By: Beth Hilbourn and John Auers
The American metal band “Slipknot” probably isn’t on many (if any) of the jukeboxes in the honky tonks and icehouses located in the USGC refining corridor; however as 2016 draws to an end, maybe it should be added, as refiners might appreciate the chorus from one of their signature tunes, “Sulfur” – “There is something in me that feels…like breathing in sulfur”. When the ball drops on Times Square in just over a month, they will have to begin complying with Tier 3 gasoline sulfur rules. This regulation, which is the latest in a long series of laws to lower sulfur levels in petroleum products, will require that all gasoline produced for consumption in the U.S. will have to contain less than 10 parts per million of sulfur. While the industry has known that this mandate was coming and has been making preparations for some time, the actual implementation will have a variety of important impacts and require refiners to get answers to some key questions. Many of these will be related to the market for sulfur credits, including – “How much will a Tier 3 sulfur credit cost?” and “When should we sell sulfur credits?” In today’s blog, we will explore the factors that will determine the answers to these questions and others which arise from the new rule.
Background
With a goal of reducing tailpipe emissions, regulators have been requiring lower and lower levels of sulfur in U.S. gasoline. Tier 2, which required average gasoline sulfur levels to be reduced from 300 to 30 ppm, was proposed in 2000 and phased in by 2006. Tier 3, which requires average gasoline sulfur levels to be reduced from 30 to 10 ppm, begins in 2017 and will be phased in by 2020. The EPA noted in its September 2016 Tier 3 presentation that the average sulfur content of the gasoline pool in 2015 was reasonably close to the Tier 2 limit at 25 ppm.
The preamble to the Tier 3 regulations states that 64 refineries will ultimately need to revamp their existing hydrotreaters or add a grassroots hydrotreater and those refiners are expected to invest $2.0 billion between 2014 and 2019. Any change in construction timing could change the sulfur credit value. There will probably be two main tiers of sulfur credits: (1) those that expire in 2019, which were created off the 30 ppm standard, and (2) those that expire beyond 2020, which will be created off the 10 ppm standard.
Two key factors are, “What construction has already occurred,” and “When will future construction happen?” There may be sulfur removal capacity that is not yet used, but that is installed. Desulfurization is an economic decision, which includes a consideration of the value of the sulfur credit market and the market for octane (since hydrotreating reduces octane). Past sulfur credit costs have been set, based on the year the credit was sold rather than the year it was generated. Through 2014, sulfur credits have gone for approximately $15-$50 per million ppm-gal. 2014 was a pinch year with some credits in the $15-$50 range and others exceeding $200. In 2015, most credits were sold in the $150-$350 range. Are recent year sulfur credits traded to meet obligations or for speculation? Since credits could be traded twice, the market could be reacting to speculation.
Starting in 2015, the EPA switched the sulfur and credit trading program from paper transactions to the EPA Moderated Transaction System (EMTS), similar to what they did with RINs in mid 2010 with the switch from RFS1 to RFS2. Hopefully, the credit generations, uses and balances will become more transparent. Unlike the RIN system, which is more instantaneous (continuous credit generation and sales, but annual credit retirements); sulfur credits are generated and retired in annual reports. Sulfur credits are less transparent than RINs since they could only be traded twice whereas RINs could be traded an unlimited number of times. The EPA recognized the importance of making credits more transparent and made the following statements in the Tier 3 preamble,
“We believe that providing the market with at least some basic information on credit availability may provide some added assurance and aid in credit market liquidity. Consequently, we pledge to work with the refining industry on ways to make information on the sulfur credit market more transparent over the period leading up to 2020, balancing their need for information with the resource constraints of the Agency. In doing so, to protect confidentiality, we will not be able to identify individual company credit balances or deficits, but would intend to provide an aggregated level of information, such as total credit balances for each vintage year, on an annual basis leading up to 2020.”
Of course, refiners with multiple refineries have an advantage in that they can balance sulfur credits between company-owned refineries without exposure to a market with limited transparency. Besides hydrotreater/hydrocracker construction timing, which is a main factor of sulfur credit price, the items listed below will affect the price of a sulfur credit.
Market Flexibilities
Higher sulfur gasoline or gasoline components could be exported and lower sulfur gasoline or gasoline components could be imported. Gasoline and gasoline component imports and exports have varied greatly over the years. For example, prior to 2008 there were very little gasoline exports. Along the import/export lines, refiners could postpone construction and not rely on sulfur credits by selling their high sulfur components to other refineries for further processing. This option is more viable for Gulf Coast refineries where gasoline components are already traded.
Under Tier 3, refineries are permitted to carry a credit deficit for one year as long as they make it up the following year, and the final rule allows refiners to apply for hardship waivers if necessary. A sulfur credit deficit has not been allowed under Tier 2 since 2010.
Operational Flexibilities
The majority of gasoline sulfur comes from FCC unit naphtha, which comprises approximately 25% of the national gasoline pool. As a result, the predominant opportunity for sulfur reduction comes from some form of FCC feed hydrotreating or FCC naphtha post hydrotreating. FCC naphtha hydrotreating has an octane cost. In the last couple of years, the premium for high octane gasoline has steadily increased; however, each refinery has operational flexibilities with desulfurization severity. It is much harder to speculate with these flexibilities if the sulfur credit market was not visible and was highly variable. Again, it is much easier for a refiner with multiple refineries to balance sulfur credits and operating flexibilities. As with operational flexibilities, operational upsets have more of an impact at a lower sulfur level.
Ethanol
Beginning January 1, 2017, denatured fuel ethanol has a maximum of 10 ppm sulfur. Prior to 2017, refiners or imports could use oxygenate added downstream from the refinery or import facility when calculating the sulfur content of a batch and assume that the ethanol sulfur was zero. Beginning in 2017, the refiner or import facility needs to either test the ethanol for sulfur or assume it to be 5 ppm sulfur. The new requirement to assume sulfur content in the ethanol used in RBOB reduces the available credits. To the extent that ethanol added to conventional gasoline has been assumed to be zero in past years, this also reduces the amount of sulfur credits available.
Small Refiner or Small Volume Refinery
Approved small refiners or small volume refineries do not need to comply with the Tier 3 sulfur standards until 2020. A small refiner list has not been published since January 2009 for MSAT II so the impact of these players in the 2017-2019 timeframe is not well understood. The small refiner MSAT II list included thirteen refineries, including some atypical refineries. If the small refiners or small volume refineries’ average sulfur level was above the 25 ppm sulfur level the EPA reported in 2015, then the average sulfur of the “regular” refineries would be below 25 ppm sulfur and meeting the 10 ppm sulfur standard in the 2017-2019 timeframe would directionally be easier. Small refiners or small volume refineries also have the ability to generate Tier 3 credits off the 10 ppm standard during the 2017-2019 timeframe. The construction timing by small refiners or small volume refineries will affect sulfur credit-pricing.
TM&C constantly monitors changes and proposed changes in regulations impacting all segments of the petroleum industry. Many of these are associated with transportation fuels, effecting not only demand but also production costs, compliance challenges, and other aspects of fuels production. We include our independent analyses of these impacts in our semiannual Crude and Refined Products Outlook (the next version of which will be released in early 2017) and our various other studies. TM&C also assists clients involved in all aspects of transportation fuel production, blending activities, planning and compliance-monitoring. Please contact us for our views on the latest developments and their potential impacts, or if we can assist in any way or answer any questions regarding the petroleum industry, product demand, regulatory impacts, fuels compliance issues or any other issues associated with petroleum refining activities.