It is rare that a fuel specification change could disrupt the oil value chain, but the International Maritime Organisation’s (IMO) planned change to bunker fuel regulation may do just that.
The IMO, the United Nations’ body responsible for the safety and environmental performance of the shipping sector, has ruled that from January 1, 2020, marine sector emissions in international waters be slashed.
To comply, the marine sector will have to reduce the sulphur emissions by over 80%, which can be achieved by switching to lower sulphur fuels. The current maximum fuel oil sulphur limit of 3.5 weight per cent (wt%) is to be reduced to 0.5 wt%. The new tougher limits will be the largest reduction in the sulphur content of a transportation fuel undertaken at one time.
Scale of the issue
The marine sector, which consumed 3.8 million barrels per day (b/d) of fuel oil in 2017, is responsible for half of global fuel oil demand. Most of this fuel oil has a sulphur content of between 1.0 and 3.5wt%, making it a high-sulphur fuel. The marine sector also consumes just over one million b/d of marine gas oil, which is a lower-sulphur, higher-value distillate. However, this represents just five per cent of the global demand for diesel and gas oil demand, the majority of which is consumed in the heavy-duty trucking sector.
If the marine sector fully complied with the IMO regulation by simply switching from high-sulphur fuel oil (HSFO) to marine gas oil, the impact on the refining sector would be dramatic.
Firstly, the strong surge in distillate demand caused by the replacement of HSFO would require refineries to run at high utilisation, which becomes increasingly costly.
Secondly, the value of HSFO would collapse until it found an outlet in lower-value end-uses. At the right price – around US$20 per barrel, less than a third of its August 2018 price level – it could compete with coal for electrical power generation.
Distillate prices would need to increase, in part to make up the shortfall from lower revenues from HSFO now priced at distressed levels and then to support the costs of higher refinery utilisation. This price spread between HSFO and distillate could increase by a factor of four from its current level of US$25 per barrel. This should provide a huge incentive for refiners to invest to upgrade HSFO to either a 0.5wt% sulphur fuel oil (termed VLSFO, very low sulphur fuel oil), or distillate. However, there is little such investment under way.
Options for the marine sector
The IMO is working with its member states to develop a regulatory framework that will achieve full compliance. But this is complex, given the fragmented nature of the marine sector and that non-compliance would happen in international waters, far from land.
Even with the forthcoming introduction of a carriage ban – ships are not permitted to have non-compliant fuels in their bunker tanks, with the regulation enforced by the port authority – it is difficult to envisage full and immediate global compliance.
The ways in which the marine sector can comply without needing to purchase marine gas oil include:
- Buying VLSFO, if available;
- Switching propulsion systems to other fuels, such as liquefied natural gas, which is an option for new-build vessels;
- Installing exhaust gas cleaning facilities (termed “scrubbers”), which enable the shipper to continue to burn cheaper HSFO by washing the exhaust gases to reduce the SOx emissions.
The key difficulties are the uncertainty around compliance and that refining and marine investments are in direct competition, prompting a “wait and see” approach from both sectors. Wood Mackenzie believes the installation of commercial scrubbers has the advantage of being less expensive. It would also be faster to put in place than a major refining upgrade, which is highly capital-intensive and can take many years to implement.
Refining sector implications
Wood Mackenzie believes that global compliance with the new IMO regulation will reach about 80 per cent in 2020.
Our analysis indicates that more than two million b/d of HSFO will be displaced from the bunker sector. However, some of that can be re-blended to produce a compliant VLSFO, but VLSFO will be priced at a premium to crude, rather than the typical discount.
Displaced HSFO can be processed within the global refining system’s spare residue upgrading capacity, but its discount to crude needs to widen to make using this spare capacity economical.
Once the regulation comes into force, the bunker sector will need more than one million b/d of additional marine gas oil. However, its pricing premium to crude needs to widen to cover both refiners’ revenue shortfall from the weakening of HSFO prices and the extra costs of higher refinery utilisation.
Wood Mackenzie also believes that by 2020, the price differential between gas oil and HSFO will be roughly double the 2017 differential. That makes a decision by the marine sector to opt for scrubbers commercially attractive.
This shift in refined product pricing results in:
- Crude differentials changing, with the discounts for medium and heavy/sour crudes (to Brent) widening significantly;
- Sweet/sour crude differentials changing, but primarily for those very low sulphur crudes that can produce a VLSFO;
- Refining margins increasing, but the impact is unevenly distributed. Those doing best will have sophisticated refineries that capture the feedstock advantage (by processing heavy sour crudes and importing heavy residues) and also the product premiums (by not producing fuel oil and having a high distillate yield).
However, there are many uncertainties around the compliance levels and the ways in which VLSFO can be supplied. Given the scale of the change, the oil value chain is likely to see high volatility during 2020.
The countdown to 2020 begins
The IMO’s regulatory change to the emissions of the international marine sector has the potential to be highly disruptive to the pricing and availability of compliant fuels. The costs of ocean going freight will increase as the marine sector uses more costly fuels, which has wide reaching consequences across the global economy.
Given the need for compliance on January 1, 2020, the impact could well be felt from mid-2019 onwards and last for a few years, as the refining and shipping sectors determine how to survive and best adapt.
Alan Gelder is VP Refining, Chemicals and Oil Markets at Wood Mackenzie. Alan leads Wood Mackenzie's global refining and oil marketing research; he manages the company's refining and chemicals outlook in EMEARC.