Viewpoint: Cracks, regulation to drive European VGO

The European vacuum gasoil (VGO) market will continue to be at the mercy of volatile product margins in 2019, exacerbated by the largest regulatory shake up in the oil market for a generation.

Record highs and lows in gasoline and middle-distillate refining margins had a significant effect on VGO demand in 2018, and will continue to do so this year.

Low-sulphur VGO, used primarily as a fluid catalytic cracker (FCC) feedstock, is usually at a premium to high-sulphur VGO, which is a hydrocracker feedstock for middle-distillates. However, this structure flipped in early December — a rare situation — and sulphur spreads are likely to remain narrow in the short term, as weak gasoline margins continue into early 2019.

Refineries able to ramp up diesel production relative to gasoline — such as those in Europe at the end of 2018 — will continue to support VGO demand at the start of 2019, because of healthy overall margins.

The opposite is true of refineries that typically seek to maximise gasoline output, such as those in the US. FCC margins declined on the US Gulf, resulting in run cuts at the end of 2018. Transatlantic arbitrage to the US, which is structurally short VGO and a regular buyer of European product, was almost non-existent for much of October and November.

Flows to the US will remain weak as long as gasoline margins are poor, but refineries will need to restock regardless. Having run down stocks at the end of 2018 — as is typical for the end of the US tax year — refiners will start buying European VGO again in January.

A relatively wide spread between Ice Brent and WTI crude futures is likely to put pressure on transatlantic arbitrage economics for European VGO in early 2019, as it did in late 2018. Brent crude's premium to WTI averaged around $9.60/bl in the fourth quarter of 2018 to date, the highest since the same period in 2013.

Exports from Europe were increasingly expensive at the end of last year, because European VGO is priced against Brent and US product off WTI. Brent-WTI spreads have been trending higher since 2016, so are likely to restrict flows again in 2019.

Freight rates look likely to maintain recent highs into 2019, which will continue to drive tightness in northwest Europe and in the Mediterranean region.

With lighter maintenance schedules in 2019, more Russian VGO is likely to reach Europe this year. But VGO exports are unlikely to rebound fully, as refineries continue to drive higher crude utilisation rates through upgrades and additional conversion units, skewing product yields away from VGO and fuel oil.

The International Maritime Organisation (IMO) 0.5pc sulphur cap on ship emissions will tighten VGO availability further. Refineries and blenders are likely to start producing new low-sulphur shipping fuels from the second quarter of 2019, ahead of the deadline in January 2020, with a significant impact on feedstock demand.

Middle distillates and gasoline will have to compete with low-sulphur shipping fuel for VGO feedstock. The IEA expects a market of around 1mn b/d of new low-sulphur bunker blends to develop, as around 30pc of the 3.2mn b/d high sulphur fuel oil bunker market switches to fuels with a maximum sulphur content of 0.5pc. Although blends have yet to be standardised by the industry, VGO is likely to make up a substantial part of any IMO-compliant fuel, affecting blending demand across products.

Argus' 0.5pc sulphur northwest European fuel oil calculated assessment, launched in November 2018, comprises low-sulphur gasoil, low-sulphur VGO and high-sulphur RMG fuel oil in a ratio of 5:3:1. VGO can also make marine gasoil — for which demand is likely to increase — although such product is likely to remain expensive relative to 0.5pc sulphur fuel oil blends.

Complex pricing decisions will determine how much VGO diverts away from gasoline and diesel production toward production of IMO-compliant bunker fuel. Regardless, VGO markets will only tighten in the medium to long term, providing price support.