If ship owners, oil refiners and traders had been hoping for a stay of execution concerning the International Maritime Organisation’s (IMO) impending rule on sulphur limits in bunker fuel, they will have been sadly disappointed October 26.
Rather than accept proposals designed to ease the shift from 3.5% to 0.5% sulphur in marine fuel from January 1, 2020, the IMO instead tightened compliance by adopting a ban on the carriage of non-compliant fuels in ships without exhaust scrubbers.
It means that the huge oil market shake up that is ‘IMO 2020’ is going full steam ahead on schedule, and that compliance – a factor with significant bearing on its impact – will be at the higher end of expectations.
But is a seemingly small regulatory change in an industry far from the public view really such a big deal?
Yes. Various estimates suggest IMO 2020 will involve a transfer in value of over $1 trillion between 2020-25. On the winning side: refiners, low sulphur crude producers, oil-fired power generators and some industrials; on the losing side, freight carriers, high sulphur crude producers and consumers.
The change in specifications is global. Bunker fuel usage is around 5-6 million b/d, roughly 6-7% of the world oil market. Not only that but 0.5% sulphur fuel oil is a new product. Refiners have to reconfigure their kit to produce it, while ship owners will be running it through engines unused to the new specifications.
Preparation for this huge change has been -- lets be polite -- slow. There is insufficient desulphurisation capacity worldwide to produce the required quantities of 0.5% fuel oil, nor will that capacity be in place by 2020.
Ship-owners have been slow to invest in scrubbers and alternative fuel engines, such as LNG, because there is a surplus of shipping capacity and this has slowed newbuild orders and discouraged retrofit investment.
And … there was always the lingering hope that the IMO would again delay. That prospect is fast receding.
Low sulphur future
The expectation is for a surge in middle distillate demand at the expense of fuel oil, creating a shortage of the former and a surplus of the latter. Demand for distillate-rich low sulphur crude will jump, while that for heavy, sour crudes will slump. Crude, oil product differentials and refining margins will all be affected, particularly in the first year of implementation.
Shipping demand for low sulphur gasoil will spill over into the wider market, so that all distillate users feel the pricing effects. The need to produce more middle distillates means less gasoline production, so gasoline cracks should widen too. But producing more middle distillates cannot avoid HFSO production and according to some analyses will create a rise in overall crude oil demand sufficient to push crude prices up by anywhere between $3-10/barrel.
There will also be a lot of very cheap HSFO looking for a home – possibly as much as 500,000 to 600,000 b/d.
Keep it at home
The new ban on HSFO carriage has a secondary implication. It will make it hard to transport HSFO, creating bottlenecks. Given also that the netback on HSFO will be very low, it is likely to stay close to home.
This implies big jumps in HSFO use for power generation in the Middle East. The second round of US sanctions on Iran kicks in November 4. Last time around this caused a surge in Iranian fuel oil use. IMO 2020 will increase this.
In addition, Saudi Arabia has been steadily stepping up its use of HSFO for years, displacing more valuable crude for export. It will take more HSFO into its power plants, which still have significant switching capacity. Other Middle Eastern oil producers, such as Iraq, are also likely to up their domestic HSFO use.
Outside of the Middle East, Russia, as a major producer of HSFO, is likely to increase domestic and industrial use of the fuel. In each case, some other fuel source will be backed out.
The remaining HSFO – somewhere between 150-200,000 b/d -- will find a home in countries with oil-fired generation capacity that are relatively unrestricted in terms of air pollution and CO2 controls, for example Pakistan, Mexico and Egypt.
In Pakistan and Mexico there could be a backwash effect in terms of reduced LNG imports, while in Egypt the HSFO bonanza could underpin LNG exports from the country’s two under-utilised LNG plants.
But if this puts more LNG on the market, LNG producers will get a bonus from the change in freight costs between LNG and coal. LNG carriers will get away scot free because they use boil-off from their LNG cargo as fuel.
In contrast, coal is shipped on standard vessels, which will have to shift to higher-priced low sulphur fuel oil or gasoil. Might not make a big difference on a short haul across the Black Sea, but the affect could be significant on longer journeys from Australia or South Africa, and in particular on arbitrages between the Atlantic and Pacific basins.
Elsewhere industrial use of HSFO will increase, with cement kilns always on the look-out for cheap sources of energy. Refinery own use of HSFO should also rise, backing out crude and natural gas.
However, two factors could derail the more apocalyptic forecasts.
First would be an increase in scrubber installation and alternative fuel use. This possibility looks limited, given the lead-time – six to nine months per ship – and the lack of installation capacity. A best possible estimate by Schroders’ commodity team illustrates the scale of the problem. They put the likely number of scrubber-installed vessels in 2020 at 1,200 -- out of the more than 60,000 needed.
LNG-fuelled ships? At end-2017 there were just 117, according to DNV. There were 111 more on order and 114 classified as LNG-ready -- a drop in the ocean.
The second and bigger issue is compliance. The bigger the price differential between HSFO and LSFO, the bigger the incentive to cheat.
This is where the IMO’s new ban really kicks in.
Enforcement of the sulphur rules previously lay entirely with flag states, a situation largely considered inadequate. The IMO itself has no powers of enforcement. The new measure gives powers to port states to police fuel use and will enter into force on March 1, 2020, just two months after the sulphur regulation itself.
Forecasts suggest non-compliance in the range of 10% to more than 30% by ship weight, representing a big margin of doubt, and putting at risk any bets made on sharply rising middle distillate margins and dirt cheap HSFO. Less compliance will reduce the impact of the ripple effects.
But putting power in the hands of the port states is a shrewd move. Globally bunkering activities centre around only a few major hubs. The possibility of exclusion from these hubs is more powerful than that of penalties potentially levied by flag states with little incentive to be punitive.
Moreover, the vast majority of shipping in terms of actual fuel use is done by a relatively small group of large companies, which are expected to comply. Some cheating is inevitable, and in some regions sufficient 0.5% fuel oil will simply not be available. But the new ban implies greater compliance, with the result that the impact of IMO 2020 will be at the higher end of the forecast spectrum.