The Fuse

IMO Rules Cause Major Change to Global Oil Mix

by Nick Cunningham | August 28, 2019

Prices for heavy oil are starting to come under pressure with new global rules on high-sulfur fuel a few months away from taking effect.

Beginning on January 1, 2020, the global shipping industry will be required to use fuel with much lower concentrations of sulfur. The regulations will put a major dent in the market for heavier types of oil, which tend to carry higher sulfur. As refiners begin implementing their plans, demand for heavy oil is taking a hit.

IMO rules reshuffle fuel mix
The rules lower the allowed concentration of sulfur in maritime fuels from 3.5 percent down to just 0.5 percent. Ship-owners can meet the new limits in several ways. They can switch to low-sulfur fuel oil or gasoil (a distillate similar to diesel), install scrubbers to remove sulfur from dirtier fuels, or switch to LNG-powered ships (the third option is probably the least attractive).

As refiners now accelerate their efforts, heavy crude prices are coming under pressure

The rules have been on the books for nearly three years, so the deadline comes as no surprise. Yet, refiners seemed to put off plans until only recently, raising questions about compliance rates. Nevertheless, as refiners now accelerate their efforts, heavy crude prices are coming under pressure.

As Bloomberg notes, the margin for turning Dubai crude into fuel oil in Asia has flipped from positive $5.47 per barrel at the end of July to negative $10.16 as of August 14, a rather staggering deterioration. “The plunge in fuel oil cracks has started to penetrate into the heavy crude market,” Senthil Kumaran, a senior oil analyst at industry consultant FGE, told Bloomberg. “But there still seems to be a disconnect in terms of the extent of declines.”

Meanwhile, prices for West African grades of oil, which tend to be lighter and sweeter and can be processed into lower-sulfur fuels, have climbed because of strong demand from China for these types of fuels, oil traders told Bloomberg. In fact, rare types of heavy oil that also happens to be sweet (low sulfur) such as those in Angola and Cameroon have seen a more pronounced boost. “Even though trading houses and refiners are keeping their strategy and timing close to their chest, it’s clear certain West African grades really stand to benefit,” Josh Lowell, senior energy analyst at ClipperData, told Reuters.

There is expected to be a premium on the supply of low-sulfur fuels

Because of the uncertainty over which fuels will be compatible with which ships, there is expected to be a premium on the supply of low-sulfur fuels, and because of their reach, the oil majors stand to benefit in the initial stages, according to Bloomberg and Wood Mackenzie. ExxonMobil, for instance, is expanding its offerings of IMO-compliant fuels at ports across Europe, as Bloomberg details.

A variety of strategies
The implementation of the IMO rules was once thought to be a looming disaster for the global oil market, causing upheaval around the world as refiners struggle to get their hands on enough light sweet crude. But, for multiple reasons, the market looks poised to avoid major disruptions.

One reason is the lightening of the global crude oil slate. Surging production of oil from U.S. shale has added supply that is light and sweet and can produce relatively more diesel and other middle-distillates, while producing relatively less heavy fuel oil.

At the same time, the supply of medium and heavy oil has fallen over the past year. Canada continues to suffer from pipeline bottlenecks, capping flows of heavy oil sands. Heavy oil in Mexico is in decline. Sanctions on Venezuela and Iran have knocked 2-3 million barrels per day of medium and heavy barrels offline. Meanwhile, OPEC+ cuts have further cut into the supply of these types of barrels. Heavier oil typically trades at a discount – often a rather steep one – to lighter oil. But the discount disappeared earlier this year amid global outages from heavy oil producers.

Taken together, the supply of medium and heavy oil has been tight, even as light oil supplies have surged. That has tamped down fears of major disruptions as the IMO rules take effect because a lighter mix is better suited for lower-sulfur fuel production.

A lighter crude mix helps, but some refiners are still ill-equipped to handle the change. More complex refineries that can adjust their inputs and outputs will fare better than smaller, simpler facilities. At the same time, investments in coking capacity have climbed, which will allow refiners to churn out less residual fuel oil. Profits on processing oil into diesel are expected to be 31 percent higher in the second half of 2019 compared to the first half, according to Goldman Sachs, a reflection of the growing premium on low-sulfur fuels.

A surge of scrubber installations has also eased concerns about problems as January 2020 nears

A surge of scrubber installations has also eased concerns about problems as January 2020 nears. Even though the deadline has been on the calendar for years, ship-owners delayed scrubber installations, raising fears of non-compliance. But the number of scrubber installations has surged this year. According to Bloomberg and data from DNV GL, there will be 3,600 vessels with scrubbers by next year, a more than ten-fold increase from 2016 levels.

Even with all of this, demand for high-sulfur heavy fuel is expected to fall sharply in 2020, which helps explain the recent deterioration in prices. “The high-sulfur fuel oil price will collapse,” Steve Sawyer, director of refining at Facts Global Energy, told Bloomberg in July. He said such fuels could trade at a $30-per-barrel discount.

The IMO rules beginning in January amounts to one of the most significant regulatory changes to global oil supplies in history, and while there will be winners and losers due to this change, the implementation should go much smoother than previously feared.

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