At one point it was very important. And I think it will be again.
IMO2020, for those who don’t know, was a limit in the sulphur content of marine fuel. The regulations reduced allowable sulphur content by ~85%. That might not seem like a big deal but it has a big impact on refinery economics. Ships burn residual fuel, meaning what’s left at the bottom of the barrel after the refinery has made gasoline, diesel, jet fuel, etc. For a refinery to make optimal profits they need to be able to sell the stuff left over. The problem is that the type of crude you run determines what your residuals look like. If you run watery shale crude, you don’t have a very high residual yield, but it is low in sulphur. If you run a typical Saudi crude, you get a high residual yield, but it’s too high in sulphur to be burned in ships unless those ships have scrubbers installed — devices that “wash” the sulphur out of the fuel.
There are some crudes that are chemically similar to the medium and heavy crudes (like from Saudi Arabia) but that are naturally low in sulphur. Those crudes are pretty rare, less than 15% of global supply, and back in January were trading for more than a 50% premium over Brent. This was because the vast majority of ships were burning this new low sulphur fuel, and if you started with a heavy or medium sweet crude, you could produce more of it. It was closer to the process refineries were used to already — run a barrel of crude, sell what’s left over to ships.
However, because there’s not enough of this medium/heavy sweet crude, refineries have to blend the waste with other stuff like diesel. Over the long term if most ships are burning low sulphur fuel oil you create a lot more incremental demand for diesel. You’re taking diesel that would be burnt in a semi truck for instance, and you’re blending it with residuals so ships can burn it. You’re basically “watering down” the residuals to bring down the sulphur content. It’s a dislocation, and you actually need to make more middle distillates (diesel). It’s sort of a hidden demand feature. There’s a blending ratio based on the sulphur content of the crude you started with. The more sulphur, the more distillate you need to mix. Since marine fuel demand hasn’t really changed, you’ve now got extra residual fuel that you can’t do anything with. In January we were already starting to see gluts of HSFO (high sulphur fuel oil). Refineries, especially in Russia and Latin America, were dumping large amounts of it. This drove HSFO prices down, while LSFO (low sulphur fuel oil) prices skyrocketed.
This affected tanker markets in several ways:
- Increased crude demand due to higher distillate needs for blending pool
- Changing trade routes due to changing trade routes around refiner residual economics
- Ships that installed scrubbers (like Scorpio) were able to burn much cheaper fuel than their competition. That’s actually part of why Scorpio had such a blow out Q1. At one point a lot of investors in the tanker space didn’t want to touch any company that didn’t have scrubbers installed.
- Ships without scrubbers (or fuel hedges) needed to burn more expensive fuel.
- Since regulations were also around sulphur content alone and there wasn’t much of a spec, ship owners also had to worry about the quality and properties of the fuel. Even now I see something about this just above every week.
- Excess HSFO was essentially duplicated demand, it either needed to be stored till someone could figure out what to do with it, or it needed to be transported to another refinery that could process it. January actually saw a record spike of fuel oil imports to the US gulf from Russia where complex refineries like PBF Energy could remove the sulphur from the residuals and or turn it into another refined product.
I can’t tell you how things are going to happen as oil markets rebalance. I think it’s too complicated for anyone to really know…but I can tell you that once they do the above factors will once again be seen in the tanker markets. We had just begun to see how things would pan out when COVID-19 hit, and I expect these issues to be at the forefront again as demand recovers and inventories start getting drawn down. In summary it’s just another factor that greatly impacts the tanker markets that quite possibly nobody is looking at. COVID-19 derailed that process — for instance nearly every tanker company has delayed or cancelled scrubber retrofits — so excess HSFO will be more of an issue than projected as the increased consumption due to scrubber adoption won’t materialize till later.