20|20 Vision: The Transition to Distillates is Going to be Messy

by Adrian Tolson, Senior Partner, 20|20 Marine Energy
Thursday February 25, 2016

First a caveat: No one knows where crude oil prices will be in four months, let alone four years.

Nevertheless it's fair to point to a rough consensus around the 'lower for longer' view of oil prices.

How the refining sector responds to a prolonged period of low prices really matters. In 2020, or possibly 2025, International Maritime Organization regulations will sideline intermediate fuel oil (IFO) as a bunker fuel, destroying a major outlet for refiners' residual product.

Instead, ships will be expected to burn bunker material with a sulphur content of no more than 0.50%.

Only vessels equipped with emission abatement technology (scrubbers) will be able to use conventional high sulphur fuel oil (IFO).

The start date for the new rules is uncertain, precisely because the intention of the refiners is unclear. There is already doubt that they will have the capacity to produce enough distillate or low sulphur fuel oil, to meet demand by 2020.

According to the International Energy Agency (EIA), a switch by the world fleet to 0.5% distillate fuel would see global fuel oil demand collapse while demand for marine gas oil (MGO) would soar.

Low Crude Prices

Do low crude oil prices make it more or less likely that refiners will invest in ramping up distillate production while scaling back fuel oil output?

Traditionally, a decline in crude oil values sees a narrowing of the price differential in the light/heavy spread. If crude prices stay low, the price gap between bunker grade fuel oil and marine gas oil is likely to become less pronounced.

The longer we see crude prices low, the longer the price differential between distillate and fuel oil will remain narrow. This will act as a disincentive to refiners who might be contemplating the expensive upgrades needed to produce more distillate. Some upgrades and already in progress, some are scheduled and will happen. Others will not happen, and so some residual production will not be reduced and will continue unabated.

Lower crude prices will continue to impact the supply and demand balance for residual fuel in other ways.

Asia, one of the key global markets for fuel oil, particularly as refinery feedstock, has already seen a plunge in demand. Independent Chinese refineries have been switching from fuel oil to crude oil as a primary feedstock. Demand from Japan's power generation sector is also down.

In Europe and North America environmental regulations continue to blow a sizeable hole in fuel oil demand from the bunker sector.

While there are some reports of refiners cutting crude production to reduce low value residual fuel production, this may only be a phenomenon inside Russia. Outside Russia refiners are generally making good money. True, integrated oil companies that are both producers and refiners are being hammered by low crude prices but their refining sectors are doing well. Independent refiners are also enjoying something of a boom with surging margins and falling costs.

Fuel Oil Oversupply

All this points to a likely oversupply of residual fuel oil. Lower crude prices will tend to perpetuate the production of residual fuel oil at refineries and leading to a potential oversupply. If January 1st , 2020 is finally set as the date for the global switch to 0.5%, then maybe we will see a lot of residual fuel available on January 2nd, 2020. Where will that fuel go?

It is quite conceivable that in order for this fuel to "disposed" of, its price will drop to the level where there is a major economic incentive to put it back into power generation (with its abatement technology already in place) as a replacement for cleaner burning fuels.

In terms of the impact on the shipping and bunker industries very cheap residual fuel will encourage quick uptake and installation of on-board scrubbers.

The transition away from fuel oil or high sulphur marine fuels to distillate based low sulphur marine fuels is going to be messy. It has become more complicated by the impact of lower crude oil prices. If crude oil rises significantly, then this will tend to reduce residual production or at least reduce the oversupply. If crude remains low all bets are off. The Marine Fuel industry was already confused as to what would happen to all the fuel oil when we transition to low emission fuels. Now we are all the more confused!