZF) and MOTOR OIL HELLAS (OTCMKTS:MOHCF) among the companies most exposed to increased competition in their key export markets.”

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Citi analysts Alastair Syme, Michael Alsford, Ryan Kauppila, and Nikhil Gupta also contributed to this research.