On January 1st, 2020, the global shipping industry will undergo a radical change, with all ships having to reduce the sulfur content within marine fuels from 3.5% to 0.5%, as mandated by the International Maritime Organization (IMO). As with all radical changes, winners and losers await, meaning there is significant opportunity everywhere.
Bunker fuels are a 5.5 MMBbl/d market and IMO 2020 is likely to have a significant impact on financial commodity markets now and over the next few years, with shipping companies facing the choices of utilizing lower sulfur fuels, installing scrubbers, or switching to alternative fuels such as liquefied natural gas (LNG). In this paper, Drillinginfo looks at what to expect.
What is happening? What are the options for shippers?
The IMO is decreasing the sulfur content specification of bunker fuels in non-emission control areas (ECAs) from 3.5% to 0.5% effective January 1st, 2020 (Figure 1). Although the IMO considered a possible delay of the implementation until 2025, the studies they commissioned indicated that there would not be a shortage of 0.5% bunker fuel oil, paving the way for the new specification to make its mark at the turn of next year. To deal with the lower sulfur specification, there are several choices that can be considered.
An Increased Demand and Higher Prices for Low Sulphur Distillates
The obvious choice is using fuels with lower sulfur content (e.g. marine gas oil, intermediate fuel oil). However, to do so, many refineries would need to install upgrading equipment to deal with the heavy end of the barrel, as high sulfur fuel oil will no longer have a market, with most demand for it wiped out over New Year’s night. Even if these refineries wished to change feedstock to accommodate, there is a limited amount of crude oil light and sweet enough for use in non-complex, topping refineries.
This option means that the cost of bunker fuels will certainly increase as the lighter components needed to blend the low sulfur product will compete as blendstock for other high-value distillate products. This will in effect increase distillate-level product demand more than 2 MMBbl/d, as this is the amount necessary to blend 0.5% sulfur specification. Conversely, 2 MMBbl/d of high sulfur resid would not have a home. Refiners with coking capacity will benefit, as they have the capability to refine the bottom of the barrel.
Given that refiners will have to meet the increased demand for the lower sulfur distillate level products that need to be blended into the bunker fuels, this will mean that the price of bunker fuels will move closer to the price of lower sulfur distillates. To put the numbers in perspective, since the middle of 2018, lower sulfur distillate content No. 2 fuel oil has been trading at a 30%+ premium to No. 6 3.0% sulfur bunker fuel (Figure 3). However, the higher demand that the IMO 2020 regulations will create starting January 2020 will mean that distillate prices will increase to incentivize refineries to produce more distillates as well.
Refiners who produce high sulfur resid, on the other hand, need to change their configuration or switch their crude supply. There are very few crudes that have the chemical composition that make the resid possible to blend away easily. These are light, sweet crude oils with atmospheric residue sulfur content below 0.5% and vacuum residue content below ~0.75% like Cabinda (Angola), Qua Iboe (Nigeria), & Eagle Ford (USA) (Figure 4). Even benchmark crudes like WTI (USA), LLS (USA), & Brent (UK/Norway) require further processing before the whole bottom of the barrel can be saleable (Figure 5). There is only a limited amount of these crudes available, however, meaning that the value of these crudes should increase for refiners that don’t have the downstream refining capacity to upgrade the bottom of the barrel.
In the end, more refinery investment will be necessary with the new specification coming into effect. These refinery solutions include solvent extraction, resid hydrotreating, & coking. Since solvent extraction and resid hydrotreating still have their limitation from a feedstock selection and sulfur reduction perspective. Coking will be the preferred option, as it has the ability to make the most valuable end products from the vacuum residue stream. However, these units will require significant refiner investment as they are the most complex unit.
What Else Can Be Done?
There are a couple more options with regards to how specifications can be met or avoided altogether. One of them is to remove sulfur post-combustion. This would require installing scrubbers on the ships. Only a fraction (less than 5%) of vessels are currently operating with scrubbers and this is only set to increase minimally by January 2020. Hence, scrubbers require significant investment as well, with costs upwards of $5MM to install. Some shops, like Mercuria, are offering their clients financing options for scrubbers in package deals that include providing them with compliant fuels and fuel hedging.
Scrubbers will certainly be a part of the larger equation as shippers navigate the IMO 2020, as they can be installed in less than a year (much faster than a coker in a refinery). They also provide a way to meet the new specification in parts of the world where there may not exist the capacity or investment potential for much more capital-intensive refinery related projects. Another option for shippers is to switch to another fuel source. This would mean switching to LNG or nuclear power to fuel ships. The concept remains largely untested and unproven in commercial uses. Also, the retrofit costs and necessary infrastructure make this a very unlikely option for widespread implementation.
Significant Opportunities for Traders
IMO 2020 will lead to significant opportunities for traders, due to the price dislocations between different refined products and crude grades in different regions. Market volatility and constrained supplies can be expected until the market can figure out the fundamental impacts and work out the issues. Trading instruments are already in place, with the NYME listing 11 marine fuel 0.5% futures contracts for trading on the CME Globex electronic platform and the Intercontinental Exchange launching a 0.5% futures contract this February. This is in response to a strong demand for marine fuel 0.5% specific derivative contracts, allowing market participants to hedge forward positions in what is a growing industry.
It is not just the crude oil and refined product markets that will be impacted by IMO 2020 either. All commodities – from steel to sugar – will be subject to the inflationary pressure that higher fuel costs will put on shipping costs.
What is clear is that interesting times lie ahead for the commodity markets as a result of IMO 2020. It could be quite a ride!
 ‘Big oil traders set to cash in on shipping fuel overhaul’, Reuters, Nov 2 2018, https://www.reuters.com/article/us-commodities-summit-imo/big-oil-traders-set-to-cash-in-on-shipping-fuel-overhaul-idUSKCN1N70QD
US crude oil stocks posted a decrease of 1.7 MMBbl last week. Gasoline and distillate inventories both showed sizeable increases of 8.1 MMBbl and 10.6 MMBbl, respectively. Yesterday afternoon, API reported a crude oil draw of 6.1 MMBbl alongside a gasoline build of 5.5 MMBbl and a distillate build of 10.2 MMBbl. Analysts were expecting a crude oil withdrawal of 3.3 MMBbl. The most important number to keep an eye on, total petroleum inventories, posted an increase of 13.3 MMBbl. For a summary of the crude oil and petroleum product stock movements, see the table below.
US crude oil production remained the same last week, per the EIA. Crude oil imports were up 454 MBbl/d last week, to an average of 7.8 MMBbl/d. Refinery inputs averaged 17.6 MMBbl/d (194 MBbl/d less than last week), leading to a utilization rate of 96.1%. Trade talks between the US and China concluding with positive sentiment and recent OPEC supply cuts are lifting prices as WTI broke through the $50/Bbl mark for the first time in 2019; however, large increases in total inventories are pressuring prices. Prompt-month WTI was trading up $2.45/Bbl, at $52.23/Bbl at the time of writing.
Prices had been rising for the last couple of weeks, recovering from crashing to their lows for more than 18 months. The supply overhang and concerns about slowing economic growth and demand for oil products caused a collapse in prices of more than 40 percent between October and late December. In the last couple of weeks, prices have gotten support from initial evidence of Saudi Arabia and OPEC keeping their promise to slash supply, as well as US-China talks in Beijing extending to an unscheduled third day and ending with hopes that the world’s two largest economies would bring a halt to and potentially solve the trade disputes.
Bullish sentiment increased further this week with WTI reaching above $50/Bbl for the first time in 2019. The increase in prices was due to Saudi Arabia already starting to reduce supply levels drastically and reducing shipments, mainly to the US. Saudi Arabia’s efforts in reducing supply erased some of the skepticism as to whether OPEC would stay loyal to their quotas. Russia’s efforts in reducing supply as one of the main non-OPEC producers in the supply cut deal increased the bullish sentiment further. The other catalyst that is giving strong support to prices is the highly anticipated trade talks between the US and China that started on Monday. The meeting between the world’s two largest economies ended today with positive news and hopes that a trade war between the two countries could be avoided thus not impacting the global economy and oil demand moving forward. Officials from the countries said details around the meeting will be released soon. On the US side, the positive jobs number has somewhat calmed worries about an impending recession for the time being; however, increasing US production is still supporting the bearish sentiment.
The rally in WTI due to positive news around the US-China trade talks took prices over $50/Bbl this week. The low end of this new range seems to be established at the June 2017 low of $42/Bbl. Drillinginfo expects prices to remain volatile within a $40-$50/Bbl window over the next month as the market tries to make sense of the fundamentals. The impacts of the production cuts and the changing demand dynamics (both seasonally and geopolitically) will dictate the direction of prices out of the range. Extensions downward could be driven by further stock builds like the one this week. Extensions upward will be met with selling due to the stock number this week and would require a surprise reversal of the overhang in the first several months of the year.
Petroleum Stocks Chart
Increased gasoline prices have caught the attention of the public. Prices have increased steadily over the last couple of years and the March price average so far sits at $2.69/gal, a whole $0.25/gal higher than this time last year (Fig. 1). As driving season begins, the $0.25/gal will begin to strain consumers’ budgets. What are the reasons behind the higher prices?
Figure 1 – US Retail Gasoline Prices (All Grades), Source: EIA
What is going on right now?
Gasoline prices have spiked this week, bewildering consumers. As big oil conspiracy theories continue to make their way around the grapevine, we explore the main drivers behind the rise in gasoline price.
Two main (and fairly simple) reasons underlie the rise in gasoline prices.
Changing Gasoline Specifications
Gasoline has two main performance specifications (among a host of others that are there for performance, safety, & environmental concerns): Octane & Reid Vapor Pressure (RVP). The octane content is the one everyone is used to seeing posted at the pump (premium 91, regular 87, etc.). The octane number captures the anti-knock properties of gasoline. The higher the octane number, the more valuable the gasoline. However, the RVP is not posted. The reason for this is the fact that the RVP specification changes every season with the weather. The RVP changes to regulate the volatility and the emissions from the combustion of the gasoline in the engine. In the summer months, the RVP specification is lower (harder to attain), meaning that the blend of intermediate refined products used in the mix are more restrictive and require higher value parts of the feedstock. Refineries have started to make the more expensive summer specification gasoline in preparation for driving season, meaning that the market for winter grade gasoline has become tighter. As weather has continued to warm up recently, demand has reached a March high according to the latest EIA Weekly Petroleum Status Report.
Rising Crude Oil Prices
The most marked reason behind the rise in gasoline prices is the price of the feedstock, crude oil. Crude oil prices have been trending higher on speculation that the oversupply that caused the price crash and led to an extended period of low prices has been reversed and inventories are being drawn down (Fig. 2). The $0.25/gal increase in gasoline prices since last year equates to an increase of 10%. That increase should come as no surprise, since the main feedstock for gasoline has actually increased 20% in the same time frame.
Figure 2 – WTI Spot Prices, Source: EIA
So What Next?
Gasoline prices are likely to climb higher in the coming months, due to the implications of the two factors highlighted above. Rising crude oil prices have already had an impact on the price of gasoline, but most refineries buy the crude oil they refine at least a month in advance, meaning that there is likely going to be higher feedstock prices for the incoming barrels that were bought more recently. The changing gasoline specification not only means that there is relative tightness in the short-term for winter specification gasoline available in storage, but that the higher priced summer specification gasoline will be hitting the market in June (also made from high cost feedstock). Driving season will also boost demand during this time frame as families hit the road for the summer. The combination of these factors means that gasoline prices will at least stay high, and likely go higher, barring another dip in crude oil prices. To track the progression of crude oil prices, follow our blog (https://www.enverus.com/di-blog/) as we continue to track the speculatively induced crude oil price bubble and wait for fundamental realities to set in.
On January 4, 2018, US Secretary of the Interior Ryan Zinke announced the National Outer Continental Shelf Oil & Gas Leasing Program (National OCS) for 2019–2024. The new plan proposes to make over 90 percent of total OCS acreage available for future exploration and development and targets the largest number of lease sales in US history. The plan is in great contrast to the current program, which puts 94 percent of the OCS off limits. The Draft Proposed Program (DPP) includes 47 potential lease sales—19 off the coast of Alaska, 7 in the Pacific, 12 in the Gulf of Mexico (GoM), and 9 in the Atlantic—during the five-year plan. The DPP is available on the Bureau of Ocean Energy Management (BOEM) website for viewing (https://www.boem.gov/).
Figure 1 – 2019–2024 Outer Continental Shelf Oil & Gas Leasing DPP (Source: BOEM)
The announcement has been touted as a great step toward solidifying the US as a leader in oil and gas production for years to come. However, it is prudent to note that given the recent price levels and how prolific, vast and economic shale resources have proven to be, the focus on the offshore will be limited in the near term. Offshore resources require a long lead time to explore and develop. Given that most of these waters previously remained unexplored and parts have not been developed at all, there will be a long lag time between when leases are awarded and when they lead to production. Shale resources, on the other hand, are much more dynamic and can react to pricing for the purposes of activity given market conditions in the near term. Whereas offshore projects can take more than two years to develop, a shale well can yield first production in as quickly as three months.
Regardless, the leasing program will allow for new exploration and development activity in the OCS and may impact production potential in the longer term. The activity will be led by majors, who have a marked advantage in longer-term projects given the capital requirements. Majors are the leaders in OCS production, and independents remain the leaders in shale (Figure 2). Keeping this in mind, the possible winners might be the majors, but it will all depend on how successful their exploration efforts turn out.
Figure 2 – Top 10 Deepwater Offshore Producers
US crude oil stocks decreased by 5.6 MMBbl last week. Gasoline and distillate stocks increased by 6.8 MMBbl/d and 1.7 MMBbl/d respectively. Yesterday afternoon, API had reported a large crude oil draw of 5.5 MMBbl, alongside gasoline and distillate builds of 9.2 MMBbl and 4.3 MMBbl respectively. Analysts, were expecting a crude withdrawal of 3.5 MMBbl. The most important number to keep an eye on, total petroleum inventories posted a withdrawal of 2.5 MMBbl. For a summary of the crude oil and petroleum product stock movements, see table below.
US production was estimated to be up 25 MBbl/d from last week per EIA’s estimate. Lower 48 and Alaska production increased by 20 MBbl/d and 5 MBbl/d respectively. Imports decreased by 127 MBbl/d last week to an average of 7.2 MMBbl/d. Refinery inputs averaged 17.2 MMBbl/d (192 MBbl/d more than last week), leading to a utilization rate of 93.8%. The reaction to the report has been mixed, but the larger than expected crude withdrawal has not offset the bearish build in gasoline & distillates. Prompt month WTI was trading down $0.79/Bbl at $56.83/Bbl at the time of writing.
Prices traded in the $57-$59/Bbl range last week. Prices rose after the OPEC meeting but started giving up gains on Tuesday after the market started to take a skeptical stance on the continued success of the cuts and API reported a large product build.
The highly anticipated OPEC meeting took place last Thursday in Vienna. The results from the meeting were positive, which were aligned with the expectations of the market. OPEC, along with 10 other countries outside the group (including Russia) reached an agreement to extend the deal to collectively cut output by 1.8 MMBbl/d until the end of 2018. The deal was previously set to expire in March 2018. The agreement also left Nigeria and Libya (previously exempt from the cuts) with a combined 2.8 MMBbl/d output cap. Nigeria and Libya are expected to keep production within their highest levels in 2017 for the duration of the deal.
OPEC’s decision on extending the deal is certainly positive news, and will support prices. The quotas placed on Nigeria & Libya are certainly encouraging, given that these countries had undermined a large portion of the cuts by the 12 quota carrying OPEC members in 2017. Nigeria & Libya increased production by more than half of the pledged cuts last year and the new quotas are viewed as bullish for a market that was highly concerned with the potential growth from these two countries. OPEC will meet again in June 2018 to discuss and review the deal and start discussing an exit strategy and plans for 2019.
There is still a lot of length to bullish speculative bets in the market because of the positive OPEC meeting outcome and continuing geopolitical issues in the Middle East. This leaves the market open for a large profit-taking rally. A lack of bullish results from inventory reports in the coming weeks and the possibility of increasing US and non-OPEC production in this recent prematurely higher price environment can shift focus back to fundamentals and reverse sentiment quickly.
The market has now held over $52.00/Bbl for over a month, establishing that as the low end of the new range. It is still critical that continued high quota compliance through 2018 along with the realization of the demand growth projected by the IEA occur concurrently for the market to have any chance to normalize inventories back to levels from prior to the price crash. Without inventory normalization, the price recovery cannot be sustained. Drillinginfo expects the trade to return to the previous range $52-$56/Bbl in the coming weeks as the speculative sector starts taking gains and fundamentals start to settle back in.
Please find the updated Drillinginfo charts on the link below:
Petroleum Stocks Report