New worries arise about foreign ULSD supply, logistics for U.S. market

Diesel Fuel News, July 21, 2003 by Jack Peckham

In a new report, Wall Street financial analyst Fitch Ratings raises concerns about whether major foreign refiners supplying the U.S. -- especially Petroleos de Venezuela SA (PDVSA) -- will meet investment deadlines for ultra-low sulfur diesel (ULSD) and low-sulfur gasoline.

The report, "What a Smell of Sulfur," points out that U.S. EPA compliance deadlines for low-sulfur gasoline (between 2004-2008) and ULSD (between 2006-20 10) will cost refiners billions, with some refiners better able to handle capital requirements than others. Fitch's analysis of a sampling of large/small refiners reflects this wide range of risk - and it doesn't even include the upcoming costs of ULSD for non-road diesel.

Because of such high investment costs and recent political turmoil in Venezuela, "we believe that there will be a sizable reduction in imports [to the U.S.], reducing the competition for domestic producers, particularly those competing for Northeast markets," explains Fitch Ratings director Bryan Caviness.

Venezuela's political chaos - including massive strikes, firings of the most experienced PDVSA personnel, and socialist-type economic/political policies pursued by President Hugo Chavez - accounts for most investor worries, even though Venezuela has managed to continue meeting its foreign debt obligations over the past year. This has come at the cost of severe financial controls on the non-oil private sector, massive economic contraction, and widespread opposition to the Chavez regime.

According to the latest Fitch risk analysis, Chavez is likely to delay a scheduled mid-term referendum on his presidency next month, pushing it back until at least the first quarter of 2004 - if ever. This could exacerbate political turmoil in Venezuela and further degrade investor confidence, with a side effect that ULSD and low-sulfur gasoline capacity projects - aimed at the U.S. market - could suffer further delays.

A flip-side risk could come if the current, Chavez-appointed PDVSA personnel go on strike if Chavez is overthrown - presumably out of fear of losing their jobs to the old PDVSA employees.

Over 36% of U.S. diesel imports come from PDVSA refineries when including PDVSA's 50% "Hovensa" joint-venture refinery (with Hess) in Virgin Islands. Canada accounts for 41% of U.S. diesel imports and Russia, 7.6%. No other single country accounts for even 1% of U.S. diesel imports.

Even though PDVSA is meeting current debt obligations, it's the future that worries Fitch. "It's more the political situation - it's a big concern," Caviness told us in an interview. "Refining investment in Venezuela is at greatest risk," compared to upstream investment in oil & gas, he added.

These risk problems "trickle down" to PDVSA-affiliated companies including Citgo and Hovensa, he added.

As for Citgo, "we have a very negative rating on them despite very strong financials," he said. This is due to the political turmoil in Venezuela and the relatively large ULSD investment hurdle for Citgo, which runs hard-to-desulfurize heavy/sour crude (see chart, above).

As for Hovensa, "we have a different view," Caviness explains. "They have strong support from Hess [as] they're effectively driving the boat," while PDVSA is still paying off a "sizable note" for the refining joint venture, he said. Still, if this refinery should slip somewhat on meeting EPA's mid-2006 ULSD deadline, "they can buy [sulfur] credits" and still stay in the U.S. diesel game, he added.

While some of these refiners face special difficulties, it's also notable that "most major integrated oil companies have not disclosed their anticipated investments" in ULSD, the Fitch report points

Refinery size, crude slate and location are three key competitive factors for these investments. What's more, some refiners will be forced by turnaround schedules to make early desulfurization investment without market compensation.

Others, like Sunoco, can minimize ULSD investment due to heavy dependence on light-sweet crudes, primarily from Nigeria. While heavy-sour refiners face much higher capex for ULSD, they also enjoy hefty discounts on crude. "Looking forward, Fitch expects the sweet-sour and light-heavy spreads to widen over the next several years" as new oil finds "tend be heavier and sourer" and also because of under-investment in heavy-sour conversion capacity.

While EPA's 2006 ULSD rules might turn the home-heating-oil Northeast states into a "dumping ground" for cheap high-sulfur diesel, upcoming EPA sulfur reduction mandates on non-road diesel would tend to dampen such a trend, the report found.

Refiner engineering & construction (E&C) capacity for desulfurization projects could be hurt by seemingly unrelated issues, such as the asbestos lawsuits pending against Halliburton, the report points out.

"Given the size and scope of the investments, schedules will invariably slip and may result in delays beyond the deadlines," the report finds.

What's more, "the reduction in diesel sulfur is much more extreme than gasoline, increasing the probability of downgrading diesel batches to off-road specifications," which could lead to further compliance delays, it says.