By John Auers and John Mayes
With apologies to The Hollies and Neil Diamond, we thought it appropriate to borrow the lyrics from the ballad both groups made famous 45 years ago in discussing the major changes coming soon for the bunker fuel market. These changes, which are being driven by environment policies dramatically lowering the sulfur specifications for the fuels ships use for propulsion, will impact not only the maritime industry itself, but refiners and blenders who produce the fuel. Costs will go up throughout the supply chain, supply/demand dynamics will change, relative prices of different crudes and refined products will be impacted, and capital investment will be made by both ship owners and refiners in response to those market developments. Due to differences in current refining capabilities and consumption patterns, refiners in different regions will be impacted in unique ways, which will further change the refining competitive landscape. While the industry will have a variety of potential options in complying with the tighter specifications, perhaps the dominant one will be a shift to the use of more diesel in the bunker pool at the expense of heavier (and higher sulfur) resid, making a truism of our title – It Ain’t Heavy, It’s My Bunker.
“The road is long, with many a winding turn”
The move to decrease sulfur levels in all fuels truly has been a “long and winding road.” Rules for gasoline and diesel have led the way, with tighter standards enacted in the developed countries of Europe and North America beginning in the 1990’s. These standards have become progressively more stringent over the years and moved, on a country-by-country basis, to most parts of the globe. The development of stricter standards for resid-based fuels, such as bunker, has been slower, but began to get the attention of regulators in the last ten years. Thus far, the effort has been focused on lowering sulfur levels in fuel used while ships were operating in defined sulfur Emission Control Areas (ECAs). These are generally located in high trafficked coastal regions adjacent to Europe and North America, and rules reducing the sulfur level in these areas has systemically been lowered, with the last step taken effective last year, reducing the level to 0.1% sulfur in all of the ECAs (see Figure 1 below).
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While the sulfur limits for bunker fuel usage in the ECA’s are tight (in fact, tight enough that they can only effectively be met by using marine diesel), their impacts have not been substantial because total usage in these areas is quite small. A much bigger impact will come when the standards for “open water” transit come into effect. Unless something changes, it appears now that that date will likely be January 2020, when the global sulfur specifications for all bunker fuel will decline from the current maximum of 3.5% to only 0.5%.
Unlike for gasoline and diesel, the rules for bunker fuels are being managed on a comprehensive global basis. The group in charge is the International Maritime Organization (IMO), which has been given jurisdiction over environmental and safety issues in international waters by the United Nations. While the date for the decrease in the global sulfur level has not been formally set by the IMO (which has the authority to delay implementation until 2025), the consensus view is that they will stick with their already announced goal of 2020. The impending shift to low sulfur bunker fuel has brought considerable anxiety to the shipping industry which fears a supply shortfall of the product. While we feel this prospect is remote, the change will have more dramatic consequences on the refining industry and both crude oil and product prices.
“His welfare is my concern”
Refineries generally do not make bunker fuel, but rather, they produce fuel oil (mostly vacuum tower bottoms and other related streams). Bunker fuel is mostly produced by blending terminals which purchase fuel oil from refineries along with distillates to produce a variety of bunker grades. This bifurcated structure has the potential to increase the level of problems in the 2020 transition.
Global fuel oil production was approximately 8.9 million BPD in 2015. Around 3.1 million BPD of this volume was used as a bunker fuel. At 35% of the total, bunker fuel was the dominant use of fuel oil. Fuel oil is also used for electricity generation, heating and for a variety of industrial purposes. In 2015, the fuel oil component represented only slightly more than half of the total bunker demand, with the rest being mostly distillates.
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While bunker fuel demand has been slowly rising in recent years, nonbunker fuel oil demand has been falling for decades. Since 1986, nonbunker fuel oil demand is down by nearly 60% and further declines are expected through the next decade. By 2020, we estimate global nonbunker fuel oil demand to be slightly over 4.1 million BPD.
That leads us to who knows where
Few crude oils produce a residual fuel which has a sulfur level below 0.5%. Even the major light crudes (Brent, Arab Light, Urals, etc.) generally have sulfur levels well in excess of this level. The crudes which do produce a low sulfur fuel oil are generally concentrated in North and West Africa and East Asia, along with a scattering of North American and North Sea grades. To complicate the issue, many of the lower sulfur crudes are comingled with higher sulfur grades when processed in refineries, and there is almost no ability to segregate the lower sulfur fuel oil molecules. As a result, to produce low sulfur fuel oil, most refiners would need to process low sulfur crudes exclusively. This reduces even further the number of global refineries capable of producing a low sulfur fuel oil in 2020.
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The dominant method by which low sulfur bunker fuel will be produced will be from the blending of very low sulfur distillates. Blenders will utilize whatever lower sulfur heavy oils are available (fuel oils or gas oils) and blend these base stocks down to 0.5% sulfur with the distillates, forcing high sulfur fuel oil out of the bunker pool. Much of this surplus fuel oil will be absorbed by new coking units constructed by 2020. TM&C monitors new coking projects and has included these volumes into the 2020 balance. While it is impossible to anticipate the level of distillate and gas oil additions, it is likely that the global surplus of high sulfur fuel oil in 2020 will be in excess of 1.0 million BPD. This represents a substantial oversupply in a market of only 4.1 million BPD. While this process produces all of the desired bunker fuel volumes, it creates a difficult problem for global refiners.
Next week, we will continue our discussion on the shift to low sulfur bunker fuel and evaluate the effects of the transition on the global refining industry. A variety of questions will be addressed. How will the industry dispose of the surplus high sulfur fuel oil when the dominant use of the product is lost to a different product? What will be the pricing effects on both fuel oil and distillates, and how will they impact crude prices and differentials. Will refiners invest in “resid destruction” units, and where and how much will this investment be? In which region will refiners be most impacted? In answering these questions, we will (paraphrasing good old Neil) learn whether refiners are “strong, strong enough to carry him.”
We have just released our 2016 Crude and Refined Products Outlook. In it we discuss in detail our projections of global and regional petroleum supply and demand and provide a detailed 20-year forecast of both crude and product prices. In developing these projections, we have taken into account regulatory and policy impacts such as the bunker fuel sulfur specifications discussed in today’s blog. We also analyze all of the other factors which we believe will be important in determining the directions of petroleum markets. Additional details about The Outlook are provided on our company website at turnermason.com.