Global Fuel Supply- the far-reaching impact of the sulphur cap Maritime Week Gibraltar • 24-28 June 2019 Global Fuel Supply- the far-reaching impact of the sulphur cap Mark Waddington Channoil Consulting Ltd

What will be covered The refining business Global supply and demand The sulphur challenge for crude oil producers and refiners Why changing crude oil supply cannot be the only answer Scenarios for refiners, bunker blenders and traders Why MGO is likely to fill the gap and what are the issues? Pricing impacts Are refinery economics being inverted?

There is no single type of oil refinery Refinery Type Typical Configuration Capital and Operating Costs Feedstock Costs Product Slate Value Topping Distillation only (gasoil desulphurisation) Lowest per BPD Highest per BPD Hydroskimming As above, plus naphtha reforming Conversion or Complex Refinery As above plus Vacuum distillation, cracking, further naphtha to gasoline conversion Deep Conversion or High Complexity Refinery As above plus , multiple conversion units, deep conversion (coking) base oils etc

Refinery economics vary widely Refinery margins – by refinery type Refining margins – by region

The middle distillate shorts of Europe and the Southern Hemisphere are supplied by the USA, FSE and Middle East Gasoil and diesel trade is dominated by the surplus regions – Middle East, Russia and the USA. Deficit Europe is competed for by these regions. Additional deficits in Africa and Latin America. Europe is the largest importer of diesel. This deficit is expected to increase-but may be changed by the regulatory changes mentioned earlier. Marine gasoil demand will increase post 2020 underpinning refining margins. Current increase in scrubber orders may alter this demand. Source : IEA

Fuel oil demand in the Middle East and Asia is met by Europe, Africa and the FSU Currently, the only significant outlet for high sulphur fuel oil is the ships’ bunker market. This means that inland refiners are limited to running high-priced low sulphur crudes, since it is uneconomic to desulphurise fuel oil. However, the bunkers fuel market is changing and will, in the near future, no longer provide an outlet for high sulphur fuel oil. New legislation reducing sulphur in bunker fuels by 2020 – will this make desulphurisation of fuel oil economic? US refiners produce low grade petroleum coke from fuel oil (coker units) which often has to be exported Straight-run fuel oil can be used as refinery feedstock In addition, substantial quantities of mainly Russian origin fuel oil are being shipped to the Far East. Source : IEA

What crude oils can be used to blend fuel oil in future and how? Crude oils compatible with HSFO Crude oils compatible with VLSFO Crude Oil Vac Res 80% Vac Res + 20% Gasoil 80% Vac Res + 20% 10 ppm Gasoil At Res Gasoil   API Sulphur Tapis 42.7 0.0 0.2 0.1 Eagle Ford 46.6 Azeri Light 34.9 0.3 Bakken 43.3 Cabinda 32.2 Qua Iboe 35.2 0.5 0.4 Troll 34.5 Ekofisk 38.9 0.6 Brent 38.5 1.0 0.8 0.9 Murban 40.5 0.7 2.2 1.9 1.7 1.6 Alaska North Slope 33.0 2.4 2.0 Forties 2.9 2.3 1.8 Oman 31.2 1.4 2.5 Upper Zakum 33.9 4.9 4.0 3.9 3.2 Basra Light 29.7 6.0 5.1 4.8 Kirkuk 34.2 6.1 5.2 4.5 1.5 Cold Lake 19.7 6.6 5.7 5.3 2.1   Crude Oil Vac Res 80% Vac Res + 20% Gasoil 80% Vac Res + 20% 10 ppm Gasoil At Res Gasoil API Sulphur Tapis 42.7 0.0 0.2 0.1 Eagle Ford 46.6 Azeri Light 34.9 0.3 Bakken 43.3 Cabinda 32.2 Qua Iboe 35.2 0.5 0.4 Troll 34.5 Ekofisk 38.9 0.6 Brent 38.5 1.0 0.8 0.9 Murban 40.5 0.7 2.2 1.9 1.7 1.6 Alaska North Slope 33.0 2.4 2.0 Forties 2.9 2.3 1.8 Oman 31.2 1.4 2.5 Upper Zakum 33.9 4.9 4.0 3.9 3.2 Basra Light 29.7 6.0 5.1 4.8 Kirkuk 34.2 6.1 5.2 4.5 1.5 Cold Lake 19.7 6.6 5.7 5.3 2.1

The range of crude oils that can make 0 The range of crude oils that can make 0.5% sulphur fuel oil is extremely narrow Compatible with ULSFO Compatible with HSFO Over 70% of the world’s crude oil supplies can make HSFO without additional low sulphur components. This drops dramatically with a 0.5% sulphur crude slate. The world does not have great flexibility in crude oil production – there is little incremental sweet crude available. US light sweet crude oil production is increasing, but only forecast to grow by ca. 3% of global oil demand – this will only marginally reduce the problem, whilst creating others. Source: ENI / Channoil

Changing crude oil slate creates other problems for refiners It is expensive to remove sulphur from residue – lots of sulphur and long molecules to treat at high temperatures Most refineries are designed to run the abundant middle eastern crude oils Sweeter crude oils are usually lighter, creating constraints in processing, resulting in shortages of other products In any case, there are finite limits to sweet crude oil availability

Refining and shipping industries are not investing fast enough to solve the problem through technology hardware alone IMO specifications require all bunker fuel oils to meet maximum 0.5% sulphur content by 2020 Heavy refinery cuts are difficult and expensive to treat On board scrubbing is coming but not fast enough Will refiners invest to meet these targets or will the industry look to other solutions? LNG as bunker fuel? Marine diesel instead of heavy fuel oil (bunkers) It may already be too late for refiners and shippers to invest to meet 2020 deadline - but they may be waiting to see post 2020 price differentials before making investments

Meeting 0.5% sulphur in 2020 will therefore require a gasoil grade in large quantity Bunker fuel demand is currently principally met by High Sulphur Fuel Oil (HSFO) and Marine Gasoil (MGO) The global supply chain will not be able to substitute all the HSFO directly with Low Sulphur Fuel Oil The 2020 requirements are expected to be met by: 40kt HSFO through scrubbers 30kt non-compliance 50kt VLSFO 80kt MGO This is expected to tighten global gasoil supply Challenges of availability and compatibility

Possible shifts in the value of residue streams We have seen that there is limited availability of crude oils that provide sufficiently low sulphur residue and gasoil components Likely sources of these components and likely price behaviour low sulphur light sweet crude oils such as WTI or Nigerian or Libyan (when available) or Caspian blends. Low sulphur atmospheric residues currently bought by refineries with excess vacuum and cracking capacity. This means that bunker buyers from these refineries are competing with cracking refineries for the product. Hence upgrading refineries that are sourcing low sulphur feedstocks will see their cracking margins reduced. Alternatively, the price to the bunker market will reflect the need to generate light products such as gasoline from upgrading. The option to use hydrocracker bottoms (HCB) as a blend stock would be very attractive to refiners, however the chemical make-up of HCB’s is complex and there is likely to be a greater incidence of unstable fuels arising from this route.

Comparative analysis of fuels in energy terms- Priced in $/million BTU MGO at 123% of Brent ULSFO at 88% of Brent HSFO at 80% of Brent

Comparative analysis of fuels in energy terms- Priced in $/million BTU MGO at 116% of Brent ULSFO at 110% of Brent HSFO at 80% of Brent

Scenarios of product availability We expect a full range of fuels at: ARA, Houston, Singapore Gibraltar, Algeciras, Malta Two suppliers have announced VLSFO for Fujairah. Location may be a disadvantage if Fujairah cannot source MGO competitively. Trampers will have to switch in and out of MGO vs. VLSFO depending on local availability. If MGO is widely available, this may preclude exemptions for lack of VLSFO. This is expected to be the case Source: LQM

Where will the high sulphur residue end up? There will be a hunt for new homes for high sulphur residue. One option is into the power generation plants of the Red Sea, which are forecast to absorb an additional 300kbpd over the next ten years. Having said that, this alone will only absorb 10-15 million tonnes per annum of HSFO. There is much more to deal with. Other than this, HSFO can be expected to find markets where it can substitute for coal in power generation. Even HSFO is clean relative to coal.

Effect on Refineries Refiners could have their economics inverted in the transition to VLSFO production. This will put margin pressure on refineries locked into sour crude But simple hydroskimming refineries who can process sweet crude are having a revival. The differential between MGO, VLSFO and HSFO is expected to widen, as are those between sweet and sour crudes. Making VLSFO will entail running more light crude putting pressure on gasoline margins or running cokers at a higher severity. A number of refineries that have no subsidy may well fail and close.

Effect on storage companies Increased MGO demand will increase demand on Class II tankage. Surplus Class III tankage may not be easily converted to Class II. Smaller bunker installations will need to segregate three grades rather than two. This will impinge on supply costs as cargo sizes will be less. Shipping cost of VLSFO will increase due to locational differences. Fujairah and the Red Sea are typical supply problem areas. Bunker suppliers will have to offer flexible options to help meet demand.

Effect on ship operators MGO is expected to be the short-term solution - availability is assured and ubiquitous. Bunker fuels will vary widely in quality and availability. Sulphur, not viscosity will be the determining factor. Ship operators will need to be ready to assess a variety of options and will need to be flexible in terms of tank allocations and switchover capability. Self-supply for shipping companies could become a realistic opportunity. Hedging and trading skills will need to be gained. Scrubber economics look better as oil prices increase and LSFO/HSFO differentials widen.

Final Thoughts IMO 2020 changes are based on a view that the industry can and must change. No industry or market participant is sitting back and waiting for events to take place. There is a huge amount of innovation in play to provide solutions. Longer-term investment plays will in part be determined by the emerging price scenarios. Price discovery will be critical to find clearing values for refined product. Refining is finding a new role with potentially inverted economics. IMO 2020 may be a much-needed wake-up call for the industry as it learns to face the challenges of decarbonisation. The global oil industry has never been dull!

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