When the clean shipping fuel rule known as IMO2020 comes into effect in two years, the impact on fuel prices, particularly diesel, will have two key inputs.
The first will be the overall price of oil. It's a number that is impacted by everything from rig counts in Texas' Permian Basin to whether Iranian exports of crude are still being hit by U.S. sanctions. And there's lots in between.
The second is what the spread is between what are known as middle distillates--which includes ultra low sulfur diesel fuel, expected to be the fuel of choice for IMO2020 compliance--and crude oil. The crack, as it's known, can be extremely volatile. But it will help determine just how much diesel prices will rise or fall relative to the broader movements in the benchmark crude numbers.
Bank of America Merrill Lynch, in a recent report, says it is "very bullish" on the diesel crack, which essentially means it expects diesel to outperform crude to the upside. The problem it sees is that refining upgrading capacity--which is the investment needed to make certain products, as opposed to conversion capacity, which is the first process that crude goes through--has failed to keep up with demand. There's going to be investment, but it's the wrong kind, according to Merrill.
"We...forecast refinery upgrading (ie. crackers, cokers, etc.) capacity to expand at a rapid pace this year and next; however, additions will be more focused on delivering light distillates at a time when more middle distillate capacity is desperately needed," the brokerage house wrote in a report. The report says that it expects middle distillate demand to rise by 2 million b/d in 2020, which will be almost a barrel-for-barrel replacement for high sulfur fuel oil, which is now largely used to power ships.
HSFO is a relatively easy product to make; it's what a refinery produces lots of if a high sulfur crude went in the start of the refining process and little processing was done to it to make gasoline or diesel. An increase of 2 million b/d in ultra low diesel demand needs equipment for that demand to be supplied. "The impact of this on prices will be felt strongly already in 2H19 as refiners, distributors and consumers start to adjust their physical flows," the report said.
There are multiple ways of measuring cracks. In the case of Merrill Lynch, it is comparing the ICE Brent crude contract to that of ICE gasoil; gasoil is a form of middle distillate so it is a proxy for diesel. The forward curve for the two contracts in 2020 now stands at about $18/b. There are other fuel oil to distillate comparisons closer to $15.
But Merrill sees the spread blowing out to about $21/bbl under IMO2020. What that means is if the comparison is against Brent, the wider spread would tack on less than 10 cts per gallon to the price of diesel, assuming static crude numbers (a big if). Yet there are whispers in the trading community that the spread could blow out to $30/bbl, which would have a lot greater impact.
It's important to note that there are some analysts looking forward who do not see the two big determinants--the overall price of oil and the crack--as separate unrelated issues. Their concern is that an extremely strong crack could drag up the price of oil with it, as some analysts believe was the case in the price spike of 2008. Diesel prices then surged well beyond that of crude and was seen as lifting the base price up with it.
Meanwhile, a Norwegian energy consulting firm, DNV GL, recently held a webinar to discuss IMO2020 and the scrubber option, where a ship adds scrubbers to remove sulfur from its exhaust, allowing the continued use of higher sulfur fuel, which is significantly cheaper than ULSD.
One fact in the webinar was sobering: DNV said earlier predictions by the International Maritime Organization, the international organization that is implementing IMO2020, called for 4,000 scrubbers to be installed by 2020.
The current level of scrubbers on ships is about 1,850, DNV said. There is a "second scrubber wave" now underway that has 1,000 projects announced in the last six months. Add those two together and it's a lot less than 4,000.
The key to how much additional scrubber retrofit will be undertaken is the spread between the price of high sulfur fuel oil and a "compliant fuel," like ULSD. If that spread is $40, DNV said, "there is no business case for scrubbers on ships with 20MW of power." If it's $100, the payback time for the system is two years.
But the numbers cited by DNV are a fraction of what's going on in the real world. Based on data from S&P Global Platts, some measurements of the spread between diesel and fuel oil are in the range of $250/t, which should make a scrubber decision simple.
One complicating factor: what will be the ultimate number of scrubbers, and how will that impact the spread between fuel oil (whose demand wouldn’t be gutted quite as much as predicted as the scrubber count rises) and distillates (where demand would be inverse to that.).
These numbers cited by DNV seem to argue that the cost mountain to install them--and thereby soften the demand surge for ULSD--is not all that high to climb. "Although scrubber systems are a significant investment, the capex is small compared to fuel costs while other cost centers are negligible," the report said.