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IMO 2020 – THE NEW MARINE FUELS ERA

National Oil Recyclers Association (NORA)

November 9, 2018

Tom [email protected]

mailto:[email protected]

2www.modernfuels.com

IMO and IMO 2020

High and Low Sulfur Demand Volume Shift

Refiners and Ship Owners – Supply and Demand

Blending

Product Quality

Product and Feedstock Values

IMO 2020 for Used Lubricating Oil Industry

Summary Conclusions

IMO 2020 – A new era in Marine FuelsUnprecedented level of Scale and Resolution Uncertainty amidst a Timeframe certainty


Who belongs to the International Maritime Organization (IMO)?Virtually every major developed country in the world is a member of the IMO

International Maritime Organization (IMO) is comprised of 173 signatory states (green) representing 97% of worldwide bunker fuel demand

IMO has regulatory authority for the marine industry for all signatory states

IMO’s MARPOL (Marine Pollution) Annex VI regulations set forth a series of sulfur reduction mandates for marine fuels which started in 2005

Source: British Petroleum


January 1, 2015 - Emission Control Areas (ECA) limit marine fuel sulfur to maximum of 0.1% within 200 miles of certain coastlines

October 27, 2016 - Marine fuels outside ECA limited to maximum 0.5% effective on 1/1/2020 (“IMO 2020”). Thus global 0.5% sulfur cap starts.

IMO 2020 will become effective in approximately 14 months

IMO 2020 – What is it?Decrease in Global Marine Fuels Sulfur Cap from 3.5% to 0.5% takes effect on Jan 1, 2020

0.1% 0.5%

Source: International Maritime Organization


Why is IMO 2020 so important? Global shipping is a huge source of air pollution. IMO 2020 drastically reduces emissions

Reducing air pollution from marine fuels is a major true needMarine fuels are 7% of transport demand yet they make up 90% of transport SOx emissions15 of the largest ships emit more SOx and NOx than all the world’s cars combined1 cruise ship emits particulates equivalent to 1 million cars

High Sulfur Fuel Oil (HSFO) is also very high in Greenhouse Gas (GHG) emissions HSFO 3.5% fuel sulfur content is 2,300 to 3,500 times that of on-road car and truck fuel

Source: The IMO 2020: Global Shipping’s Blue Sky MomentGoldman Sachs Equity Research, May 30. 2018


Refiners produce Supply / Shippers generate DemandSupply and Demand imbalances cause price instability

SUPPLY - Refiners ProduceLighterGasolineJet (Kero)Diesel

HeavierVacuum Gas Oils (VGO)

VGO makes gasoline, diesel, jet (kero) in FCC units (Catalytic Crackers). VGO makes base stock too

HeaviestVacuum Tower Bottoms (VTB) VTB (aka Vacuum Residuum) are made into HSFO, Asphalt, and are also feedstock to Cokers, Visbreakers, or Solvent De-asphalters

DEMAND - Shippers Burn

High growth fuelMarine Gas Oil (MGO)

< 0.1% Sulfur (ideally)

Post IMO 2020 fuelLow Sulfur Fuel Oil (LSFO)

< 0.5% Sulfur

Phasing out fuelHigh Sulfur Fuel Oil (HSFO)

< 3.5% Sulfur

HSFO (made from VTB) is the only refined product priced belowthe cost of the crude oil (feedstock)

Refineries with FCC and coker units (aka “conversion units”) have higher complexity


IMO 2020 creates a massive demand shift between productsHSFO is replaced by (MGO) Distillates and LSFO while total demand is increasing rapidly

A. High Sulfur Fuel Oil (HSFO) - down ~2.5 mm bpdB. Distillate Direct - up 0.2 mm bpdC. Distillate Blending - up 1.4 mm bpdD. Low Sulfur Fuel Oil (LSFO) - up ~1.0 mm bpd

B

AC

D Post 2020 HSFO volume should increase as new scrubbers are added

Other names for HSFO include IFO 380, Bunker C, No. 6 Fuel Oil (Resid)

= LSFO

HSFO =


Potential Future HSFO Outlets for up to 2.5 mm bpd“Wanted: Home for large amounts of HSFO – Please respond asap”

Blend HSFO with low sulfur streams – what is blending limit without breaking 0.5% cap?

Off-shore power generation – how much can be absorbed by a currently served market?

Asphalt – how much HSFO can asphalt market absorb? Asphalt market is seasonal (North)

Storage – store HSFO until more scrubbers come on-line

Any other ideas???

Currently markets for excess HSFO do not existIn the markets we trust ….worst case is HSFO competes with coal (BTU basis)Who will make the products that replace the HSFO?

Refiners will make enough MGO and LSFO to meet demand


SUPPLY SIDE - Refiners’ options Multiple options – for complex refiners the “Do Nothing” option looks attractive

Change to sweeter crude slateLess sulfur in, less sulfur out, so sell more marine fuel, but limited supply

Reduce volume to Conversion Units and make less gasoline and diesel in order tosell VGO or Straight Run products as marine fuel blend stock

Shift yields in the Conversion Units to produce more middle distillatessacrificing gasoline and diesel to make additional lower sulfur fuels

Add Resid Upgrader (coker, visbreaker, solvent de-asphalter)Huge $1 billion+ investment and 5 years to implement - how long will spreads last?

OR

Do nothing - Complex refiners well positioned when crack spreads increase- Simple refiners making high yields of HSFO are vulnerable

Most refiners taking wait-and-see position


DEMAND SIDE - Ship owners’ options Scrubbers are being added by shippers, and LNG and slow steaming are 2 additional options

Ships with scrubbers can burn HSFO. Scrubbers have high potential ROI’s based on wide forecasted spreads between MGO/LSFO and HSFO

There are only ~1,152 ships which have scrubbers installed or on order, of the 50,000+ ships worldwide

Why so few? 1. Terminals have limited tankage, most HSFO tanks will be re-purposed to LSFO

Questions of future HSFO availability and price (particularly in smaller ports)?2. Flip side - more scrubbers create more HSFO demand, reducing scrubber ROI3. Regulatory Risk – closed loop/open loop, NOx, GHGs (waste water ballast history)

LNG has very limited adoption rate (mostly new builds). Retro-fitting is expensive and there are limited ports able to supply LNG

Many ships are already slow steaming, so further fuel efficiency gains are limitedShip owners mostly playing wait-and-see, despite foreseeing billions in higher fuel costs soon


Certainty: IMO will NOT delay 1/1/2020 effective date on 0.5% sulfur cap (Trump’s EBP rebuffed)

Refiners waiting: waiting on long term LSFO demand and long term LSFO to HSFO spreads

Ship owners waiting: waiting to see where HSFO supply and price spreads settle before investing

November 2018 situation still “chicken and egg”. Long term options prior to 2020 disappearing

THE QUESTION: Where will the MGO and LSFO supply come from?

THE ANSWER: Blending of lo and hi sulfur blend stocks

What blendstocks can cover a roughly 2+ million bpd demand-supply shortfall of compliant fuels?

Answer = Distillates and Intermediates…

Big Picture – Distillates and MGO will substantially replace HSFO2.5 mm bpd less HSFO will need at least equivalent replacement of MGO and LSFO


Some Fuel Blend StreamsEnd products and Intermediate products – but price, availability, and sulfur vary widely

Each option has different implications for quality and value


2 Component Blend Example: 1 low S component (like MGO) + 1 high S component (like HSFO)

Worldwide average sulfur content of HSFO is about 2.7% (= 27,000 ppm). IMO 2020 spec is 0.5%

Sulfur blend (linear): (% of low S X low S ppm) + (% of high S X high S ppm) = S%( 88% x 2000 ppm ) + ( 12% x 27,000 ppm ) = 5000 ppm = 0.5%

Note: blend ratio in above example is a 7.3:1 ratio of low S to high S blend components

The less S in the high S component, the less low S component is needed to blend and hit the 0.5%

The more low S component in the blend, the higher the final blended product’s cost will be

Total bunker demand of 3.8 mm bpd and an average blend ratio of 7.3:1 would resultin demand of 0.5mm bpd for HSFO and 3.3mm bpd for low sulfur blend stock

Sulfur Blending 101Core quality and economic elements of sulfur blending (S = sulfur)


2 LSFO blend examples: HSFO with MGO, HSFO with LS VGOIn high blend ratios cost is largely driven by the cost of the low sulfur component

MGO to HSFO blend ratio is 5.5x

LS VGO to HSFO blend ratio is 7.3x

LSFO blend margins on each

- $71.54 loss on MGO blend+ $91.83 profit on LS VGO blend

Logical outcome of above blends…

MGO is sold “neat” (not blended)

LS VGO shifted to making marinefuels. Thus less VGO makes gasoline, diesel, jet (kero), or base stocks

Market will use lowest cost, low S blend stock first, then the next lowest cost and so on

Sulfur Target = 5,000 ppm

Blend Components Price / MT Sulfur (PPM) % of blend Sulfur in blend Product CostMGO $735.00 1,000 84.62% 846 $621.92

IFO 380 $451.50 27,000 15.38% 4,154 $69.46spread => $283.50 100.0% 5,000 $691.38

MGO Blend Ratio 5.5xBlended Product Cost / MGO Price 94%

Sulfur Target = 5,000 ppmLS VGO Premium to WTI ($/bbl) $13.50

Blend Components Price / MT Sulfur (PPM) % of blend Sulfur in blend Product CostLS VGO $538.45 2,000 88.00% 1,760 $473.83IFO 380 $451.50 27,000 12.00% 3,240 $54.18

spread => $86.95 100.0% 5,000 $528.01

LSVGO Blend Ratio 7.3xBlended Product Cost / LS VGO Price 98%

MGO Blend LS VGO BlendLSFO Price $619.84 $619.84 Price MGO $735.00

Blend Cost $691.38 $528.01 LSFO/MGO % 84.33% <== Key AssumptionGross Contribution -$71.54 $91.83 Calculated LSFO Price $619.84

Option 1: Blend HSFO with MGO

Option 2: Blend HSFO with LS VGO

LSFO Pricing Calculation

MGO blend leads to ~$31 billion higher annual marine fuel cost, but LS VGO blend leads to ~$10 billion higher annual marine fuel cost

Calculation = ((Product cost to IFO 380 price) / 7 bbls/MT) x 2.5 mm bpd x 365 days/year}


The October 2018 Houston Lo to Hi sulfur spread is $275 (ShipandBunker 11/1/2018)

Q1 2020 average forecasted Lo to Hi sulfur spread is $440 (Argus Marine Fuels Outlook 10/2018)

Forecasted increase in the Lo to Hi sulfur spread is $165, an increase of 60%!

Forecast for High Sulfur to Low Sulfur Spread ($ / metric ton)Massive increase in forecasted price spreads between low sulfur and high sulfur fuel oils.

Forecasted higher sulfur to low sulfur discount is worldwide - Europe, Asia, US, and Middle East

Source: Argus Marine Fuels Outlook, Oct. 2018

Source: Argus Marine Fuels Outlook, Oct. 2018


Scale of the IMO 2020 Sea Change – Magnitudes MatterMarket Size – Comparison of product demand to total worldwide Used Lube Oil collected

Used lube oil (uniquely) can be processed into high quality base oil, distillate (MGO), or LSFO

Used lube oil volume is very small: about ½ total base oil, 1/3rd distillate increase, and 1/5th LSFO market

But to sell a new product into the Marine Fuels market, product quality will be a MAJOR factor to market acceptance

(1) 0.2 mm bpd direct and 1.4 mm bpd through blending into HSFO

-

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

Used Lube Oil G-I/II/III Base Oil Distillate INCREASE (1) LSFO Post 2020Forecast

HSFO Today HSFO Post 2020Forecast

Comparing Global Market Volumes (mm bpd)(mm bpd)

Sources: LubesNGreases 2018 Guide to Base Oil RefiningS&P Global Analytics


Contamination - major focus since widely diverse LSFO blend stocks will flood into market worldwideHouston Summer 2018 Most likely 1 contaminated load affected ~200 ships

Gresham’s Law – bad drives out goodBad load propagated ship-to-ship: Houston => Panama => SingaporeLasting repercussions – who is at fault? who pays? how to detect?Bad load passed ISO-8217 specifications - detection required GC analysis A LSFO specification is currently in development

Compatibility - in blending a rule of thumb is: “like likes like”HSFO (residual) and MGO (distillates) very different, HSFO high in asphaltenesAre blend fuels (oxidatively) stable or do they form sludge? Increased sludge formation (asphaltenes/oxidation)=>clogged filters and fuel pumps

Tank Segregation Terminals currently only need HSFO and MGO tanks, so just 2 tanksIMO 2020 demands LSFO tank + blend stock tanks – but do they all mix? Major tank constraint => selective sourcing – no contaminated or incompatible fuels!

Product Quality – Equally important to price and availabilityContamination and Compatability, How to store all the blend stocks?

Fuel compatibility tests must be physical. Currently no other reliable test method exists


1 Year Look Back ValuesLook for applicable and stable relationships

Group III far above all others. Group I and II at parity. MGO now trading above Group I and II. LSFO (synthetic 7:1 blend) at parity with Group I/II. Brent correlates well with MGO (2 dotted lines). HSFO and Used Oil are lowest values.

Sources: Argus Marine Fuels Outlook, Ship & Bunker, EIA

$0.80$0.90$1.00$1.10$1.20$1.30$1.40$1.50$1.60$1.70$1.80$1.90$2.00$2.10$2.20$2.30$2.40$2.50$2.60$2.70$2.80$2.90$3.00$3.10$3.20

Products and Feedstocks Look Back Values

Group III (4&6 cSt)

Group II (100&220)

Group I (150)

MGO

LSFO (7:1 synthetic blend)

Brent

WTI

HSFO

Used Oil (discount to HSFO)


MGO, LSFO, and HSFO - 2 Year Look Forward Value ForecastHSFO forecasted to de-couple from WTI and Brent

MGO forecasted to increase by ~9%, but HSFO expected to drop by 64%

Base stocks, Brent, WTI, and Used Oil (now discounted to Brent) all held constant to isolate IMO 2020’s effect on MGO, LSFO, and HSFO values

Source: Argus Marine Fuels Outlook – October 2018

$0.35$0.45$0.55$0.65$0.75$0.85$0.95$1.05$1.15$1.25$1.35$1.45$1.55$1.65$1.75$1.85$1.95$2.05$2.15$2.25$2.35$2.45$2.55$2.65$2.75$2.85$2.95$3.05

1 Year Avg. Q1 2019 Q2 2019 Q3 2019 Q4 2019 Q1 2020 Q2 2020 Q3 2020 Q4 2020

2 Year Forecasted IMO Effects on MGO, LSFO (synthetic), and HSFO Values

Group III (4&6 cSt)

Group II/I (100&220/150)

MGO

LSFO (7:1 synthetic blend)

Brent

WTI

Used Oil (discount to Brent)

HSFO (aka IFO 380)


Index selection considerations1. Representative - appropriate index that is reflective of market disruption2. Simple - easily understood and implemented3. Trustworthy - price reporting service trusted by buyer and seller

Evaluate alternative indexes - Pros & Cons

Used Oil Price Index OptionsValue and Acceptance, Trust and Timeliness are key considerations

A potential basket of MGO and Brent might optimally link demand and supply with market shifts over time

Index Pros ConsGroup III better value very limited marketGroup II/I high base stock volumes limited buying market

MGO transparent values adjustment for distance excellent correlation for inland vs. coastal

HSFO none drastic decline in valueBrent stable and good linkage not "perfect" tie to fuelWTI does move with fuels brent better crude choice

Indexing Options & Considerations


Re-refinersMake base oils, VTAE, and naphtha Process using distillation and hydrotreating or solvent extractionSource used oil either through third parties or through captive gathering

Distillers Make VGO (cat crackers), marine fuels (blend stock), VTAE, and naphthaProcess using distillation (without further processing) Source used oil either through third parties or through captive gathering

Gatherers Typically make a de-ashed, de-watered product sold as Recycled Fuel Oil (RFO)

Source used oil from generators and sell to re-refiners, distillers, aggregator/blenders, or asphalt and industrial burner customers

IMO 2020 will affect each segment differently. Thus each segment will have different strategic interests and options

Used Oil Industry by Business SegmentRe-refiners, Distillers, and Used Oil Gatherers


1. HSFO demand drop for ULO from marine fuels market, so more available at lower pricesGood for re-refiners and distillers but not for gatherers

2. New distillation plants constructed to make MGO and LSFO, leading to more ULO demandGood for gatherers, but not for distillers or re-refiners

3. Industry consolidation and more integration at the gathering levelIncreased asset price for sellers and increased competitive pressure on non-sellers

4. VGO switches to marine fuels, leading to base oil volume decreases and price increasesGood for re-refiners, particularly those making higher end base oils (group III)

Potential IMO 2020 Impacts by Used Oil Business SegmentVaries by Company: Integrated or not, Geography, Size, Competitors, Markets/Technology

Potential impacts below assume crude oil price generally remains in $60 to $80 range


Re-refiner Wait-and-see, as feedstock costs drop profits expected to riseDe-bottleneckOpportunistic backward integration/market share pickupGroup III?

Distiller Wait-and-see, as feedstock costs drop profits expected to riseDe-bottleneckOpportunistic backward integration/market share pickupGroup III? (with or without hydro-treating)

Gatherer Sell ULO into marine fuels market (MGO and LSFO) using appropriate indexes (NOT HSFO)Forward integrate into plants to lock in “forever” off-take (but get help!)Exit via sale of business? (timing and value)

IMO 2020 Strategies for Used Oil Players by Business SegmentVaries by Company: Integrated or not, Geography, Size, Competitors, Markets/Technology


Summary ConclusionsSea change ahead and not very far away

IMO 2020 will take effect on January 1, 2020, less than 14 months from now

Huge and rapid demand shift from HSFO (resid) to MGO/LSFO (distillates and blends)

HSFO value decreasing dramatically, but MGO and LSFO values rising more slightly

How are you positioned now with respect to IMO 2020 driven market changes?

Selling (or buying) volumes and values? Where are the opportunities?

Index smart –what index best fits your desired end values in light of upcoming changes?

Uncertainty and opportunity are just two sides of the same coin

If the uncertainty of navigating this sea change ahead makes you uncomfortable, know you are not alone. Many, many large companies feel exactly like you do!


APPENDICES


Current and Future Emission Control Areas (ECA)Mediterranean Sea, Mexico, China, Japan, Australia potential future ECA


Can the January 1, 2020 IMO 2020 date be Trumped?IMO vs. Trump Administration’s desire to delay 1/1/2020 due to lack of LSFO – who wins?

Oct. 19, 2018 Trump seeks Experience Building Phase (EBP) delaying IMO 2020 start date to assess how low sulfur fuel oil demand can be met (subtext: election year fuel price increases will create headwind to Trump re-election campaign)

Oct. 24, 2018 IMO (MEPC 73) categorically states there will be NO delay in January 1, 2020 implementation date (IMO has been firm on date since October 2016)

Oct. 26, 2018 IMO ups ante and further approves carriage ban barring ships without scrubbers from carrying non-compliant fuels starting March 1st, 2020

Oct. 26, 2018 IMO (MEPC 73) sets GHG emissions target reduction of 50% by 2050 (mid-term measures proposed for implementing in 2023 to 2030 timeframe)

American Petroleum Institute (API) and American Fuel and Petrochemical Manufacturers (AFPM) each support IMO’s staying firm on date - “don’t move the goal posts”

Unusually strong alignment between environmentalists and Big Oil!


Can refiners switch crude slates to low sulfur crude oil?Key problems: Optional product value? How much is available?

Only about 25% of all crude oil production is sweet (low sulfur) crude oil

Low sulfur crude optimally used to make more valuable gasoline, jet (kero), diesel

Bottom line: sweet crude supply alone is insufficient to meet future IMO 2020 demand


Bottoms Problem - Pre-2020 HSFO VolumesHSFO current dumping ground for high sulfur, “ugly” streams (bottoms & low value streams)

For our purposes; HSFO = IFO 380 = Bunker C = No. 6 Fuel Oil (sometimes Resid)

Total resid volumes declining, but bunker fuels still exceed 3.5 million bpd

Generally consistent trending but the world is about to change


But a diesel shift of 5% would have increase on diesel prices worldwide

Shift of only 5% from diesel would cover 1.3 m bpd of LSFODiesel is the ultimate fall-back blendstock


Product’s and feedstock’s valueProducts => Group III, II, I base stocks, MGO, LSFO (synthetic ratio 7:1, MGO:HSFO)Feedstocks => Brent, WTI, HSFO*, Used Lube Oil (% of HSFO* or % of Brent)

* Houston pricing from source: Ship and Bunker.

Look back 1 year1. Absolute trading values over past year2. Relative values (spreads) over past year

Look forward 2 years (Q1 2019 through Q4 2020)3. Value changes driven by IMO 2020 – isolate on just HSFO, LSFO and MGO

Index Selection – representative, simple, trustworthy 4. What indexes can meet all the criteria?

Values Look Back and Look Forward, Assessing possible indexes Look back, look forward, products and feedstock values and spreads – holding crude constant


1 Year Look back SpreadsAnalyze spreads for volatility and trends

1. Green line MGO to Used Oil spread wide and growing (Used Oil discounted to HSFO)2. Blue line MGO to Brent more stable (versus MGO to WTI which is trending upwards)3. Dotted black Group 1/II now trading below MGO – very unlikely to persist over time

Sources: Argus Marine Fuels Outlook

-$0.30-$0.20-$0.10$0.00$0.10$0.20$0.30$0.40$0.50$0.60$0.70$0.80$0.90$1.00$1.10$1.20$1.30$1.40

Key Spreads over 12 Month Look Back

MGO less Used Oil

MGO less WTI

MGO less HSFO

MGO Less Brent

Brent less HSFO

Group II/I less MGO


$240 billion in expected increases costs to consumers worldwide

Why is Big Oil behind IMO 2020?70% of the benefit will accrue to complex refiners, buying heavier crude and producing no HSFO

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