The International Maritime Organization (IMO) will make a significant change to the maximum allowed sulfur content of marine fuel consumed on open oceans beginning January 1, 2020. This global change (via IMO revision of its MARPOL VI rule) was triggered by an IMO decision in 2008. Over the past year, Stillwater Associates has offered a series of articles on aspects of this "IMO 2020 Rule." Here, we dive deeper into the specifics of the pricing changes to come, and how we expect the economic aftermath of the implementation of the IMO 2020 Rule to play out.
IMO 2020 Rule Overview
The IMO 2020 Rule will reduce the maximum sulfur content of marine fuel consumed on open oceans from 3.5% to 0.5% (by weight) globally on January 1, 2020. Vessels that have installed and operate stack gas scrubbing systems will be exempted from this rule and allowed to continue utilizing 3.5% sulfur marine fuel.
Impact on High Sulfur Vacuum Resid & High Sulfur Fuel Oil (HSFO) Prices
More than two million barrels per day (MMBPD) of high sulfur vacuum resid (HS resid) will likely be displaced from the global marine fuel pool by the IMO 2020 Rule in the first year of the rule's implementation (2020). This volume assumes that IMO will put in place effective enforcement measures that will minimize consumption of non-compliant marine fuel (i.e. cheating). A key question for the refining sector is where this displaced HS resid will alternatively be placed.
Currently, global refining resid hydrotreating capacity could only handle a small percentage of this displaced HS resid volume (likely no more than 0.4 MMBPD). As such, a large volume of displaced HS resid will need to be placed via other mechanisms. The expected difficulty in placing all of this displaced HS resid volume is reflected in the forward view of HSFO prices versus other commodities. HSFO prices will drop markedly relative to marker crudes like Brent, lower sulfur fuel oils, and clean refined products to create an incentive for this surplus HS resid volume to find new homes. In a worst case, HSFO prices may drop to a level where HSFO becomes an attractive fuel for power plants.
As shown on Table 1, the Rotterdam 3.5% sulfur fuel oil price relative to Brent widens from the current $10 per barrel (bbl) to almost $25/bbl by December 2019 when refiners are already operating in the IMO 2020 Rule mode that will take effect the following month. Similarly, Rotterdam 3.5% sulfur fuel oil price relative to Rotterdam 1% sulfur fuel oil widens from the current $2/bbl to more than $17/bbl in December 2019.
Table 2 reflects the same price differential trend when comparing Singapore 380 centistoke (cSt) HSFO price versus Brent. The Brent - Singapore 380 cSt HSFO price differential jumps from the current $7/bbl to more than $21/bbl by December 2019
A couple of additional points worth noting on the above price differential outlooks:
The Rotterdam and Singapore HSFO differentials to Brent both decline from December 2019 through 2021. This suggests the marketplace expects shipowners and refiners to find opportunities to improve marine fuel purchasing and refinery processing activities as the market chaos from the rollout of the IMO 2020 Rule subsides.
The price of Brent crude declines slowly in the forward view from present through 2021. This indicates that the marketplace does not currently see the IMO 2020 Rule sparking a significant increase in world crude oil prices.
Complex refineries (i.e. those with resid processing facilities) will have a strong financial incentive to fully utilize and even expand existing cokers, resid hydrocrackers, and resid hydrotreaters to consume the surplus HS resid. However, existing refinery capacity (even with debottlenecking investment) will be insufficient to consume all the displaced HS resid during the initial rollout of the Rule in early 2020.
A key assumption implicit in the IMO 2020 Rule is that there will be sufficient outlets for HS resid beyond refinery processing.
With insufficient refinery processing capability in the early years of IMO 2020 to handle all of the displaced HS resid, a significant portion of the surplus HS resid will need to be placed in markets other than refining. Power generation appears to be the most likely candidate for consumption of the surplus HS resid (in the form of HSFO).
HSFO prices will need to decline markedly to make this potential fuel financially competitive with the least attractive current fuel sources for power plants. This may mean HSFO price dropping to a level needed to back out coal from power plants. The question then becomes not whether there will be a home for displaced HS resid, but rather what (lower) refinery gate price will it take for the surplus HS resid to be placed.
Asphalt prices (and prices for other commodities that utilize HS resid) should drop concurrent with HSFO prices. Many refiners currently producing HSFO will evaluate increasing or commencing asphalt production in view of significant declines in HSFO unit revenue. Reductions in asphalt prices may stimulate some asphalt demand increase relative to concrete for road paving applications.
Impact on Diesel and Other Refined Product Prices
The primary replacement in marine fuel for HS resid is widely expected to be diesel/gas oil. Especially in late 2019 and early 2020, vessel operators may opt to burn straight diesel/gasoil to avoid marine fuel quality issues (e.g. compatibility and stability).
As vessel operators gain experience around potential marine fuel quality issues, compliant marine fuel blends of diesel/gasoil and resid may become more commonplace. Unless the resid used for these blends has a low sulfur content (e.g. less than 1.0%), blend compositions will be primarily diesel/gasoil. (Historically, the primary component of HSFO has been HS resid.)
Table 3 illustrates that this increased demand for diesel/marine gasoil will drive diesel and gasoil prices up relative to marker crudes like Brent. Amsterdam, Rotterdam, Antwerp (ARA) gasoil and Singapore low-sulfur gasoil prices versus Brent widen from current differentials of about $12/bbl to more than $17/bbl in 2020.
Refiners constantly optimize their forward views of optimum crude slate composition and products mix. Implementation of the IMO 2020 Rule represents a significant opportunity or challenge, depending on how complex a particular refinery is. As the diesel/gasoil price differentials to Brent widen, all refiners will evaluate processing strategy changes that will maximize their refinery margins.
Most refiners will see a financial driver to shift operations more towards a maximum distillates operating mode, away from a maximum gasoline operating mode.
If the diesel-to-gasoline differential becomes wide enough, refiners will be incented to divert lower sulfur (or hydrotreated) cat cracker feedstock to the marine fuel pool reducing incremental volumes of diesel/gasoil.
Similarly, the price of jet fuel will need to rise along with diesel/gasoil to incent refiners to continue meeting world demand for jet fuel in a period of higher diesel/gasoil prices.
IMO 2020-compliant marine fuel will likely trade at a discount to diesel/gasoil but at a premium to Brent because of its high diesel/gasoil content. Lower sulfur content vacuum resid is likely to rise in value versus marker crudes like Brent due to its ease of inclusion in IMO 2020-compliant marine fuel blends.
Impact on Crude Oil Prices
The above narrative assumes that crude oil production volumes from existing wells will not change markedly in 2020 as a result of price changes triggered by the IMO 2020 Rule. As such, the 2020 global mix of sweet and sour crude volumes is not likely to change markedly due to IMO 2020.
The global mix of sweet and sour crude oil production volumes may change beyond 2020 if the relative prices for crude oil grades change markedly from current levels (e.g. if sweet/sour crude differentials widen measurably) and if the marketplace perceives these changes as durable. If substantially wider sweet/sour crude price differentials are expected, the exploration and production sector will prioritize resources toward production of lighter, lower sulfur content crudes in its expenditures on existing fields and in developing new reserves.
Crude oil price differentials in 2020 and beyond relative to marker sweet crudes such as Brent are likely to widen depending on sulfur and vacuum resid content.
High sulfur crudes (that tend to have significant yields of high sulfur vacuum resid) will trade at steeper price discounts to Brent.
Very low sulfur crudes (e.g. shale and tight oil) are likely to command higher price premiums relative to Brent.
Impact on Refining Operating Economics
Topping and cracking refineries (i.e. those lacking resid processing) will be the most threatened by IMO 2020. Survival may depend on whether clean products prices increase enough to offset the lost revenue from HSFO, asphalt, and other products with prices tied to HSFO.
Most complex refineries should be economically advantaged by IMO 2020. These refineries will experience a strong economic driver to fully utilize their HS resid-related processing facilities (cokers, resid hydrocrackers, hydrotreaters, sulfur plants, and hydrogen plants). Debottlenecking projects for existing facilities are likely to have strong economic drivers. Complex refineries will also benefit from the likely reduction in sour crude prices and higher clean products prices without suffering from the downside of lower HS resid prices or higher sweet crude prices. Those refineries with gas oil hydrotreaters, distillate hydrocrackers, and gas oil hydrocrackers may identify opportunities to utilize these processing facilities differently. For example, rather than processing hydrotreated gas oil on a cat cracker, a refiner may see an incentive to use the hydrotreated gas oil as a marine fuel blendstock, or a refiner may see opportunities to modify existing distillate and gas oil hydrocrackers to also desulfurize HS resid, redirecting portions of the hydrotreated distillate and gas oil streams to marine fuel blending rather than cracking these streams into lower valued gasoline and light ends.
Even with debottlenecking existing resid processing facilities, however, until additional resid processing facilities are constructed there will not be enough refinery resid processing capacity to handle all the HS resid volume generated by the impact of IMO 2020. Engineering, permitting, and construction of new resid-processing facilities can take five-to-seven years. There does not appear to be an unusually large amount of new resid processing capacity moving towards construction at this point in time, so any such additional capacity will not be online by the time the IMO 2020 Rule goes into effect.
The sustainability of IMO 2020-related impacts
The sustainability of changed price differentials resultant from the IMO 2020 Rule will depend on at least four factors:
How effectively the IMO 2020 Rule is enforced
The timing and extent of vessels with stack gas scrubbers entering service
The timing and extent of refiners adding new and expanding existing resid processing facilities
The timing and impact of IMO's proposed regulations limiting future greenhouse gas (GHG) emissions from marine vessels
1. Enforcement of the IMO 2020 Rule
The price differential between IMO 2020-compliant fuel and HSFO will be large. Unscrupulous vessel operators will be tempted to cheat and use non-compliant marine fuel. To combat this possibility, IMO's Pollution Prevention and Response (PPR) sub-committee has been tasked with improving enforcement mechanisms. PPR has proposed amendments to MARPOL Annex VI that would prohibit carriage of non-compliant fuel oil for combustion purpose with a sulfur content exceeding 0.5%. If IMO Flag States are given and utilize the authority to enforce these amendments, the prevalence of deliberate non-compliance will be significantly reduced.
2. Vessels with Stack Gas Scrubbers
The maritime industry has faced serious financial challenges in recent years. Excessive tonnage globally continues to depress vessel charter rates. Even with what appear to be compelling economics, however, the maritime industry has been slow to retrofit existing vessels with stack gas scrubbers. A higher percentage of new vessels replacing end-of-life vessels are being equipped with stack gas scrubbers, but that number is not the majority. In fact, the rate of adoption for stack gas scrubbers has been so low that there are concerns as to whether HSFO will be broadly available. As the 2020 marketplace draws nearer and as opportunities to financially hedge investments becomes stronger, however, we may see higher adoption rates for stack gas scrubbers.
3. Refiners Debottlenecking or Adding New Resid Processing Facilities
Refiners have longer investment lead-times than shipowners. As such, they are monitoring how shipowners respond to IMO 2020 before making determinations about how to proceed. As discussed above, if refiners believe that the wider differentials caused by IMO 2020 will be sufficiently durable, investments can be justified to add resid processing capacity at refineries.
4. IMO's Future Greenhouse Gas (GHG) Regulations
IMO's initial GHG strategy was adopted at its MEPC 72 meeting in April 2018 and would limit total GHG emissions in 2050 to 50% of actual GHG emissions in 2008. Additionally, IMO aims to have future GHG regulations defined and adopted by 2023. Shipowners may be reluctant to invest in stack gas scrubbers if traditional marine fuels will have to be phased out over the next couple of decades in favor of liquefied natural gas (LNG) or other types of marine fuels.
Stillwater Associates stands ready to partner with you to explore options and help select the most beneficial strategy and tactics for your situation. Contact us to see how we can add value to your business.