Tier 2 Gasoline Sulfur Credits – To Sell or Not to Sell, That is the Question

By Tom Hogan

Current Sulfur in Gasoline Regulations

The United States EPA has reduced the allowable maximum annual average sulfur content in gasoline twice. The annual average sulfur content maximum was set at 30 ppm (Tier 2) in 2005 for most refiners and importers and at 10 ppm beginning in 2017 for most refiners and importers. Small refiners were allowed higher sulfur content for several additional years in the first program and again will be allowed to produce an annual average higher than 10 ppm (Tier 3) through 2019. The program includes a credit trading feature to allow refiners and importers that produce gasoline below the annual average to generate credits and subsequently sell them to refiners or importers with averages above the annual standard.

Sulfur credits are generated by subtracting the actual sulfur content from the standard (30 ppm before 2017 and 10 ppm in 2017 and beyond for most refiners) and multiplying times the volume of gasoline in gallons. For example, a refiner producing 25,000 B/D of gasoline (a relatively small refinery) at an annual average of 20 ppm sulfur would generate 3,832,500,000 ppm gal sulfur credits versus a 30 ppm standard. Because the sulfur credit numbers could become very large, the industry standard became valuing them in million ppm credit lots. Through much of the program, the information on the sulfur content of gasoline in the U.S. and sulfur credit information was not available and it was not possible to determine the available credits for compliance in subsequent years. However, the price of the gasoline sulfur credits was a pretty good indicator that in the early years of the program there were lots of credits. Prices were generally $25-35 per million gallon sulfur credits. EPA has begun publishing some of the sulfur credit information from the EMTS (EPA Moderated Transaction System). The information tells an interesting story. See Table 1 below for a condensed version of the currently available information.

Historical Perspective

There is a lot to learn in this table. Some observations starting in the columns from left to right include,

  1. The average sulfur content in gasoline is steadily coming down, falling from 30-24 ppm over the past five years. With the introduction of the new 10 ppm standard in 2017, the average sulfur content will need to drop much faster, over 14 ppm in only 3 years.
  2. The gasoline volume for U.S. consumption in the EMTS system is significantly less than the total gasoline consumed in the United States which is generally around 8.7—9.1 million barrels per day. The difference is because California gasoline is excluded since the EPA deems California’s gasoline regulations to be at least equivalent to federal standards. Also, ethanol added downstream of the refinery to conventional gasoline is generally not included in the calculation. Considering these exceptions, the gasoline volume in EMTS reasonably represents the remaining United States gasoline consumption.
  3. Gasoline refiners and importers generated over a trillion sulfur credits in 2015 and 2016. Note that the sulfur credits generated are not equal to the standard less the annual average credits times the total gasoline volume. This is because the number of credits generated is not the “net” credits generated. It is the volume of gasoline produced at less than the standard only. With no prior year credit inventory offset, the net credits in any given year would equal the average sulfur times the total volume. However, with all the prior year sulfur credits available, gasoline producers and importers are able to conserve most current credits for use in the future.
  4. The total credits retired for compliance in 2015 and 2016 which were generated in 2015 and 2016 are quite small, on the order of less than ½ % of the total credits generated. All Tier 2 credits based on the 30 ppm standard will expire after the 2019 compliance period. Therefore, beginning in 2020, essentially all sulfur credits used for compliance will have been generated against a 10 ppm standard.
  5. There are about 3.7 trillion Tier 2 sulfur credits that were generated in 2012-2016 that can be used for compliance in 2017 through 2019.
  6. Finally, the price of sulfur credits began low at around $27 per million credits rising to a high of around $240 per million credits in 2015 before falling to around $130 currently. It is important to note that only refiners and importers can own the credits (unlike RINs). This creates a relatively non-transparent market. There is significant variation from our notional numbers and what might have been paid for any single transaction.

Implications for 2017-2019

Sulfur credits in 2017 and 2019 are interesting because most of the credits used for compliance are likely to be Tier 2 credits, while essentially all of the credits generated will be Tier 3 credits. There are some exceptions for small refiners who can generate Tier 2 credits for use only by other small refiners. The preferential use of the Tier 2 credits for compliance is because they expire in 2020 while the Tier 3 credits will have a five year life.

This will result in refiners and importers satisfying any sulfur average shortfall in 2017-2019 with Tier 2 credits and retaining the credits generated in 2017-2019 (Tier 3) for use in 2020 forward. For example, see Table 2 for actual versus estimated sulfur credits in 2016 and 2017.

Table 2 shows the stark difference in sulfur credit deficits and surpluses as the Tier 3 program kicks in. Under the assumptions, the sulfur deficit grows almost 8 times more than in 2016 while the surplus decreases over 88%. Since the obligated parties would want to retain the Tier 3 credits generated in 2017, the entire deficit is likely to be met with Tier 2 credits. If the average sulfur content and volume of gasoline in 2018 and 2019 is similar to 2016, there will not be enough Tier 2 credits available to satisfy the deficit in 2019. This would require satisfying some of the deficit with the much more valuable Tier 3 credits generated against a 10 ppm standard.

Likely Sulfur Compliance Strategies

One possible strategy is that the industry average sulfur is kept below the 2016 average sulfur. Assuming 122.2 billion gallons of gasoline production per year for 2017-2019, and Tier 2 sulfur credits of 3.7 trillion ppm gallons from 2012-2016, the average annual sulfur deficit that could be met would be about 10 ppm. That would mean that the average sulfur content of the gasoline in 2017-2019 would need to be no more than 20 ppm. In fact, since the sulfur deficit is always more than the average sulfur, the actual average sulfur would need to be less than 20 ppm. In addition, if the gasoline volume produced was more or less than the 2016 production volume that would also increase or decrease the demand for sulfur credits.

The problem with assuming the industry will reduce sulfur content to an average below 20 ppm is that it requires all refiners to act in unison. This is unlikely because the sulfur credit market is not transparent and significant producers’ strategies will disproportionately impact the market. A more likely scenario is that if the cost of prior year inventory is cheaper than the cost of desulfurizing the gasoline to 20 ppm, the sulfur average will not come down until the prior year inventory is depleted or until the prior year inventory cost rose to the cost of incremental desulfurization. In this scenario, the value of Tier 2 sulfur credits is likely to rise as the inventory is depleted in 2018 and 2019. The highest price would be expected in 2019 when it became obvious there were not enough Tier 2 credits available to satisfy the expected sulfur credit deficit.

The primary drivers in the value of Tier 2 sulfur credits will be market transparency, expected to remain limited, plus the incremental cost to desulfurize gasoline below 10 ppm. The difficulty in any industry projection is that each refiner has unique costs for desulfurization. A rational informed market would assess the current need for credits against the availability of Tier 2 credits. If they look like they will be in surplus by the end of 2019, their value will drop, maybe even precipitously. If they look like they are going to be short, they are likely to be close to the value of the Tier 3 credits which might top $1,000 per million gallons. The biggest challenge will be assessing the projected sulfur levels in gasoline for 2018 and 2019.

To Sell or not to Sell Tier 2 Gasoline Sulfur Credits

TM&C is not a trading firm and does not “call” a market. However, there are certain clues on how the Tier 2 sulfur credit price might be impacted. It is unlikely that anyone will use Tier 3 sulfur credits generated from a 10 ppm standard before 2019. If the expected sulfur average for gasoline for 2017-2019 is greater than 20 ppm, it indicates the Tier 2 credits in 2019 will probably be valued close to a Tier 3 sulfur credit. The biggest problem with determining the annual sulfur level is timeliness of the information. The average sulfur level for each year will only be known definitively months after the year is complete.

Another critical factor is, who holds the sulfur credits and who needs them. Over 70% of the refining capacity in the United States is owned by just eleven companies. Assuming these companies generally have enough refining flexibility to meet the sulfur requirements within their systems, they would be able to individually impact the sulfur credit market by either choosing to reduce average sulfur closer to the 10 ppm average in 2017 forward or by choosing to produce gasoline at higher sulfur levels if they have adequate Tier 2 credits to offset any deficit. Again, access to this market intelligence would be very limited.

Finally, each refiner/importer will be making decisions on whether to reduce sulfur or to depend on credits. In a perfect market with ultimate transparency and lots of participants, the price of the Tier 2 credits would reflect the complex interaction between each refiner’s desulfurizing cost and the availability of the Tier 2 credits. Since the sulfur credit market is almost the definition of a non-transparent market, price alone is not likely to be a reliable indicator of the market value over the three years. For instance, it is possible that the price might spike or fall in early 2018 but then fall or increase precipitously in late 2018 or in 2019 as more information is available and the refiners make the economic decision to desulfurize gasoline to lower or higher levels. Therefore, price alone is not a good indicator of where the Tier 2 credit value may be headed. One caveat is that if the Tier 2 credit price comes close to the Tier 3 value, it would probably be time to sell Tier 2s and buy Tier 3s which can be used beyond 2019.

TM&C constantly monitors changes and proposed changes in regulations which can impact all segments of the petroleum industry.   Many of these are associated with transportation fuels, affecting not only demand, but also production costs, compliance challenges, and other aspects of petroleum refining.  We include our independent analyses of these impacts in our semiannual Crude and Refined Products Outlook (the 2018 Edition is scheduled to be released in within the next few weeks in early February 2018) and our various other studies. TM&C also assists clients involved in all aspects of transportation fuel production, blending activities, planning and compliance-monitoring. More information on these publications and our other work involving oil industry developments and dynamics can be obtained by contacting either one of us, visiting our website at turnermason.com or calling Cindy Parker at 214-754-0898.