Distillate Shortage: Why it is a very BIG DEAL

[dan_s]

Looming regulations on marine fuel sulfur limits to roil the oil market next year

Oil is bound up with many policy debates and discussions, from climate change to ethanol and fuel economy standards. But one important policy issue preoccupying the oil industry and likely to impact oil prices has so far gone remarkably unnoticed in Washington: A mandatory reduction in sulfur limit emissions for ocean-going ships starting on January 1, 2020, commonly referred to as “IMO 2020”. IMO 2020 is expected to reverberate onshore and impact consumer oil prices, especially for trucking and airline companies, and home heating oil consumers. The International Energy Agency referred to IMO 2020 as “easily the most dramatic change in fuel specifications in any oil product market on such a large scale.”5

By way of brief background, in October 2016 the United States along with other nations participating in the UN International Maritime Organization (IMO) confirmed an earlier, tentative decision to implement a reduction in the sulfur content of the fuel used in ships on the high seas (“marine bunkers”) from 3.5% to 0.5% sulfur as of January 1, 2020. Ship owners have two main compliance options to meet the looming regulations.

First, ships could continue to burn high sulfur fuel but install exhaust gas cleaning systems commonly called “scrubbers” to remove sulfur from the ship’s emissions. Only a small fraction of ships have installed scrubbers however and insufficient time remains to install many more before the deadline. Therefore, most will opt for a second option, to switch from high sulfur, heavy fuel oil to lower sulfur heavy fuel oil or middle distillates (“distillate” also referred to as “gasoil” or “diesel”).

A major question hovering over the market is whether a big new demand wave for low-sulfur distillate from shippers would overwhelm the refining industry's ability to supply it while meeting demand needs by other users such as motorists, airlines, and home heating oil consumers. While IMO had considered a 2025 implementation date, the decision taken in 2016 to start in 2020 was backstopped by a reportcommissioned by IMO that found “the refinery sector has the capability to supply sufficient quantities of marine fuels with a sulfur content of 0.5% or less...while also meeting demand for non-marine fuels.”6

But as the IMO 2020 deadline fast approaches, leading official forecasters and private sector experts expect implementation will trigger a large spike in the price of crude oil and refined products, particularly for “middle distillate” fuels. In a recent report, IEA concluded the global refinery system would not be able to produce a sufficient amount of low sulfur fuels in 2020 and at least for a few years afterward. As a result, shippers facing a new IMO mandate will bid low sulfur distillate away from other users mentioned above. IEA expects the scramble for clean distillate triggering a 20-30% spike in the price of heating oil and diesel fuel. IEA noted this “sharp increase in the price of [distillate] following the 2020 IMO changes penalizes demand in other sectors.”7

Moreover, IEA warned that IMO 2020 could push up global crude oil prices and therefore pump prices.
A worrying number of refiners, including large integrated oil companies, have publicly stated that one of their options to meet the new sulfur specification would be to use lighter and sweeter crude oil that requires less intensive hydrotreatment. As the two important futures benchmarks, Brent and WTI, are based on light sweet crude oil output, the increased demand for this type of crude oil may fuel a sharp increase in futures prices, with consequences felt across all product markets.8