The current maximum high-sulphur fuel oil (HSFO) limit of 3.5 weight percent (wt. %) will fall to 0.5 wt. % very-low-sulphur fuel oil (VLSFO), representing the largest reduction in the sulphur content of a transportation fuel undertaken at one time. Slashing marine sector emissions in international waters has huge implications for the industry, which will have to adapt to a low-sulphur world in which emissions are reduced by 80%.
Why does it matter?
The marine sector in 2017 consumed 3.8 million barrels per day of fuel oil, representing half of the world’s global fuel oil demand. The change in IMO regulations will displace this volume disrupting the pricing and availability of compliant fuels. It also has serious implications for the downstream, upstream, LNG and shipping (tanker, dry bulk, container) sectors.
The effect on commodity markets will be profound: a large majority of the world’s commercial fleet will shift from burning fuel oil to middle distillate-based bunkers, and refiners are expected to increase crude runs to maximize distillate output for the shipping industry’s needs.
Industry disruption is expected to last anywhere between 1 to 5 years depending on the speed at which refiners can produce compliant fuel and the specific strategies that shippers employ to meet the challenge.
Compliance with IMO 2020 among shippers was initially forecast to be low. Uncertainty and doubt over the date of its regulatory implementation, and the degree to which it would be enforced as a result of the IMO not having a legal enforcement mechanism, meant that shipping companies delayed taking the necessary actions.
As major ports and insurers declared they would require ships use the new fuel the industry began to embrace compliance. Being relatively consolidated the risk of “rogue shipping operators” failing to adhere to IMO 2020 is relatively small, and the IMO carriage ban introduced in late 2018 further enforced compliance by prohibiting the transportation of non-compliant fuel by ships without “scrubbers” (technology that removes polluting sulphur emissions from ship exhausts). This regulation, scheduled to take effect in March 2020, reduces the likelihood of ships switching fuels at sea.
Regulatory compliance is challenging and experts do not expect the whole shipping industry to meet the new standards in time. Current analysis predicts around 85/90% compliance at the start of 2020. Consultancy Channoil suggests that 10% may cheat, concentrated in areas where supply is almost impossible or policing lax, but compliance will be rigorously enforced after a three-month window.
Domestic adherence within territorial waters is voluntary. Citing the cost of regulatory compliance as prohibitive, Indonesia announced in July 2019 that it will not enforce IMO 2020 for its domestic fleet. Indonesian vessels operating in international waters are expected to comply however.
How can the shipping industry comply, and what are the challenges?
The shipping industry has known about the mandated shift to low sulphur fuel for nearly three years, but details remains elusive about the availability and pricing of compliant products. While high sulphur fuel oil (HSFO) can be converted to low sulphur (LSFO), the capacity to meet global demand simply does not exist. This means the industry has three realistic compliance options and the consensus among analysts is that it will adopt each in roughly equal measure:
- Low Sulphur Fuel Oil (LSFO)
- Marine Gasoil (MGO)
- Retrofitting on-board scrubbers to filter High Sulphur Fuel Oil HSFO.
Each of the three option’s attractiveness will depend on the relative prices that emerge and how they play out over the next few years. Significant price spreads will open up between high and low sulphur crudes. There will be market imbalances that open up offering opportunities for those refineries in a position to capture them.
Longer-term, the marine industry can look to change propulsion systems altogether by switching to LNG (or a select amount of other fuels like LPG or Methanol), which is an option for new-build vessels. Wood Mackenzie anticipates that the use of LNG in shipping will increase 70% between 2019 and 2020 displacing 100,000 barrels per day (bpd) of marine fuels.
The main problem the shipping industry has to address is how it will cope with an unfamiliar set of new fuels in the light of IMO 2020. The refining industry is expected to offer a wide range of products and little is known currently about the new 0.5% sulphur blends that will be available. Refiners will blend new marine products primarily using the 0.5% sulphur limit as their target – rather than the 380 CST viscosity specification they currently aim for when blending high sulphur fuel oil – and they will have a wide array of options in order to meet requirements. Products, for example, could range from a largely unaltered low sulphur straight run fuel oil to a primarily distillate-based product, or use other refinery streams including VGO and hydrocracker bottoms.
Challenges will come when the products are mixed and some blends prove incompatible with one another. For example, when a more aromatic 0.5% product comes into contact with a more paraffinic blend, the products are likely to separate and form sludge, blocking filters. Risk of engine failure is a real possibility in this scenario and a contamination crises in the bunker fuel industry (as seen in 2018) across the global supply chain is concentrating minds in the lead up to 2020.
IMO 2020 compliant fuels are more expensive than the traditional high-sulphur bunkers. The extra costs for ship owners will depend on the adoption of various compliance options and spreads between fuel type prices and are expected to have cost implications running to tens of billions of dollars extra a year for the sector.
How easy will it be for ship owners to be successful in passing on their bunker costs to charterers? In the short-term charging clients sufficient premiums in freight rates to cover new expenses looks unlikely. With the outlook for ton-mile demand still uncertain, tanker owners will need to consider a scenario in which they have to absorb a sizeable proportion of the extra costs, at least during the 2020 transition period.
As of July 2019, indications from suppliers suggest that IMO 2020 compliant fuels in Singapore, the region and world’s biggest bunkering hub – are between $125 and $150/mt more expensive than the HSFO they are currently using.
The impact of IMO 2020 on Refiners
No single path exits for refiners to prepare for the coming IMO 2020 changes. The options are to continue with a business-as-usual approach and hope the market takes care of issues, or, upgrade via expensive modernization projects to allow production of more IMO compliant fuels. Those refineries embracing the latter strategy are investing in upgrades to coking and hydrocracking capacity to capture feedstock advantage and product premiums. These complex refinery units are designed to break down heavy oil into lighter products, serving to reduce production of fuel oil.
Traditionally seen as an offshoot of the industry the feedstocks market will become critical. In a more sulphur constrained world the industry will witness a massive shift in the blendstocks that are going to be used for 0.5% fuel. Vacuum Gas Oil (VGO) and Low Sulphur Straight Run (LSSR) will come to the fore of the blending market. This is already evidenced by increasing demands for storage ahead of 2020.
Growing demand for middle distillates could also result in upward price pressure on fuels such as diesel and jet fuel. The higher demand for gasoil will largely have to be met by higher crude runs, likely increasing crude prices, distillate premiums to other fuels, and refining margins in general. The switch to marine gasoil will add about 1.5 million barrels per day to distillate demand globally, leading refiners to run an additional 2.2 million barrels per day of crude oil through distillation. McKinsey believes this should increase refining utilization in the major hub markets by 2.9 to 6.7 percentage points.
U.S. refineries are well-positioned for the change being the most complex in the world and therefore able to extract a higher proportion of lighter, low-sulphur fuels from each barrel of crude oil. Refineries with sophisticated set-ups (like those in the US Gulf Coast) also benefit from the ability to process heavier, higher-sulphur, or “sour,” crude oil. Basic refineries will bid up the price of lighter, sweeter barrels to meet the demand generated by the rule change. More advanced refineries can still utilise the cheaper, heavy crude (such as Brazilian or Angolan grades, for example).
In Asia Refineries in Taiwan and South Korea have begun to test the waters by exporting some cargoes of IMO 2020 compliant very low-sulphur fuel oil (VLSFO). Reuters has reported that, since June, Taiwan’s Formosa Petrochemical, South Korea’s GS Caltex, S-Oil Corp and Hyundai Oilbank Corp have sold VLSFO cargoes.
IMO 2020 is likely to provide a short-term lift to refining margins although the benefits will be unevenly distributed amongst the sector based on the sophistication and complexity of each refinery set-up. There is a broad consensus however that the industry is over-building, with margins expected to weaken over the longer-term.
Given the scale of the changes, the uncertainties around compliance levels and the multiple ways in which VLSFO can be supplied, the oil value chain is likely to see high volatility during 2020.
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