Fuel oil markets have entered the long shadow of the IMO’s low-sulphur ship fuel rules. The transition to cleaner fuel will be guided by market prices. Clean product demand is set to soar (at current prices) while demand for fuel oil is set to plunge. So clean product values need to rise relative to dirty products to encourage more efficient refining and, most likely, clean product demand destruction to enable the global refining system to meet clean product demand without overproducing fuel oil.
Based on current swap values, a refinery producing 80% clean products and 20% fuel oil in 2020 might still be able to break even. But these are the sorts of refineries that currently rely heavily on fuel oil exports, demand for which is set to drastically shrink. Consequently, clean products need to rise to a larger premium to dirty products than the $40 per barrel spread implied by 2020 diesel and fuel oil cracks. This also means that prices need to start doing the work today to start pushing simple refining, and price-sensitive clean product demand, out of the market.
Market difficulties may be compounded by decelerating Russian fuel oil yield declines. We expect Russian fuel oil output to fall by under 60 thousand b/d y/y in 2018, vs 0.1 mb/d in 2017 and over 0.24 mb/d in 2016, largely due to delayed upgrades at several Rosneft plants. Russian fuel oil output will fall to a record low below 0.75 mb/d in some months this year, but not before the end of the summer.
The slow pace of refinery upgrades in Russia means that big shifts in Russian refinery activity are on the horizon with the new IMO bunker rules. Some 1.5 mb/d of Russia’s widely scattered refining capacity is obsolete, according to the Russian energy ministry, suggesting that some rationalisation will be required. But this will not be easy to achieve. Some of the least efficient Russian refineries are big gasoline producers for the Moscow region. Others are major employers in deprived regions.
Even if runs went to zero at the most vulnerable plants that are minor producers of clean oil products, Russian fuel oil output would fall by only 0.2 mb/d (about 25%). Runs would plunge by more than 0.8 mb/d. Upgrades due online over the next 18 months should cut fuel oil output by 0.1 mb/d, but this is well short of the cuts needed by H2 19.
Some help may come if Russia boosts domestic demand. Higher domestic natural gas prices could make fuel oil more competitive as a fuel for power generation and other applications, but if this does not happen, there is unlikely to be a way to get fuel oil to be cheap enough to sustain demand while providing an acceptable return to Russian refiners.
In the meantime, Singapore stocks are high and demand-side news has hardly been supportive. South Korea’s surprising return to the spot market has been offset by rising nuclear power output in Japan and high supply into Asia from the Atlantic basin and the Middle East. Inflows from the West and the Middle East need to decline for this market to perform, but that does not look likely. Renewed Pakistani demand will help at the margins, as will a new 76 thousand b/d RFCC at S-Oil’s Onsan refinery in Q2 18, but our balances are still set to weaken from here.