Lesson to be learned from the IMO regulations
When ten years ago I delved into the secrets of global energy markets, crude oil price was called ‘the mother to all prices’. At that time, the predominant feedstocks for the production of electricity were coal and gas, so the price of electricity depended strongly on the prices of these fuels. As coal and gas prices were set in relation to oil prices, the economic viability of nuclear power plants over a period of at least 20 years was also closely linked to future oil price developments.
Through electricity and gas prices and transport fuel prices, the cost of oil purchases influenced inflation, which guided central banks in their decisions on interest rate paths. Financial institutions, in turn, protected themselves against the effects of inflation by trading in oil futures, thus contributing to the development of the ‘paper’ oil market. The oil price and central bank interest rates became the most powerful macroeconomic variables. The interaction between those variables was so strong that discussions developed in the literature on which of the two had a greater impact on global economic activity. While studying the works of Edmund Phelps (2006 Nobel Prize in Economics for research on the role of innovation in economic growth) at that time, I came across a sentence that stuck in my mind: “global energy systems are so complex that interfering with them almost certainly leads to unintended consequences”. A decade has passed since that publication, during which the global energy system has undergone significant changes due to innovation, which had been the subject of Phelps’ studies. Because of revolutionary technologies for extracting natural gas and oil directly from the source rocks and deep-water drilling, concerns about the availability of the resources have given way to concerns about demand. Another contributing factor was the dynamically developing renewable energy sources and innovations improving energy efficiency. Many of those technologies would have never seen light, or would have developed at a much slower rate, if it had not been for climate regulation and the huge financial outlays in this field. All this made global energy systems even more complex and even less predictable.
Take for example the IMO regulation limiting sulphur content in bunker fuel to 0.5%. This seemingly simple and clear intervention in the market of fuels and maritime transport services has so far brought about completely unexpected effects. I have written more about what was expected here, so now let me just present a short reminder. The oil refining process yields many products such as jet fuel, gasoline, diesel oil, and sulphur-rich heavy fuel oil (HSFO). There is a final customer for each of these products. Jet fuel powers aircraft, gasoline and diesel oil are fuels for land transport, and heavy fuel oil used to be purchased mainly for sea transport. Following the introduction of IMO regulations, ships will have to switch to low-sulphur fuel (with sulphur content of less than 0.5%). It was widely expected that demand would shift to fuel of a similar quality as diesel oil, which is used in land transport. Since HSFO has lost its main customer, a surplus of this product appears on the market, driving a decline in its price compared with the price of oil, i.e. the crack margin for HSFO. The emergence of a new customer on the diesel market should lead to an increase in its price in relation to oil price (crack margin on diesel oil). Since around 4% of the global demand in oil and liquid fuels is maritime transport , satisfying the increased demand for diesel oil requires refineries to raise their oil throughputs, because increasing the conversion rate alone would not be enough. The factor that encouraged refiners to invest in increasing the conversion rate and processing volumes was the prospect of higher refining margins to be achieved thanks to a greater share of high-margin fuels (mainly diesel oil and gasolines) in their total output. It was anticipated that the shift in demand towards light products would be followed by a change in the structure of demand for light and heavy crude and an increase in the Brent/Urals differential.
- Today, we know that those expectations failed to materialise, and refining margins in December and January reached the lowest levels in seven years. The reason was very low crack margins on diesel oil, which had fallen short of any projections. However, HSFO fared surprisingly well. We can also explain why the effects of the IMO regulations proved so different from what had been anticipated. The global economy has slowed down. One reason for this is customs wars, which hit international trade hard. As a result, demand for crude oil and liquid fuels is growing more slowly than expected. In 2019, the demand rose by 0.8 million barrels per day (mbd), while projections made in the summer of 2019 had indicated that the growth would be 1.6 mbd.
- At the end of 2019, new refinery capacities were put into operation, geared towards scaling up diesel oil output (through both higher conversion rates and larger processing volumes), and planned with the 1.6 mbd demand growth in mind.
- The surplus HSFO and gasolines, whose production rose because of increased oil processing, were placed on the market in the form of new bunker fuel: very low-sulphur fuel oil (VLSFO), being a mixture of HSFO and vacuum gas oil (VGO), which made it possible to use the surplus products.
- Ships are successfully testing this new, cheaper bunker fuel, and so far it has pushed out demand for diesel oil from the sea transport sector.
- As a result, the effects on the differential for light crudes, with a low sulphur content, and heavy sulphur-rich crudes, are smaller than expected.
To sum up, the results of the IMO regulations are different from what was anticipated because of the collision of the scaled up refinery production, which had been prepared for strong demand, with the currently weak demand, as well as the new bunker fuel (VLSFO), which is displacing diesel oil.
Many of us are wondering whether this situation could not have been foreseen. With hindsight, one could argue that the refiners believed too much in margin growth and they all adapted in the same way. Diesel oil supply has increased, while demand for this fuel has weakened for economic and technological reasons (the emergence of a new blend as bunker fuel). Sadly, that is being wise after the event. And before the event? I will stick to Edmund Phelps' conclusion – interfering with complex systems will almost certainly lead to unintended consequences.