May-2019

IMO 2020 — the deadline approaches

How is the refining industry reacting to the shake-up with less than a year to go? The refining industry has responded to the forthcoming IMO 2020 lower sulphur bunker fuel regulations in a variety of ways.

STEPHEN GEORGE
KBC

Article Summary

For some it has been a new challenge and a compelling justification for investment in their plants, while others have considered new crude diets or a ‘wait and see’ approach. In any case, the IMO regulation has given the industry a valid reason to improve itself, and it is buoyant with change. As the 2020 deadline approaches, changes to operating strategies are needed to ensure that refiners remain profitable during what will be a huge shake-up to the industry.

How will markets respond?
It is important for the industry to know how markets will change during this period of uncertainty. Our main thesis is that demand will be met, but at a price. Economic fundamentals will work, markets will clear and the price of marginal blendstocks will drive bunker markets. By 2020, distillates will receive price support while high sulphur fuel oil will plunge in value. This will create the all-important spread between compliant and non-compliant fuel oil. The question of the moment for shipping and refining alike is: how wide is this spread, and how long will it last?

Compliant bunker will start off pricing near distillate, and will evolve to a new equilibrium as the market rebalances. Compliant gasoil will remain close to 0.1% gasoil while compliant fuel oil is likely to play a swing role in the market, reducing its premium to high sulphur fuel oil with more availability and market acceptance. Estimates of how long this might take range from a few months to a few years (possibly five or 10 years). Refiners will hope for the longer period, but we know that KBC’s models are wired to push for more margin, and this will have a natural rebalancing effect on the market.

Our view at KBC, which aligns with technical mindsets in the industry, is that equilibrium emerges within about the first two years. That does not mean we are back to where we started, especially with regards to high sulphur fuel oil demand. As results have shown, the trough at 2020 rebounds fairly quickly. If we look further out into the illiquid future reaches, the spread is expected to return to present values around January 2023.

What to give away in compliant bunker fuel?
This is one of the biggest questions that the IMO regulations has thrown up. What is for certain is that bunker fuel will not be made like it is now. Today we use a mix of residue components, fluid catalytic cracking (FCC) slurry and distillate cutter stocks to produce a fuel that often has considerable sulphur giveaway but is tight on viscosity, flash or cold properties. We are currently making a low value product that gathers bottom of the barrel components and minimises the amount of high value cutter stock we have to add to get rid of the low-value components.

By 2020, the industry should be making fuels using a range of higher value components, including straight run products such as atmospheric residue and reduced crudes that are normally further refined to add upgrade value. We shall be adding in streams like vacuum gasoil (VGO); potentially some hydrotreated products including VGO and atmospheric residue; and we may be adding in some expensive distillate components depending on market demand and fuel availability.

Today viscosity matters, but tomorrow it will be cheap and sulphur will be at the forefront. Hitting 0.5% in the fuel oil pool is not easy, and it is not going to be cheap. These new formulations are going to pose new challenges. New low viscosity, low sulphur bunker fuels will still have to be compliant with International Standards Organization 8217 fuel oil specifications. These fuels can be any mandated sulphur level, but they must comply with the standard on stability as well as meeting the flash and cold properties of the existing specification.

And will they comply? Some reports suggest it cannot be done everywhere, which has created alarm in the shipping industry. But it also creates market opportunities for those who can guarantee that stability and compatibility in sufficient quantities.
 
Searching for equilibrium
Equilibrium will be defined when shipping demand reaches the indifference value between using a stack gas scrubber and purchasing compliant bunker fuel oil. This value will vary for different sizes of ships in the market, but it is likely to emerge when the spread between compliant and non-compliant fuel oil is around $100-120/t, at a point where investment in a new scrubber no longer has a payback that would jump an investment hurdle.

For the market to reach that point, the fuel oil bunker pool will need to reject more expensive distillates and VGO from the compliant fuel pool. In effect, it will emerge when refiners, traders and blenders understand how to make stable, compatible, compliant bunkers from sweeter conventional residue fuel oil components, allowing for a price premium for the segregated purchasing, refining and handling of these materials.

It is also important to take a look at the impact on gasoline markets. The key driver of higher gasoline prices will be a shortage of VGO in the market caused by the direct blending of sweet VGO into bunker fuel. If the market values VGO close to distillate, there is little sense in putting it into a conversion unit, losing yield to liquified petroleum gas (LPG), coke and energy.

If the lack of VGO causes an imbalance in blending components for gasoline, there is the possibility that gasoline prices would rise to the point where VGO is essentially purchased back into the FCC unit to produce an important gasoline blending component. With this in mind, IMO could be bullish for gasoline, at least until the market is more balanced.
 
Rethinking crude for more valuable products
Crude oil is generally priced on the basis of the value of the products it contains on simple distillation. This is the ‘gross product worth’, and the important point for IMO is the inherent value in the residue of very sweet crude oil. Normally, when we price residue streams we use either a low sulphur or high sulphur assessment – if the residue is less than 1% sulphur, it is sweet and gets a higher valuation. If more than 1%, it is assessed on 3.5% fuel oil (plus a premium if justified), and gets a lower valuation.

IMO 2020 upsets the apple cart by introducing new gasoil and fuel oil products at 0.5% sulphur that will become the principal products in the global bunker market. These products exist only on paper today, and they will initially price much closer to distillates.

Sweet heavy crudes like Angolan grades, with atmospheric residue yield in orange, will command a high premium based on the uplift of this very sweet residue. Brazilian grades like Lula and the forthcoming Buzios grade will also benefit from being sweet and heavy. Lula production is at 800 000 b/d, while Buzios will start producing late this year and is forecast to be at 750 000 b/d by 2021.

The universe of sweet crudes is around 10 million b/d. Some of them are very unlikely to see salt water. Some of them are inappropriate for making bunker fuel. Some, like US shale and Azeri, are sweet and light. In the main, the heavy sweets are most likely to benefit from IMO. We would expect refiners who are using these crudes to adjust their baskets based on their actual need for sweet barrels.
 
Refiner response
Companies started considering their approach and response to the IMO regulations in late 2016. The investment time horizon was impossibly tight to bring on board by 2020, and only a few have made major investments, but this is the array of choices we have seen refiners adopting:
• Stop making high sulphur fuel oil (HSFO) entirely
• Delayed coking – ends fuel oil production, full stop
• Residue hydrocracking – nearly eliminates fuel oil, but is expensive and can be prone to on-stream reliability issues
• ARDS/VRDS – so, making LSFO that can be sold for IMO.