By John Mayes and John Auers
The move to low sulfur bunker fuel coming in 2020 as a result of new regulations from the International Maritime Organization (IMO) has been a frequent topic of this blog. Certainly, the markets most directly affected by the rules are fuel oil and distillate, and we have amply discussed the impacts on these products in several previous blogs. But these are not the only petroleum market segments which will have to adjust to the post-2020 environment. We recently discussed how IMO will roil the anode coke markets as low sulfur residual barrels are diverted into bunker fuel markets (1/9/2018) and highlighted a recent study we published on that situation (Anode Coke Markets – the Gathering Storm). While the low sulfur resid markets will indeed become sellers markets, the opposite dynamic will be taking place on the high sulfur side of the spectrum. With demand in the bunker market for high sulfur barrels going away, other markets where sulfur is not an issue will become awash in supply. Today, we will focus on one of these, asphalt, which will be particularly affected as producers of high sulfur barrels look for alternate markets. .In fact, as we think about this we are reminded of the classic crime drama from 1950, “The Asphalt Jungle,” an apt description for what the post-2020 asphalt market might look like. As an aside, it is certainly worth your time to watch or rewatch that film, if only to see Marilyn Monroe in one of her very earliest roles.
Background
In January of 2020, the IMO is requiring a reduction in the sulfur content of bunker fuel from the current level of 3.5% to only 0.5%. Most of the fuel oil currently produced in the world is well above this level. Complicating the problem is the fact that most global crudes produce a fuel oil which is also well above this requirement. While there are a number of crudes which can produce this quality of bottoms (mostly occurring in the U.S. and West Africa), these crudes are generally mixed with higher sulfur grades when processed through crude units. These complications will make the production of a compliant bunker fuel which is resid based very problematic.
As a result, it is likely that a significant portion of the new, low sulfur bunker fuel will be produced by blending substantive volumes of ultra-low sulfur diesel fuel and low sulfur gas oils into the bunker pool. As we have stated in previous blogs, these diversions are likely to create significant pricing distortions for both distillate (on the higher side) and high sulfur fuel oil (on the lower side).
While all refiners will reap the benefit of higher distillate prices, fuel oil refiners will be particularly challenged by the low fuel oil prices. Global nonbunker resid demand has been declining for decades and most of this decline has been mandated by ever-tightening environmental restrictions. This would seem to make the potential return of these markets highly doubtful. The only significant new disposition for the surplus high sulfur resid would seem to be as coker feed in competition with heavy crude grades. The pricing impacts could be dramatic, however, and fuel oil refiners would highly be pressured to seek new markets for their product.
The Asphalt Potential
One of the new markets which is almost certainly to be impacted by the IMO regulations is asphalt. Long the haven for inland refiners without coking units, asphalt production has been an integral component of the petroleum business since its inception. The major problem with the sudden infusion of asphalt base stocks from refiners fleeing the fuel oil market is that the asphalt is already fully supplied. New supply sources may prove to be challenging for the asphalt market. This can best be seen by analyzing the 2017 asphalt supply and demand balance as reported by the EIA.
The EIA data states that total U.S. production of asphalt in 2017 was 330 MBPD (Table 1). There was a modest amount of imports (38 MBPD), an even smaller volume of asphalt exports (19 MBPD), and a small stock change of -4 MBPD which yields a domestic demand of 353 MBPD.
The EIA also reports that the production of residual fuel oil in excess of 1.0% sulfur in 2017 was 322 MBPD. This is the material which is at risk in 2020 as a result of the new IMO regulations. The number of ships which have installed scrubbers is very low, and unless there is a significant level of noncompliance by the maritime industry (which is viewed as unlikely in U.S. ports), demand for high sulfur bunker fuel is expected to decline sharply. It is likely that U.S. demand for high sulfur bunker fuel in 2020 will fall to below 50 MBPD.
One of the avenues that the over-supply of high sulfur fuel oil will be partially alleviated is through movements to refineries with coking units, which then switch to a lighter crude slate to balance on total coker feed. These coking refineries will be induced by the very low resid prices as a vehicle to reduce total feedstock costs. It is likely however, that most of this substitution will be within intracompany systems where quality and supply and be better controlled. Third-party movements are expected to be modest. In total, it is doubtful that the use of high sulfur fuel oil as a feedstock in U.S. refineries will exceed 100 MBPD.
Assuming 50 MBPD of remaining high sulfur demand and up to 100 MBPD of diversions to refineries as feedstocks, the volume of unplaced high sulfur resid is in excess of 170 MBPD. Increased fuel oil exports are not likely given that the rest of the world will have a greater excess of high sulfur fuel oil than the U.S.
The dominant alternate market for fuel oil in the U.S. is asphalt. The magnitude of the surplus fuel oil in 2020 however, has the capacity to swamp the asphalt market. The surplus 170 MBPD of fuel oil represents a potential increase in asphalt supply of over 50%. Assuming asphalt demand in 2020 remains relatively constant with 2017 levels, this imbalance would have serious effects on asphalt prices. Because most larger paving projects are bid out in the prior year, the asphalt pricing decline may precede that of the fuel oil market.
In addition to the pricing risks, new entries into the asphalt market will also be impacted by the vagaries of asphalt sales. Asphalt demand is highly seasonal (Figure 1) with the result that asphalt inventory levels vary significantly (Figure 2). Most existing asphalt refineries have sufficient tankage for winter fill requirements. New entries into the asphalt markets may not be fully prepared for the tankage requirements. 
While it is expected that the IMO regulations will have a ripple effect which impacts many other products, the effect on asphalt may be more of a tidal wave.
TM&C constantly monitors changes and projected changes in pricing, supply and demand for all petroleum products. Our projections take into account changing rules and regulations (such as the IMO LS bunker regs), technological advancements, production and transportation costs, demographics, changes in consumer behavior, and other factors impacting petroleum markets. We include our independent analyses of these impacts in our semiannual Crude and Refined Products Outlook. Our latest version of this study was released in February, and we will be issuing a Mid-year Update later this summer. In addition, our Worldwide Refinery Construction Outlook, which follows the same schedule, provides a detailed list of global proposed refinery construction projects and an estimated likelihood for the eventual completion of each. In both of these studies, the impacts and refining market responses to the 2020 IMO regulations have and will continue to be an important feature. They also are discussed and analyzed at length in our recently released special study, Anode Coke Markets – the Gathering Storm, which was mentioned earlier. More information on these publications and our other work involving oil industry developments and dynamics can be obtained by contacting us, visiting our website at turnermason.com or calling Cindy Parker at 214-754-0898.