Blog November 18, 2019

This is the second in a series of three blogs exploring the impact of IMO 2020 on international crude and distillate markets. While the first in this series focused on U.S. distillate fundamentals, this blog takes a closer look at what fuel substitution will mean for distillates, stock levels, and the ability of European refineries to supply low sulfur fuels. The third and final blog will explore the potential impact an IMO 2020 world could have on crude markets and refinery runs.

Background

Beginning January 1, 2020, the Marine Pollution (MARPOL) permitted limit for sulfur content in ships’ bunkers will be reduced from 3.5 percent to 0.5 percent (for ships operating outside designated emission control areas). The International Maritime Organization (IMO) first proposed new regulations over ten years ago, and finally adopted the resolution in October 2016. The sulfur constraints imposed by the IMO regulations have far reaching consequences. 

In the last three years, many sources speculated on the consequences of the biggest legislative change to energy use since the removal of lead from motor fuels in the 1980's. What is not established yet is a cohesive view of what the outcomes will be. As the uncertainty is only likely to increase up to and after the implementation date, a clear view of the facts is essential to understand the changes as they occur.

Much of Northern Europe, including The Baltic Sea and North America, already use 0.1 percent bunker fuel under the IMO Emission Controls Area. The main impact will be for global shipping outside of this region, but the knock-on effect to fuel supplies will be felt globally.

Existing 0.1 percent Sulfur Emission Control Area
Figure 1: Existing 0.1 percent Sulfur Emission Control Area. Source: MARPOL

Fuel Alternatives

At the start of 2020, it’s expected that there will be a readily available supply of Very Low Sulfur Fuel Oil (VLSFO). Most analysts' current estimates put this at between 1.0 and 1.5mn bpd, far higher than expected only a few months ago. Despite its name, VLSFO contains a significant amount of diesel molecules, produced using an intermediate product called vacuum gasoil (VGO), which displaces it from the finished gasoline and road diesel production streams. When the supplies of VLSFO are exhausted, increased pressure will be felt in the distillate market as shippers turn to Marine Gasoil (MGO). MGO is a pricier alternative than VLSFO for shippers to comply with the mandate because it is a blend of light cycle gasoil that contains about 60 percent aromatics and is a higher density than ‘standard’ diesel.

Uncertainty still surrounds the likely fuel substitution that will occur. Global shipping consumes in excess of 3.8mn bpd of High Sulfur Fuel Oil. Estimates of the likely shift to MGO as a possible substitute range broadly from 1mn bpd to 2.5mn bpd. As of November 18, VLSFO for December barges in Rotterdam traded at $502.50/MT, compared to $564.00/MT for Marine Gasoil, according to London fuel oil brokers.

Production Can Rise

Our data shows that Europe looks well placed to absorb much of the impact that will be felt globally. Historically, European refineries operate at lower utilization rates compared to their U.S. counterparts. Primary processing at monitored European refineries operated at 91 percent utilization in early November, our data shows, and has room to rise higher as refineries continue to ramp up after seasonal maintenance. Additionally, European refineries are generally well placed to process heavy Russian crudes, often blended with sweeter North and West African grades, offering greater flexibility and an inherently higher distillate yield than U.S. refineries.

Similar to U.S. refineries, refineries in Europe also conducted upgrades and maintenance ahead of IMO 2020, with some middle distillate processing units expected to complete in the coming weeks. Notably, Total’s 43,500 bpd Hydrocracker in Antwerp, Belgium; Cepsa’s 52,000 bpd hydrocracker in Huelva, Spain; and Total’s 55,600 bpd hydrocracker in Normandy, France. We expect middle distillate utilization to rise from a very low 81 percent (Genscape November 7 report) to a more seasonal 95 percent and higher ahead of January 1, 2020. Higher refining margins are incentivizing refiners to maximize distillates over other product production and keep stock levels resupplied.

European refinery primary processing capacity utilization
Figure 2: European refinery primary processing capacity utilization. Source: Genscape
European refinery middle distillates capacity utilization.
Figure 3: European refinery middle distillates capacity utilization. Source: Genscape

Stocks Rose in 2019

Unlike the U.S., ARA distillate stocks at both refineries and terminals are at a healthy level as of early November, further cushioning the impact in Europe, according to our data. Despite several weeks of stock draws, our monitored storage facilities show distillate stocks at 4.428mn MT (November 1 report), up 8.5 percent from this time last year, or an increase of over 6mn MT over the course of 2019-even accounting for large stock draws in recent weeks.

ARA gasoil inventories
Figure 4: ARA gasoil inventories. Source: Genscape

Prices Fall from Two-Year Highs

While stocks are higher, the gasoil cost of storage recently reached new two-year highs. As a proxy for the cost of storage, the two-month time spread on ICE Gasoil futures reached over $15/MT in the first half of October. Since then, the time spread fell to $4/MT along with inventories, a reflection of anticipated improved supply and increased refinery production. Similarly, the crack spread (ICE gasoil vs. ICE Brent futures) reached new five-year highs above $19/bbl in October, but since retreated to around $16/bbl in early November.

Gasoil vs. brent and two-month calendar spread
Figure 5: Gasoil vs. Brent crack and two-month calendar spread. Source: ICE

A New Balance

From a European perspective, the distillate market is faring better than many of the earlier predictions. For now, fears of a global slowdown in shipping caused by trade wars and slower economic growth are outweighing fuel supply worries. Many issues are yet to be fully realized with less than two months until the implementation of IMO 2020. What is becoming apparent is the regional variations in preparedness. Market mechanisms in the oil industry will likely create a new balance as they always do. While this process is underway, our data will continue shine a light on the storage, transportation, and refining changes as they happen.

Stay tuned for part three of our “IMO 2020 is Coming” series where we’ll share insights on how this regulation may impact the crude market and refinery runs, along with a live webinar with our analysts. Subscribe to our mailing list now to be the first to know.