Everybody knows Canada’s energy sector has a big problem: getting bitumen to tidewater in the face of a political climate hostile to both pipelines and inshore tanker traffic. But there’s another environmental issue on the global agenda that could have serious market repercussions for some Canadian players.

In October, the International Marine Organization (IMO), an agency of the UN that regulates global marine shipping, will make a decision on dropping the maximum sulphur limit on fuel used in ocean-going ships from 35,000 to 5,000 parts per million (ppm). The question isn’t whether this drop will happen, but when — in 2020 or 2025.

Throughout much of the world, sulphur specifications for transportation fuels have dropped to very low levels (the limit for Canadian diesel, for example, is just 15 ppm). The fuel that powers most cargo ships, meanwhile — residual fuel oil (RFO) — has always been the exception to that trend. RFO is made of hard-to-refine rejects from refinery processes and contains high levels of carbon, sulphur, nitrogen and metals; sulphur content in RFO can run up to 35,000 ppm. Ships prefer to burn RFO because it’s cheap and has a high energy content. It also generates very large amounts of air pollution.

But to date, the economic arguments in favour of RFO have largely trumped environmental concerns. In 2009 it was estimated that just 16 of the largest ships in the world collectively emit more sulphur than all the world’s cars put together.

In 2008, California set limits on fuel sulphur for ships running in California waters. This kicked off a trend, leading to the IMO setting limits around specific coastal areas called ’emissions control areas’ (ECAs). These limits are now set down as low as 1,000 ppm — which effectively bans RFO in ECAs where diesel is now burned instead. But outside those coastal ECAs the limit has only dropped to 35,000 ppm — and RFO is still the shipping fuel of choice.

Diesel and LNG (liquid natural gas) are the leading candidates for replacement fuels. And this is where Canadian refiners and producers should start worrying. Diesel and LNG (liquid natural gas) are the leading candidates for replacement fuels. And this is where Canadian refiners and producers should start worrying.

So the ECA limits haven’t caused much disruption to shipping or to the crude and petroleum product markets. But the International Marine Organization’s pending new regulation could force most shippers to stop burning RFO by 2020.

Though the IMO has not issued a final recommendation, data suggest that there is enough alternative fuel on the market to permit the switch. Political trends seem to be favouring an earlier introduction of the new RFO regulation.

Diesel and LNG (liquid natural gas) are the leading candidates for replacement fuels. And this is where Canadian refiners and producers should start worrying.

The global shipping industry burns over 3 million barrels per day of RFO. The marine market for RFO has been growing, while the overall market for RFO has been shrinking for years (from 13 million barrels per day in 1989 to 8.5 in 2012). In other words, alternative outlets for this fuel are drying up — and those that do exist will continue to shrink due to environmental pressures.

What we may end up seeing is a spike in diesel prices coupled with a large drop in the price of RFO. That in turn would cause a dramatic widening in the price difference between light crude (which has a low RFO yield) and heavy crude (a high RFO yield).

Refineries that are designed to produce negligible amounts of RFO are “high conversion”; they use units called cokers that extract carbon in the form of ‘petroleum coke’ from those streams that other refiners put to RFO, and then process the intermediate material into useful products. Those refineries do well in a market with a wide price spread between light and heavy crude.

For the Western Canadian oilpatch, the fallout from that price spread is a mixed bag. Bitumen fits the profile of an extra-heavy crude with a lot of sulphur, so it may not receive a strong price. Oilsands upgraders, on the other hand, are high conversion facilities that should thrive as they make their money on that same spread.

McKinsey & Company, one of the world’s premiere management consultants, says in a recent report that they don’t think the change in the shipping fuel standard will have a major impact on crude markets. But they admit they’re at a loss to explain recent very large investments in high conversion operations that seem to be relying on a major shift in the light/heavy crude price spread.

“The advantage for someone with a high conversion project coming on just as differentials widen would be enormous,” says the report.

If that turns out to be true, Eastern Canada refineries — with only one, smallish coker east of Regina — will be at a great disadvantage. But the oilsands upgraders should benefit from a broader light/heavy price spread.

We’re still arguing about how Canada can get more out of its energy sector with a reliable transport link to tidewater. But isn’t it time we started thinking about how to get the most value for the material we already produce, given these risks? Shouldn’t we act now to protect our remaining Eastern refineries? 2020 isn’t very far away.

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