Topsy Turvy ride: How Refining sector got reoriented after IMO2020

As a result of IMO 2020, the global oil and refining industry faces imminent disruption. Changes to global bunker specifications since 2020 will cause significant disruptions within the industry and beyond, necessitating significant shifts in refinery operations.

From a refining perspective, the blend-stocks used for bunker fuels will undergo a significant change, initially posing a significant disposal problem for approximately 3 million barrels per day of high sulfur fuel oil. Marine gasoil and various low-sulfur blends of gasoil and residuals will take the place of that volume. It is anticipated that marine gasoil and the new blended fuel will see significant price increases, whereas HSFO prices will decrease.

Rebalancing products will require relatively expensive steps throughout the refining process, resulting in much wider price spreads for all middle distillates than for HSFO. In order to produce sufficient compliant marine fuel after 2020, the refining circuit may need to run additional crude and may not be able to completely destroy the excess high sulfur fuels, forcing them to lower their prices for power generation or storage. Cracks from jets and diesel will soar. As yields shift toward middle distillates, gasoline cracks may also receive support. The new fuel with 0.5 percent sulfur will initially be comparable to marine gasoil in price. The flow of products, crude oil, and refinery operations will all undergo significant shifts.

However, as refinery conversion capacity grows and ships add scrubbers, all of these initial price effects will fade in the coming years.

Key refining implications include:

• Increasing numbers of refineries looking for light, sweet crude and high crude runs since 2020, Prices for key sweet benchmarks like Brent and WTI will likely rise as a result of bullish market sentiment for sweet crude.
• Cracks in middle distillate is rising since 2020 from their current levels before decreasing in 2022-23. Cracks in gasoline will also have strength, but it will be much less than in distillates. Due to increased use in power generation, HSFO absolute prices may occasionally approach low levels and HSFO cracks is decrease since 2020.
• Product spreads between clean and dirty will widen from their current levels, driven by marginal refinery economics. If HSFO disposal necessitates lower pricing in order to compete with baseload power generation, spreads might occasionally widen even further than they typically do when driven by refineries.
• In refinery parity, the spreads of light-heavy and sweet-sour products will significantly widen crude quality differences. Margins at refineries with high conversion rates will be extremely high.
• In particular since 2020, medium conversion refiners will also see significant margin enhancements.
• Due to the need to backfill from the virgin naphtha pool and lower gasoline production from fluid catalytic cracking, reforming margins and utilization rates should rise. Naphtha prices will also rise as a result. This causes petrochemical feed preferences to shift toward LPG/ethane on the margin.

Global crude quality getting lighter, sweeter helps, but is not enough by itself for future:

Since 2005, the global average crude quality has been getting lighter and sweeter. This started because the growth of medium grades continued while the growth of heavy sour crudes slowed dramatically. This was followed by an explosive increase in US production of light sweet shale crude and condensate around 2010.

Despite the rise in crude runs, the total volume of 650 F atmospheric residue contained in crude runs has effectively leveled off due to a rapid increase in average API gravity and a subsequent decrease in average residual fuel oil content.

New refinery capacity helps, but is not enough by itself for future:

By 2020, planned refining facilities will also significantly contribute to the destruction of excess HSFO. Coking, hydrocracking, and cat cracking account for approximately 1 million b/d of annual conversion capacity additions. The new capacity's geographical distribution will also play a role, with many conversion additions taking place in China and in other nations that are typically not bunker supply hubs. They might be a sink for bunker blend components with a higher sulfur residual, but they won't necessarily be a source for bunker blend components with a lower sulfur residual.

Heavy oil desulfurization facilities, of which 70% will be atmospheric residue desulfurization and the remaining 70% will be VGO desulfurization, will also help. Asia houses the majority of these new facilities. However, not all of them may directly assist in resolving the bunker spec transition issue. Before the IMO decided to implement the bunker spec change in 2020, they were all planned. As a result, they may not be able to easily switch operating modes because they probably have additional processing objectives or requirements, such as helping to meet FCC feed sulfur specifications.

Because of this, there won't be enough deep conversion for HSFO to initially clear through conventional refining steps because of the magnitude of the change.

A roughly $30/b spread of gasoil-HSFO in Europe corresponds to this first round of HSFO destruction. In order to incentivize less appealing refining options, subsequent processing layers for HSFO destruction necessitate a further drop in the price of HSFO (approximately $30-$50/b spread), and a third tranche involves increased consumption in land trade, excluding other fuels (high sulfur crude burn, coal, or gas), implying even wider spreads between gasoil and fuel oil, depending in part on the absolute price levels of oil and competing fuels.

While initial differentials may be very wide, investments in scrubbers and refinery conversion capacity will likely narrow differentials and bring them into the first tranche between 2021 and 2023.

Including products like biofuels and NGLs, global demand for major petroleum products produced through refining is expected to continue growing at a rate of 1.0-1.4 million barrels per day per year, which indicates that refinery runs will continue to expand at a similar rate. Baseload HSFO used in power generation, which comes from new plants in Saudi Arabia and Bangladesh, is included in this demand. Incremental crude runs come from US low-sulfur crude and condensate because less Venezuelan and Iranian production is replaced by more US production.

2 million b/d of HSFO can be destroyed if new refining facilities are built by 2020 and demand for asphalt and power plants increases. This still falls short of the required HSFO destruction of nearly 1 million b/d. Middle distillates, such as gasoil and jet kerosene, will also fall far short of the required target. Strong middle distillate demand will necessitate larger-than-expected yield shifts in addition to a reduction in gasoline production.

There will still need to be some further refinement steps after these modifications. Increasing coker utilization rates, for instance, will be one step. According to data from the United States, the current utilization rates, which are around 89 percent, are lower than the extremely high utilization rates that have historically existed (above 94 percent). HSFO production would decrease by another 350,000 b/d if all cokers worldwide increased their utilization rate by 4%, with the appropriate incentives.

If environmental restrictions on FCC emissions are not broken, other stretch refining steps like deeper vacuum distillation cut points and some substitution of high sulfur resid for low sulfur resid in resid FCC could provide additional flexibility—albeit with some FCC capacity or other debits. There will be incentives to store HSFO, especially in 2020, when the market wass likely to move strongly into contango, so better segregation or optimized blending could also free up some LSFO at the expense of HSFO.

However, even small shifts in the balance of supply and demand, such as raising the diesel-fuel oil spread above $50/b, could have significant effects on prices. In relatively short rebalancing tranches, the margin determines the severity of price effects. Such a high impact case could occur if scrubber assumptions are overly optimistic, if more shippers choose marine gasoil over the new 0.5 percent fuel oil, or if cokers cannot be used at higher rates.

Long term Future looks much promising though:

After 2022, additional refinery facilities are already planned that will destroy HSFO, and other projects and operational adjustments are likely to be initiated. And ships will continue to add scrubbers, especially for new vessels. My assumption is that the total scrubber-equipped fleet reaches several thousand vessels in 2025, consuming 1 million-1.5 million b/d of HSFO. Consequently, the HSFO destruction issues that refiners are expected to face in 2020 will be much more manageable in subsequent years and should be essentially resolved by 2025.

Product prices, crude differentials, and refinery margins will see disruptive changes before reverting to trend in later years:

As already noted, wider spreads between light, sweet products and heavy, sour ones will be required to allow more expensive rebalancing steps to be carried out economically. For current, the situation looks similar to 2008 in some ways, in that conversion capacity will be straining to balance. But in other ways it will be different from 2008, as absolute price levels will likely be much lower and absolute demand growth for all products, including gasoline, will likely remain fairly healthy – whereas demand for gasoline collapsed in 2008-09.

Furthermore, the shortage of low sulfur bunkers is likely to steal low sulfur VGO from conversion feeds, which is exactly the opposite of what occurred in 2008.

The price effects will be widespread:?

• Middle distillate cracks increased sharply in the second half of 2021, peak in 2022, and then start to ease. The peak may not be at the start of the year too, as enforcement will tighten with a March 1 HSFO carriage ban, while inventory levels of previously stockpiled low sulfur fuels will be gradually worked off.
• Gasoline cracks will also see support, although not as much as for middle distillates. Catalytic cracking units will likely be operated differently in order to consume high-sulfur feeds and increase distillate production. This will lower gasoline production and should increase emphasis on reforming operations to backfill gasoline.
• HSFO cracks will be the inverse of middle distillates, getting quite weak from 2020.
• Low sulfur-high sulfur fuel oil spreads will widen sharply.
• Crude quality differentials will move with products, also getting very wide since 2020. Discounts for medium sour and heavy crude will be much deeper relative to light, sweet benchmarks.
• Low sulfur VGO will become more expensive relative to crude and products, as it is a cheaper blending component for low sulfur bunkers than using gasoil.
• Light cycle oil will become more valuable. Normally, LCO has a relatively lower value as it cannot easily be desulfurized to 10 ppm for use in road diesel, but lower severity desulfurization will readily get it down to 0.5% sulfur. Furthermore, LCO is aromatic and thus may be useful in reducing compatibility issues when blending with resids.
• Higher freight costs will widen all inter-regional arbitrage differentials.