Europe/U.S. diesel desulfurization mandates could trigger 'critical moments' in 2006 supply

Diesel Fuel News, April 1, 2002 by Jack Peckham

San Antonio - Regulations in Europe and North America requiring diesel fuel desulfurization by 2005 and 2006 could trigger critical supply problems in the U.S. due to insufficient diesel desulfurization capacity."

"Europe and to a lesser extent the U.S. are undersupplied in gasoil, and this situation will peak in 2005-6," contends Paris-based Marc Seris, chief downstream economist at Petroleum Finance Company (PFC), in a presentation to National Petrochemical & Refiners Association meeting here.

"Afterwards, extra capacity - perhaps even some hy-drocracking in larger refining centers - absorbs part of the excess demand. But the U.S. could face critical moments in 2006 if there is insufficient diesel desulfurization capacity," Seris warns.

The growing shortage of diesel fuel in Europe means that gasoil margin spreads to Brent crude "will remain higher over this decade," although "fuel oil margins will decline progressively until 2007, and then rebound as inland fuel oil specs go to 1%" sulfur in 2003, he said. If crude prices weaken, then fuel oil spreads improve, and vice-versa. "Diesel is a potential problem on both sides of the Atlantic, as Europe is currently short of ULSD capacity, and the UK and Germany are absorbing all initial production capacity," Seris warns.

"As ULSD specs set in Europe are much sooner than in the U.S., this gives a chance for Europe to build significant desulfurization capacity before 2006, when U.S. specs are phased in.

"Sufficient ULSD and gasoil price spreads to high-sulfur fuel oil could sustain hydrocracking economics in some large European refining centers (ARA, Rhine, Seine, France-Mediterranean and Italy) where vacuum gasoil can be transported over short distances. This may be necessary to avoid severe shortness for U.S. in 2006, if too many refiners decide to go for the gasoil option instead of ULSD," he said.

Unlike some forecasters who see never-ending growth in European vehicle fleet dieselization, Seris believes that the diesel growth curve will flatten after 2005.

"The main driver [to dieselization] has been differences in taxes in several EU countries, such as France," Seris said. "In 1998, there was ample talk of harmonizing taxes on diesel and gasoline, but crude price hikes killed these initiatives. If a sustained period of lower crude oil prices persisted, increasing taxes on diesel would be back on the agenda.

"However, the very high rate of diesel car sales has created a strong lobby against change in current legislation. Harmonization [on diesel/gasoline tax rates] won't begin before at minimum 2003-04, with only delayed effects on demand."

As for refiner responses to ultra-low sulfur diesel (ULSD) mandates, most Northwest Europe (NWE) countries already have tax incentives spurring early ULSD production, he pointed out.

Germany is moving to a 10-ppm ULSD next year "and will likely be followed by Benelux [Belgium, Netherlands, Luxembourg] and other NWE countries by 2004 or 2005," he said. "At the same time, some Mediterranean countries may require derogations to delay the introduction of 50-ppm sulfur ULSD until 2006 or 2007."

Meantime, the EU is also mulling a cut in heating-gasoil sulfur to 1,000 ppm by 2009, new sulfur limits on marine-gasoil, and a 1.5% sulfur limit on bunker fuel (to be introduced in NWE in 2003). Eventually, jet fuel is likely to be hit by Euro desulfurization mandates as well.

As a result, "taking the 2,000-ppm sulfur quality as a base, the average cost of diesel desulfurization will increase from U.S. 80 cents/barrel in 2000 to around $2/barrel in 2010," he said.

"Convergence [to ULSD in Europe] will be slow, with NWE leading the pack and Mediterranean refiners trailing behind," especially on the 10-ppm ULSD limit, he said.

Desulfurization technology advances combined with Euro tax breaks mean that ULSD production costs are "far lower than was initially projected," he said.

"In markets where significant tax breaks are implemented; most refiners will find it advantageous to invest in quality, but not capacity. The example is the whole of NWE. The main limit on investment will be that several markets --Mediterranean and to a lesser extent, France -- will not introduce severe quality limits soon."

Retarding ULSD output among Mediterranean refiners is a crude slate much more sour, and average desulfurization capacity less than that of NWE refiners.

For Euro refiners generally, higher diesel profitability can be realized for 10-ppm ULSD versus 50-ppm ULSD until about 2007.

Although 10 ppm ULSD isn't compulsory (but rather it must be "available" starting in 2005), "the refining industry is almost certainly going to impose it as a standard rather than running both 50 ppm and 10 ppm simultaneously in the same market," he said. "As soon as a market will start to fiscally incentivize 10-ppm ULSD, the market will directly converge to this more severe spec."

Meantime, cracking margins in Europe "will remain lastingly higher for diesel than for gasoline" through the decade.