Sulfur reduction in marine fuels grabs some attention

Of course, thie observations here aren't discouraging if you happen to be a refiner with a lot of hydrocracking capacity to make diesel.

Economist Philip Verleger has long argued that the spike in crude prices in the spring was essentially crude going along on a very wild ride driven by the diesel market. Diesel, he argued in speeches and writings, was squeezed by a variety of factors, including environmental rules designed to drastically reduce the content of sulfur from much of the diesel consumed in the Western world. Given that the desulfurization process generally leads to reduced output, that trend helped tighten the market.

With tighter sulfur rules on marine diesel and bunker fuel now looming, Verleger sees another crisis in the making.

It's an interesting take. He has plenty of company among forecasters who see the seeds of a future price spike being sown in the decline in non-OPEC production and the slow cutoff of investment in the industry as prices continue to fall (or more recently, get stuck at levels that don't encourage spending on higher-cost projects.) But Verleger's projection is aimed straight at the tighter sulfur rules for shipping.

"The next price surge will almost certainly come with new constrains on maritime oil users," Verleger wrote in his latest weekly report. "Under these new rules, refiners will have to invest in capacity to remove sulfur from atmosphere residual fuel oil and to treat thermally or catalytically cracked residues. Refining experts at the International Energy Agency have repeatedly warned that the investment costs for such modifications will be considerable. They also warn that the engineering and fabrication industries may not have the capacity to supply the necessary processing units in a timely fashion."

Under the agreement, some areas of the world will see a progressive reduction in SOx emissions from ships, with the global sulfur cap reduced initially to 3.5% (from the current 4.5%), effective from January 1, 2012; then progressively to 0.5 %, effective from January 1, 2020, subject to a feasibility review to be completed no later than 2018.

But in several key areas known as Sulfur Emission Control Areas, the limits will be reduced to 1% beginning on July 1, 2010 from the current 1.5%, and further reduced to 0.10%, effective January 1, 2015.

Verleger also refers to the agreement in late January, as yet nonbinding, that would require lower sulfur content in heating oil in the northeast US, where the vast majority of the country's heating oil is consumed. When heating oil prices spike, the lack of a sulfur standard allows the market to benefit from a flood of material from all parts of the world. No boutique fuel here! Just bring it in, no matter what its PPM is. If this agreement among the various states becomes law, some of those high-sulfur imports into the US that can now help get the market through cold snaps will no longer be available.

The Barrel was in a discussion one time when somebody asked why there are no sulfur standards for heating oil. "So Grandma won't freeze," came the response. That may not happen in the new era, but she's likely to be a bit chillier at times.

It was ironic that on the day after the Verleger report was released, Alon USA announced it would not build a planned hydrocracker -- which increases the plant's output of diesel, which can be used in ships -- at its Paramount, California, refinery due to price escalation. The hydrocracker "does not make sense," according to CEO Jeff Morris, who made the comments at the Credit Suisse 2009 Energy Summit.

Based on Verleger's projections, it will make sense down the road. But in this period of capital constraints, those sorts of calculations can't always win the day. (Note that Valero also has delayed construction of a hydrocracker, a decision announced several months ago).

One last note: diesel, relative to crude, spent much of the autumn stronger than it was in the spring, when Verleger says diesel drove the price up. Measuring ultra low sulfur diesel as a percentage of Light Louisiana Sweet (LLS) crude, the spring peak was a little less than 128%, in late May. That ratio climbed as high as 150% just before Christmas, but more recently has sunk below the 120% level, as refiners moved to reduce gasoline output and increase diesel. The fact that diesel did hold and actually increased its strength relative to crude in the fall, when prices were dropping, would tend to argue against diesel being the primary engine of the spring runup. But it also is probably true that the enormous buildup of crude these past few months has negated diesel's ability to pull up the price of crude, even though it had been looking relatively stronger than it was in the first half of the year.