In 2020, global sulfur limits for bunker fuel will be lowered from the current 3.5% to 0.5%, affecting over 3 million b/d of residual fuel oil (resid). We expect the shipping industry to react by switching to a combination of marine gasoil and low-sulfur resid bunker. This will at least initially result in higher refining margins and wider light-heavy differentials, making an array of sulfur removal investments very attractive. However, the opportunity for refiners will depend greatly on how quickly other sectors respond.

Lower sulfur limits

In October 2016, the International Marine Organization (IMO) agreed to limit sulfur content in all marine fuels to 0.5% as of 2020. The 0.5% limit will be the maximum level globally, although designated Sulfur Emission Control Area (SECA) regions in the North Sea, English Channel, and along the East Coast of North America will remain at their already lower levels. The long-term sulfur target was originally agreed on already in 2005, however the timing was only confirmed in 2016; IMO will continue meetings on the topic which will take up issues related to monitoring and enforcement.

The volume of oil demand in ship bunker is significant. In 2016, demand for high-sulfur resid for ship bunkers reached 3.3 million b/d—out of 7.2 million b/d of total fuel oil demand and 95.4 million b/d of total oil demand. The demand for this fuel is widely distributed across the major regions of the world, guaranteeing that refiners in all regions will feel the effects of the IMO regulation.

Exhibit 1: 2016 bunker fuel consumption by type

SOURCE: McKinsey Energy Insights' Global Downstream Model

Industry options for compliance

Meeting this demand will be a challenge. Refiners are not set up to make this volume of residual fuel oil with only 0.5% sulfur. Traditionally, the bunker fuel market has been a sink for refiners to put high-sulfur resid material into, allowing them to avoid investment in high-cost upgrading and hydrotreating processes. While there is some low-sulfur resid material below 0.5%, it already has other uses.

Looking at the quality of resid in the global crude slate, we estimate that there is about 5.8 million b/d of atmospheric resid below 0.5%, with a fair share being some waxy crudes in Asia. Currently, very little of this material (less than 300,000 b/d) is expected to be blended into fuel oil, with the majority being used in conversion units. There is also some low-sulfur resid material generated by conversion capacity. However, we estimate that this is far less than the volume consumed in conversion, resulting in net availability of approximately 700,000 b/d, while the remainder of the low-sulfur fuel oil (500,000 b/d) will need to be generated through hydrotreating. Therefore, while 0.5% sulfur resid can be part of solution, it is not likely to be able to meet the entire new demand for low-sulfur bunker.

Exhibit 2: Availability of low-sulfur resid material in 2020

SOURCE: McKinsey Energy Insights' Global Downstream Model

The next best source of low-sulfur fuel for shippers is marine gasoil (or a combination of marine gasoil and fuel oil), and we expect this material to play a role, at least partially during the early years. Many ship engines are expected to find it relatively easy to switch to a combination fuel (even if switching to pure gasoil may present challenges in some cases), with only minimal operational changes and no significant capital expense or time out of service. As diesel range material, the sulfur content of marine gasoil can be controlled through the same hydroprocessing steps used to make low-sulfur diesel. Because of global diesel sulfur limits lowering over the years, refiners have already significantly expanded this capability. However, gasoil range material is far more valuable than resid because of its ability to blend at least partially into diesel. So even with no change in current pricing conditions, switching to marine gasoil would add significantly to the cost of fuel for shippers.

These economics have many shippers looking at other alternatives, such as adding emissions scrubbers or switching to LNG as a fuel. Installing scrubbers would allow shippers to continue to burn high-sulfur fuel oil, but it comes at a high conversion cost both from the capital expense of the scrubber equipment and the lost time in service while the ship is in dry dock. Additionally, ship owners may also be hedged against the fuel prices through Worldscale pricing adjustments. As a result, shippers thus far have been averse to investing in scrubbers in large numbers. Switching to LNG also incurs some significant upfront costs. However, a bigger deterrent so far has been concern about the lack of progress on LNG bunkering infrastructure.

There is also the potential for some shippers to simply not comply. While some players are already looking into mitigation options, the lack of a clear enforcement mechanism announced by the IMO so far may lead to reduced compliance with the new regulation. However, it is likely that the pressure on at least the largest shippers to comply will push them to advocate strongly for a robust enforcement mechanism that keeps a level playing field.

For these reasons, we expect the market, at least initially, to largely shift to using a combination of marine gasoil and low-sulfur resid as the new specifications take effect. Based on the resulting impact on prices, we then anticipate waves of investment in shipping and refining, with only modest amounts ahead of the start date.

Market impact will be significant

Shifting a large portion of bunker demand from high-sulfur resid to a combination of marine gasoil and low-sulfur resid will affect markets in a number of ways. The higher demand for gasoil will largely have to be met by higher crude runs, putting upward price pressure on global crude prices, distillate premiums to other fuels, and refining margins in general. Also, the loss of demand for high-sulfur fuel resid will cause its price to fall, further adding to the widening spread between traditional high-sulfur resid bunker and marine gasoil. Finally, the price differential between high-sulfur and low-sulfur resid is expected to increase significantly.

Under a scenario where the majority of current high-sulfur fuel oil switches to a 50/50 share of marine gasoil and low-sulfur fuel oil (adding 1.3–1.4 million b/d of demand for each of those two products), our modelling estimates that refiners would need to run an additional 2.1 million b/d of crude oil through distillation. This will push up utilization levels across all key hubs, with the strongest impact in Northwest Europe, where MARPOL could result in an over 10% increase in refining utilization between 2019 and 2020 (and an over 15% increase over an alternative no-MARPOL case).

Exhibit 3: MARPOL effect on refining utilization

1 Belgium, Netherlands, UK

SOURCE: McKinsey Energy Insights' Global Downstream Model

This should also tighten distillate markets relative to gasoline, adding to the cost of marine gasoil. Currently, markets are fairly balanced between diesel and gasoline, and demand growth for gasoline is generally higher than for diesel. This is keeping the relative prices of diesel and gasoline fairly comparable. History shows that in years when diesel demand accelerates relative to gasoline, diesel prices shift to premiums over gasoline of USD6 to 20/bbl (depending on season).

Finally, the sudden oversupply of high-sulfur resid material resulting from a shift in bunker fuel demand will mean lower high sulfur fuel oil (HSFO) prices. In recent years, resid markets have been fairly tight, with resid pricing at the low end of its historical differential to crude. This tight market pricing reflects resid being valued as a feedstock in marginal refinery conversion capacity. With an oversupply of resid expected to reach up to 1.4 million b/d in this scenario, the marginal barrel will have to find a home in a much lower-valued use. In the past, this has typically been in competition with natural gas in power markets that have the ability to switch. However, given the volume of excess resid predicted and the fact that it will all be very high-sulfur material, this could overwhelm the traditional substitution market. If so, then resid would likely have to find a home competing with even lower value coal in the power sector, resulting in prices around USD20/bbl. This would drive a significant improvement in margins for full conversion coking/hydrocracking plants during the early years post-implementation.

Implications for market participants

Under these market conditions, there would be a huge incentive for shippers and refiners to contemplate capital investments to capture value from this spread. The pay-out time for scrubber investments on ships—to allow shippers to continue using low-cost HSFO—would fall to months. For refiners, the expected returns on existing coking and hydrocracking investments would also be huge.

The likely implication for the refining industry would be a cycle of capacity additions, distillation as well as conversion, driven by higher margins—especially for more complex configuration.

The key risk would be the duration of the improved utilization levels and price spreads. Given the expected development of global fuels demand and some of the longer-term trends (electric vehicles, increasing fuel efficiency) which may start having a negative impact on key products consumption on the one hand, and the high incentive for scrubbers and additional conversion capacity on the other, it is likely that the improvement would be relatively short-lived. That means a return to lower margins over the next few years. Investments that miss the early years of peak margins could potentially achieve much worse than expected returns.

There also remains the risk of non-compliance from shipping market participants. Under such circumstances, the overall impact on product spreads and utilization would be proportionately lower, with more limited incentives to invest in scrubbers and additional conversion capacity.