New MARPOL (International Convention for the Prevention of Pollution from Ships) limits on sulfur content in marine fuels starting in 2020 could result in 1-1.8MMb/d of additional refinery runs to produce higher volumes of marine gasoil. This additional crude demand would contribute to crude market tightening in 2020-21 and could provide OPEC with an opportunity to increase volume and market share. Shell photo.
MARPOL legislation comes into effect in 2020
By Anna Nikitina
This article was published by McKinsey Energy Insights on May 17, 2018.
MARPOL in a nutshell
In 2020, global sulfur limits for marine bunker fuel will be lowered from the current 3.5% to 0.5%, affecting 3.7MMb/d of fuel demand from the shipping industry. However, there is a high degree of uncertainty over the level of compliance from shipping companies, and if they do switch, which alternative fuels they will opt for. They could in fact continue using the high sulfur grades and install sulfur scrubbers, which remove the sulfur from exhaust gases after combustion.
Top shipping companies such as Maersk and Hapag-Lloyd have stressed that they will meet the new regulations by switching to alternative fuels. In our base case, we expect 80-90% compliance with the MARPOL regulations in 2020.
There are several ways the industry could comply:
- Low-sulfur fuel oil (LSFO): this alternative fuel complies, but there is limited availability. It cannot fully address demand for compliant marine bunker fuel after 2020, although higher refinery runs would raise production, as would greater desulfurization of high sulfur fuel oil (HSFO) within existing capacity
- Marine gasoil (MGO): this alternative fuel also complies, and can be increased by raising refinery runs and also through more cracking, desulfurization and other secondary refining where capacity for this already exists
- Scrubbers: this add-on allow shippers to continue burning HSFO, while releasing emissions into the water instead of air, which is permitted. However, we estimate that scrubbers will account for less than 15% of global MARPOL compliance
- Liquid Natural Gas (LNG): although a potential alternative fuel, it is unlikely to emerge as a viable substitute for conventional bunker fuel in the near term and its share of demand is expected to stay below 1%
There is also a risk that some shippers will not comply at all, as the International Maritime Organisation (IMO)—under whose auspices MARPOL was set up—does not have a proper enforcement mechanism in place. However, as stated above, bigger and more established shipping companies are more likely to comply and, as a consequence, they will push for tighter enforcement and development of technologies that identify non-compliant ships.
Increased refinery runs will boost crude demand
With demand for alternative fuels suddenly increasing, a change in the global fuel mix on such a large scale will be challenging for refineries to accommodate, as they are not configured to produce the extra required volumes of MGO or LSFO. Because of the greater constraints on LSFO output, we expect MGO will take the lion’s share of the additional demand—ranging from 75% to 40%, depending on shipper behaviour (Exhibit 1).
Therefore, this higher demand could lead to a rise in crude runs, resulting in an incremental rise in oil demand (on top of the expected underlying liquids demand of 103.4 MMb/d) of 1.0-1.8MMb/d by 2021, corresponding to 40-55% share of MGO in the total mix. In our 75% MGO ‘maximum impact’ scenario, we could see runs rise by as much as 3.8MMb/d as a result of MARPOL, although this scenario requires full global refinery utilization and is highly unlikely.
While widening spread between sweeter and more sour grades could also encourage refiners to expand their HSFO processing and blending capabilities, uncertainty around MARPOL implementation hinders justification of such significant investments ahead of time. Currently, very few refiners have announced HSFO conversion capacity additions and the general approach in the industry is to wait and see.
We expect that if more than 40% of ships switch to MGO, its rising price will eventually prompt some ships to install scrubbers and switch back to burning HSFO. Therefore, if there is a high level of MGO adoption soon after the new rules are introduced, it won’t last long, and the rise in crude throughput will decline after 2021 until it reaches 1MMb/d from 2025 onwards.
While the MARPOL legislation comes into effect in 2020, we expect that traders will begin increasing purchases of MGO in Q4 2019 in an attempt to accumulate stock before prices start to rise under the influence of higher demand. Therefore, in our reference case we see 0.3MMb/d of demand being shifted from 2020 into Q4 2019.
On the supply side, OPEC is the key beneficiary
We believe markets will tighten from 2020 onward as a result of the anticipated 1MMb/d rise in underlying demand from MARPOL, which will combine with the results of reduced capex post-2014 that has led to faster declines at non-OPEC legacy fields and low production coming from new projects. This will push prices up to $70/bbl.
The additional demand from MARPOL presents OPEC with a chance to re-claim market share. Due to limited availability of sweeter crudes, OPEC’s mostly sour grades will remain in demand, providing an attractive revenue opportunity even if the differential widens. Therefore, we expect that OPEC will add a further 0.9MMb/d to output between 2020-21, after growth of 0.5 MMb/d up to 2020. Market share will stay at or below 43%, before edging up after 2020. Short-term OPEC output growth will come from both enhanced recovery at existing fields and new projects such as Khurais in Saudi Arabia and Halfayah in Iraq.
If high MGO uptake causes crude demand to rise by 1.8MMb/d, there could be the potential for OPEC to add 2.2MMb/d of production by 2021 and increase its share above 44%. However, we believe OPEC is unlikely to be able to respond to such a significant rise in demand within such a short timeframe, and instead we could see an increase in price volatility, with Brent reaching $75-85/bbl in 2020-21.
Anna Nikitina is a senior analyst with McKinsey Energy Insights based out of McKinsey’s London office.