By John Auers and John Mayes
In last week’s blog, we provided some background on the mandate by the International Maritime Organization to reduce the global sulfur level in bunker fuel from 3.5% to 0.5%. In addition, we discussed how the compliant fuel would likely be produced. As we noted, we feel there will be little difficulty in producing 0.5% sulfur bunker fuel in that it would simply require the addition of a large volume of very low sulfur distillates. After all, in the Emission Control Areas (ECA’s) of North America and Europe, sulfur levels have already been reduced to 0.1%, and there has been no shortage of fuels to supply these markets. The 0.1% sulfur ECA compliant bunker fuel is almost entirely distillate-based.
Rather than product availability, the dominant issue will become the alternate disposition of the high sulfur fuel oil which will have to be backed out of the bunker pool. This volume is likely to be in excess of one million BPD. Nonbunker consumption of resid fuels (primarily for power generation) is forecast to be only about four million BPD by 2020 (the date when the mandate is expected to take effect) and these requirements are obviously already being met by existing sources of resid production. In addition, this demand is falling, for the same reasons as in the bunker market, and it appears the world is headed for a severe surplus of residual barrels.
This week’s discussion will focus on the effects of the transition to low sulfur bunker fuel on product supply and demand for not only bunker fuel but also distillates (which will get a much needed boost from the extra consumption). In addition, the price implications for both these products and high resid yielding crudes will be analyzed. We will discuss these effects in a tiered fashion, as both primary AND secondary impacts will be important in determining which refiners will be able to “bear the burden” and which will not.
Primary Effects of the Bunker Sulfur Shift
Because of the large volumes of distillates expected to be used to meet the low sulfur requirements, bunker prices are likely to rise proportionally and should equilibrate approximately with low sulfur gas oil. Low sulfur gas oil (also at 0.5% S) would become an acceptable supply source for bunker fuel and is generally priced at a discount to gasoline and diesel. Whatever the final level, low sulfur bunker prices should rise from a discount to crude oil to a premium over crude. Prices for the surplus high sulfur fuel oil, however, will decline, probably substantially.
The other initial pricing effect would be an increase in distillate prices. The same assumption of 1.0 million BPD of surplus fuel oil would equate to an additional 1.1 million BPD of distillate (BTU adjusted). In 2020, TM&C estimates that global distillate demand will be approximately 37 million BPD. This incremental demand is equivalent to nearly two years of historical global distillate demand increases. As the distillate prices increase in 2020, they will in turn pull distillate containing low sulfur bunker prices even higher.
These product-pricing shifts will create winners and losers in the global refining industry. While all refineries will benefit from the higher distillate prices, the winners will be refineries which do produce little to no fuel oil (coking or asphalt refineries) or produce fuel oil which can be blended to the 0.5% sulfur level. The losers will be cracking and hydroskimming refineries which produce fuel that cannot be blended into the bunker pool. It is likely that the higher distillate margins will not offset the much lower fuel oil margins.
Fuel oil production varies significantly by region. In North America, fuel oil represents only about 5% of total crude runs while in the Former Soviet Union and the Middle East, it represents 25%. The fuel oil output is a function of the gravity of the crude slate as well as the level of resid destruction (primarily coking) capacity in the refineries. In the U.S., virtually all of the heavy crude is processed through refineries with cokers or those producing asphalt. The refineries which make fuel oil generally process a light crude slate, thereby minimizing fuel oil output. Fuel oil production is so low in the U.S. that it actually imports heavy oils for bunker sales. In 2015, the U.S. imported 135 MBPD of fuel oil.
The primary shifts in refining margins will have a significant regional character. Refineries in the U.S. tend to be overwhelmingly coking and asphalt-based. There are also high concentrations of coking refineries in India and China. As a result, these regions will enjoy improved margins from the shift to low sulfur bunker fuel. In the U.S., 61% of the refineries have coking capacity, while an additional 18% produce asphalt. Only 20 U.S. refineries produce fuel oil and many of these will be well-suited to producing low sulfur bunker fuel because of their low sulfur crude slate. The coking capacity as a percent of crude capacity for selected countries is shown in Figure 2.
Refineries in Europe, however, are predominantly cracking facilities with low levels of coking capacity. While many other regions also have low coking capabilities, these refineries are often linked to host governments and not as subject to market pressures. Refineries in Europe are generally market-based, and as a result, are highly vulnerable to the impact of low overall margins brought on by depressed high sulfur fuel prices. This will just add to the competitive pressures that refiners on the Continent have already felt and will likely result in even more rationalization of capacity.
Secondary Effects of the Bunker Sulfur Shift
As the distillate and fuel oil prices shift to their new bases, it would be expected that cracking refiners would attempt to reduce their losses associated with the production of high sulfur fuel oil. The initial response of most refiners in this situation would be to reduce the volume of high sulfur fuel oil by shifting to a lighter crude slate. A shift from Arab Heavy crude to Arab Light, for instance, would reduce fuel oil output by 37%. Lighter crude grades, however, are higher priced and have different yield patterns which may be incompatible with the refinery hardware configuration.
While it is not possible to forecast how low the high sulfur fuel oil price would decline, its theoretical floor could be as feedstock to coking refineries in competition with heavy crude prices. This determination is complicated and would entail a shift to light crude grades in conjunction with the high sulfur fuel oil.
These secondary effects may be as dramatic as the primary, but will be focused on crude prices and differentials. Because of the attempt to reduce the negative impact of lower high sulfur fuel oil prices by lightening the crude slate, there would be increased pressure for a rise in light crude (Brent) prices. The combination of this and the potential of coking refineries using high sulfur fuel oil as a replacement for heavy crude grades would also widen the light/heavy crude differential. Both of these crude-pricing shifts also generally reward coking refineries and penalize refineries without resid destruction capabilities.
Considering all of the effects of the upcoming low sulfur bunker specifications, it is clear that a major problem is potentially brewing for global refiners, with the impacts very region and refinery specific. Certainly additional study is required to better quantify the likely surplus of high sulfur fuel oil in 2020 (or whenever the 0.5% bunker specification goes into effect) and the pricing implications for low and high sulfur fuel oil, distillates and heavy crude differentials. We have made a concerted effort to include the effects of the LS bunker mandate, as well as the many other regulatory and policy impacts in our just released 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 all of the major refining and demand centers around the world. Please feel free to contact either of us or visit our website to get more information on this publication or any of the other services TM&C offers to industry players and participants.