Friday, November 15th, 2019

Hello all,

Happy Friday and welcome to Energized, your weekly look into the geopolitics, news, and happenings of energy markets.

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Now, onto this week’s spotlight issue, “IMO 2020 Regulation”

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IMO 2020 Spotlight Issue

 

With only six weeks left in the year, you’re probably thinking about the holidays and what the new year, and new decade will bring. Equally important (half kidding) is IMO 2020, the International Maritime Organization’s long-anticipated regulatory reduction in sulfur emissions that goes into effect January 1st, 2020. IMO 2020 affects multiple industries and will hopefully lead to a more sulfur-free world, but it won’t be easy.

Background:

Bunker Oil, Sulfer Oxide, HSFO, LSFO, VLSFO, ULSD, and Scrubbers

+ Sulfur 2020 – cutting sulfur oxide emissions – International Maritime Organization

IMO 2020 affects mainly the shipping industry by reducing the amount of sulfur oxide that ships can emit. Commerical ships mainly use bunker oil as their fuel source. “Bunker oil for ships is heavy fuel oil, derived as a residue from crude oil distillation. Crude oil contains sulfur which, following combustion in the engine, ends up in ship emissions. Sulfur oxides (SO_x) are known to be harmful to human health, causing respiratory symptoms and lung disease. In the atmosphere, SO_x can lead to acid rain, which can harm crops, forests and aquatic species, and contributes to the acidification of the oceans.”

According to Seahawk Investments, “The global fuel sulfur cap is part of the IMO’s response to heightened environmental concerns, contributed in part by harmful emissions from ships.”

Fuel oil is the heaviest product that can be obtained from crude oil, heavier than gasoline or naphtha. It has a long hydrocarbon chain and is used primarily as heavy fuel for marine vessels. If containing a lot of sulfur, as is often the case, it is known as high sulfur fuel oil (HSFO). Refineries produce many distillates, with fuel oil often being the residue during distillation. When a marine vessel is refueling, the process is known as “bunkering”, hence the term “bunker oil”. So in this context, fuel oil, heavy oil, marine oil, and bunker oil, are all the same thing.

For a while now, the marine industry has been striving for lower sulfur emissions. Therefore, the switch from a maximum sulfur content of 3.5% to 0.5% will not be as severe as it looks. Ultra-low sulfur diesel (ULSD) has been the industry standard diesel fuel for the marine and locomotive industries since 2006. It contains a negligible amount of sulfur and can be combined with higher sulfur fuel oils, reducing the sulfur concentration via blending. The blended result is usually called very low sulfur fuel oil (VLSFO).  According to Stillwater Associates, “A simple sulfur balance suggests that blends between 80 and 85 percent ULSD will meet the 0.5% specification, and the most common proxy for VLSFO price in the future is five parts ULSD price and one part HSFO.”

Unlike VLSFO, Low sulfur fuel oil (LSFO) is typically more of a standalone commodity, not the result of blending diesel and high sulfur fuel oil. Last month, LSFO futures began trading on the Singapore-based Asia Pacific Exchange (APEX).

The takeaway here is that ships have several options to get to the new 0.5% spec, including blending HSFO and ULSD to get VLSFO, or using LSFO, standalone diesel, natural gas, or liquefied natural gas (LNG). Another way is using scrubbers, which are onboard systems that spray alkaline water into the vessel’s exhaust to remove sulfur oxide. The point being, while there are multiple ways to comply with IMO 2020, there’s no way around avoiding costs, much of which will be passed along to the consumer.

	Current Industry Specs	IMO Specs
Maximum Sulphur Content	3.5%	0.5%
API Gravity	11.3	17-25
Density	991	952-904
Barrels/Metric Ton	6.35	6.6-6.96

Data derived from argusmedia.com based on ISO data

API gravity is simply a measure of how heavy or light a petroleum liquid is compared to water. An API gravity above 10 suggests the fluid will float on water, whereas an API gravity of fewer than 10 means it will sink. As you can see in the above table, the API gravity of heavier sulfur-containing bunker fuel is barely above the API of 10, meaning it will just be able to float on water. The API of 0.5% sulfur-containing fuel is much lighter at 17-25.

Overall Impact/ Impact on the Shipping Industry

+ Just how disruptive will IMO 2020 be? – BCG publications

Clearly, sulfur’s got to go. But what are the steps to getting there?

“Precisely how great the disruption proves to be—and, critically, how long it lasts—will be influenced by several factors, including the speed at which refiners can produce compliant fuel and the specific strategies that shippers employ to meet the challenge.”

“We have modeled a wide variety of scenarios and can imagine a disruption lasting anywhere from one year to more than five years, generating significant costs for many businesses. ”

So if costs are high, is there a chance certain fleets or ports won’t comply?

“The degree of compliance among shippers seems likely to be high. Shippers will certainly have incentive to comply. Major ports, as well as insurers, will demand that ships use compliant fuel. The shipping industry is also relatively consolidated, which limits the number and percentage of ships in the global fleet owned by rogue operators that might be inclined to ignore the mandate.”

That’s good news coming from the BCG report, which continually stresses that preparations for IMO 2020 regulation have been occurring for some time now. But couldn’t ships just bunker with LSFO and then switch to HSFO at sea to save costs?

“In late 2018, the IMO approved a so-called carriage ban that prohibits the transportation of noncompliant fuel by ships that lack scrubbers (technology that removes polluting sulfur emissions from ship exhaust). This regulation, which is scheduled to take effect in March 2020, reduces the likelihood of ships switching fuels at sea.”

So basically, install scrubbers or use compliant fuel. Clearly, IMO has thought this through, making it a real pain for shipping companies to get around the new regulation. As we will discuss in the Argus report later, the demand for HSFO, which has 3.5% sulfur content, will decrease and the demand for VLSFO will increase. The current consumption of HSFO, which represents the vast majority of marine fuel currently sold, is nearly 4 million barrels per day.

So the switch will happen because IMO has made it difficult for ships to dodge regulations, but what are the costs?

“Choosing to fuel vessels with increasingly expensive VLSFO would cost the shipping industry dearly—an additional $60 billion in 2020 over current fuel costs, according to one estimate.”

$60 billion in one year is no small amount. The costs will be largely incurred from the need for refiners to increase the production of VLSFO and diesel to produce enough <0.5% sulfur blends. Additionally, engines that use diesel or a blend of diesel and natural gas provide a worry-free alternative for shippers who were already looking for an upgrade anyway. Marine diesel is an established fuel that “poses no compatibility risk” since it contains such negligible quantities of sulfur.

LNG is another “worry-free” alternative. That being said, “the high cost of engine and infrastructure conversion and the logistics of onboard storage (LNG tanks take up considerable space) will likely dissuade a critical mass of shipping companies from pursuing it, at least in the near term. (Over the longer term, as the global fleet of vessels turns over, LNG could become increasingly popular as a fuel, especially if the pressure to reduce emissions intensifies.)”

“Scrubbers could be yet another viable choice for some shippers. But scrubbers are expensive—retrofitting a vessel requires an investment of $2 million to $3 million—and installation can take up to six months. Scrubber installation is also hindered by shortages of skilled craftsmen and necessary raw materials, such as high-quality steel and chrome alloys. In addition, the open-loop scrubbers now being installed could prove to be a short-lived option, given environmental concerns about putting sulfur directly into the water.”

“Regardless of what path shippers ultimately choose, they will try to pass along their costs to customers. How successfully they will be able to do so remains to be seen.”

The main point from IMO 2020 regulation, it seems, is that it will be expensive for shippers, whether they choose the VLSFO, LSFO, diesel, dual fuel (diesel and natural gas), or LNG route, and those costs will pass along to their customers in a way that remains to be seen.

+ Uncertainty shrouds IMO 2020’s impact – Forbes

This Forbes article continues the discussion on the costs falling on the consumer. “The consumer will pay for the change in a number of ways, as this legislation alters the relative values of all refined products. It is likely the cost of air travel will increase, as will road freight costs.”

+ IMO 2020 and effects on the shipping industry – Seahawk Investments

“The new regulation will have big impacts on the shipping industry’s operating costs, global freight rates, global fuel supply and demand, and more.”

The article notes that VLSFO is a primary solution for small and medium-sized vessels, and “as the marine sector accounts for about half of the global fuel oil consumption, this drastic shift will initially challenge the supply side for VLSFO.”

Scrubbers

The article notes that scrubbers, due to their high initial cost but long-term benefits, will be the primary solution for large vessels.

“According to IHS Markit research, on-board ship scrubbers will be the primary path for large ship. The cost of installing scrubber is between $2 mln and $6 mln for each ship. The upfront cost is high, but it will be paid off in long term. However, other than the high upfront cost of installing scrubbers, there are other challenges for shipowners, as reported by Noah T. Jaffe of ReedSmith: (i) scrubber technology is new and unproven, (ii) further environmental regulations may render this approach unviable – for example, some countries have banned the use of open-loop scrubbers (e.g., China, Singapore and Fujairah), and (iii) the availability of HSFO in small or distant ports is uncertain as refineries will reduce their production of such fuels and global supply is expected to shrink. The current rate of scrubber installations is at low level, but improving. As of the beginning of July 2019, only 4% of all vessels are scrubber-fitted and ready to be in operation. This figure is expected to rise to 11% and 15% by the end of 2019 and 2020, respectively.”

LNG-powered ships

“Another possible solution to meet IMO 2020 is the use of LNG-fueled vessels.”

“As of February 2019, there were 143 LNG-powered ships in operation and a further 135 on order. Analysts predict 300 (lowered from 400 to 600) LNG-fueled ships, compared with 2,000 ships with scrubbers, by 2020.”

“In summer 2018, top carriers such as Maersk, CMA, CGM, and MSC announced to add bunker charges to compensate for the unexpected increase of bunker costs. For this purpose, a bunker adjustment factor (BAF) tariff was created to recover fuel-related costs.”

Implications of IMO 2020

“The significant increase in operating costs will lead to an increase in freight costs worldwide. In precise terms, an Asia to North Europe round trip could cost an additional $1 mln [million] after the new regulation takes effect.”

Increased bunker prices will likely result in slower shipping speeds, at least in the short-term. “As fuel consumption increases with the speed of a ship, the average speed of ocean-going vessels has come down by 15-25% over the last decade.”

Impact on the Traders: Markets, Pricing, Key Takeaways

+ IMO 2020: navigating varying specifications and arbitrage – Argus Media

Singapore is the largest bunker fuel oil importer in the world, obtaining nearly a quarter of its high sulfur fuel oil from Russia. A drop in imports to Singapore from Russia will be something to watch in 2020. For context, Russia exported 244,000 barrels per day of HSFO to Singapore in the first half of 2019. Argus notes that including transshipments from the Netherlands would increase the total to 296,000 barrels of HSFO per day. With the Russian surplus of fuel oil looming in 2020, it’s likely the country will have to use the fuel as a feedstock for various industrial applications or as a fuel source in power generation. The natural gas that would have been used for power generation could then be exported.

Argus notes that Singapore is also importing more diesel in response to IMO 2020 regulation, most notably from South Korea, China, and India.

One of the most interesting points from the Argus webinar is the increase in the storage of LSFO in hubs like Singapore, the USGC/Carribean, USEC, USWC, NW Europe, Mediterranean, and the UAE. Much of these exports of LSFO are coming from West Africa, which began ramping up exports in anticipation for IMO 2020 starting in July of this year. Argus expects heavy competition in the coming years between American, European, and Southasian importers for West African exports of LSFO.

Countries like Brazil, who can export LSFO with a maximum sulfur content of 0.8%, can still compete in the market by blending down their fuel oils to lower sulfur levels.

In terms of other fuels, Argus notes that the U.S. is “long diesel”, with over 75% of diesel exports going to Latin America, followed by 17% to Western Europe, and 7% going to other sources.

21% of total U.S. diesel exports go to Mexico. Argus expects Mexico to be even more reliant on clean fuel imports such as diesel in the coming years. This is because Mexico’s fuel oil has a whopping 4% sulfur concentration, heavily missing the mark from IMO 2020 requirements. “Pemex is expected to drop its refinery utilization rate in 2020 to reduce this high sulfur fuel oil output,” said Argus. “Mexico is expected to become even more reliant on the U.S. Gulf Coast for clean petroleum products such as diesel.”

Pricing

It’s not even 2020 yet but already the difference between LSFO and HSFO has been bouncing around between $10-$30 per barrel, depending on the region. Prices for LSFO are lower in the U.S. for example due to the abundance of clean fuels like diesel. The difference between LFSO and HSFO is actually the lowest in Fujairah [major port in the UAE located on the Gulf of Oman] and Singapore due to the present need for HSFO bunker fuel and the lack of availability of HSFO compared to other regions. Argus expects that gap to remain narrow for the rest of 2019 then, as expected, widen in 2020. The gap between LSFO and HSFO is quite high in Northwest Europe and the U.S. since there isn’t really a need to bunker HSFO and availability is much higher compared to Fujairah and Singapore.

Is response to the rise of 0.5% sulfur fuel oil demand, Argus is launching 24-month rolling price curves for key regions around the world. So far, Argus has 0.5% curves for New York, USGC, NW Europe, Zhoushan [major Chinese port located on the East China Sea], and Singapore. The different curves will give the industry a sense of the arbitrage between places such as Singapore, likely trading above the United States for example. The Argus Marine Fuels Forward Curves service “enables industry participants to measure risk, improve mark-t0-market accounting, calculate profits/losses, and properly valuate assets.”

Key Takeaways

Argus’ key takeaways are as follows

• “US Gulf 0.5% sulfur typical density will settle and the market will remain barrel-denominated”
• “Russia’s huge HSFO surplus in 2020; demand for W African LSFO up”
• “Latin America’s dependence on the US for diesel to increase”
• “Diverging 0.5% sulfur forward curves signaling NW Europe to US Gulf arbitrage”
• “CME and APEX list futures settling on Argus-assessed FO [fuel oil] in Singapore”
• “Argus to launch an electronic trading platform for 0.5% sulfur FO”

Make sure to watch the Argus full webinar or check out the slide deck for more information.

+ Singapore to launch low-sulfur fuel oil contract ahead of new shipping rules – Hydrocarbon Processing

Hydrocarbon Processing covered the launch of Argus’ Singapore-based LSFO futures contract.

As alluded to earlier in this newsletter, “Singapore-based Asia Pacific Exchange (APEX) will launch a low-sulfur fuel oil (LSFO) futures contract aimed at helping shipping and energy firms manage price fluctuations as stricter global marine fuel rules kick in from 2020.”

“The new contract aims to help the energy and shipping sectors to hedge risk in the relatively new market for 0.5% LSFO delivered marine fuels, or bunkers.”

“The cash-settled, U.S. dollar-denominated LSFO futures contract will be for 10 tonnes of fuel oil, and will use the Argus Bunker Index (ABI) Singapore LSFO 0.5% as the settlement price, according to APEX and Argus company websites.”

Impact on the Refiners

On the refiner side, expect increased demand for VLSFO. Complex refineries will begin converting their high sulfur crudes to lower sulfur products, including VLSFO. They will also likely begin to “maximize their production of distillates—which can be used to make compliant fuel, such as marine gas oil (MGO), a fuel that could rise sharply in demand. Simple refineries that mostly produce HSFO and have relatively low distillate yields will have greater difficulty maintaining their margins,” according to the BCG report. The report continues, “optimal marine engine operation hinges not just on sulfur content but on secondary fuel characteristics (such as viscosity and stability), and the comingling of fuels from different providers on vessels is inevitable.”

U.S. onshore shale wells typically contain light, sweet crudes that contain less sulfur, causing less of a headache to refiners in the U.S. On the other hand, notoriously heavier crudes in places like Venezuela will cause even more strain on refiners who now face decreased demand for the HSFO commonly produced from heavier crudes.

Generally though, “Refinery earnings should improve, as tighter fuel quality standards requires higher activity levels by the refining sector, for which it will earn a margin,” according to a Forbes article. Additionally, “The relative value of crude oils will change, as high sulfur, heavy crudes will become less valuable than today. This will have an impact on the upstream sector and has the potential for this legislation to drive all crude prices higher.”

“Refinery investments will also be important, as refiners could undertake major projects to supply 0.5% sulfur fuel oil. To date, few have committed to major capital projects and those that have are investing around US$1 billion on projects that will take a number of years to implement,” continues the Forbes article.

BCG anticipates a few different disruption scenarios:

The BCG report is dense and worth a read if you want to learn more about their different modeling scenarios and what they suggest.

+ SK Innovation expects IMO 2020 to help improve refining margins – Hydrocarbon Processing

A recent announcement by SK Innovation, the owner of South Korea’s top refiner, SK Energy, supports the notion of improved refining margins as previously mentioned in the Forbes article.

“Refining margins are expected to improve led by middle distillates demand as the International Maritime Organization (IMO)’s shipping fuel rules set to take effect from 2020.”

You can check out the article for more nuggets from SK Innovation.

+ Refiner to start producing IMO-compliant fuel oil mid-2020 – Hydrocarbon Processing

“Gunvor Group will overhaul its refinery in Rotterdam in March next year and reconfigure the plant to produce some low sulfur fuel oil that complies with new, global shipping rules, its chief executive officer said.”

The article reinforces points we mentioned earlier, such as “the industry has been gearing up as the switch approaches. Fuel suppliers are stocking up Very Low Sulphur Fuel Oil at key ports and refineries are also favoring heavy sweet crudes that yield higher volumes of compliant fuel oil.”

Remember that “ships could also opt for more expensive diesel or continue using high sulfur fuel oil if they install units that remove sulfur, known as scrubbers.”

Conclusion

+ IMO 2020 and effects on the shipping industry – Seahawk Investments

Bringing back the Seahawk Investments article from the beginning of this newsletter…

“In order to comply with IMO 2020, shipowners will primarily choose either to switch to VLSFO or to install scrubbers on existing vessels.”

“IMO 2020 is a game-changer in the shipping industry, affecting shipowners, refiners, and all other key stakeholders along the marine fuel supply chain. The world will see a greener environment in the shipping industry, but also a profound change in global fuel supply and demand. Some players such as refiners with an already set-up infrastructure to supply compliance fuel, or marine equipment suppliers for scrubbers benefit from the changes. Shipping costs are likely to increase once the regulation takes effect.”

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Have a great weekend!

-Danny Foelber

EKT Interactive Managing Editor

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