by Tajinder Dhillon.
The International Maritime Organization (IMO), which sets standards for marine fuel, will establish on Jan. 1 a new regulation that will significantly impact the shipping industry. Ships operating in non-emission-controlled areas will be required to reduce the sulphur content in marine fuel to 0.5% from 3.5% by weight. This is the second time in the last seven years that the sulphur cap has been reduced, the first being in 2012 when limits were reduced to 3.5% from 4.5%.
The primary source for marine fuel is “bunker fuel,” a heavy residual fuel oil that is left over from the crude refining process once lighter gasoline has been separated out. Not all crude oil is the same. API gravity and sulphur content are the two determinants to describe crude. A “heavy sour” oil will have lower gravity and higher sulphur content (i.e. greater impurities). The burning of high sulphurous bunker fuel produces sulphur oxides, which produces sulfuric acid, contributing to poorer air quality.
Global bunker fuel demand is approximately 16 million tons per month, with the majority coming from Asia and Middle East. Singapore, the largest ship refuelling hub in the world, is accountable for 25% of global demand. The transition from high sulphur fuel oil (HSFO) to low sulphur fuel oil (LSFO) will significantly impact multiple groups within the industry, from refineries who need to ensure ample supply of LSFO is available, to marine hubs who must stock compliant fuel for ship owners who need to refuel. Oil majors including BP, Total and Royal Dutch Shell have already communicated that they are ready to offer consumers compliant marine fuel ahead of the new regulation.
With the run up to January 2020, prices of HSFO have started to drop dramatically as seen in Exhibit 1.
Exhibit 1: Prices of High Sulphur Fuel Oil
The new regulation will reduce demand for HSFO (i.e. heavy oil) and increase demand for LSFO (i.e. light oil). As a result, we would assume that the spread between light and heavy oil will increase, as light oil will continue to command a price premium relative to heavy oil.
Several executives have commented on this during earnings releases.
Brian Gilvary, CFO of BP noted, “looking to 2020, margins in light heavy crude differentials are expected to be supported by increased demand for marine diesel and very low sulphur fuel oil needed to meet the IMO’s new MARPOL bunker fuel specifications.”
OMV Chairman and CEO Rainer Steele was more direct, stating, “on heavy and sour crudes, I think the spread will widen. The market is getting less and less interested to buy that stuff.”
The Organization of the Petroleum Exporting Countries (OPEC) has also stated in its latest oil outlook that demand for HSFO will decline from 3 million barrels a day in 2019 to just 1.2 million in 2020.
Repsol CEO Josu Miguel alludes to a decline in demand stating, “operators have already started to adjust their inventories ahead of IMO, resulting in a collapse of high sulphur fuel oil spreads.”
With an alternative source of fuel required to meet regulations, many believe that marine gasoil will be the preferred option for ship operators. Marine gasoil is a diesel-blend fuel which has lower sulphur contents vs. HSFO. OPEC believes that diesel demand in the bunker sector is forecast to rise to 1.5 million barrels per day in 2020, from current levels of 900,000 barrels per day.
With higher demand for diesel, refineries who can adapt their product slate and fill demand should be rewarded by investors. If we expect the price of heavy oil to decline, complex refiners can take advantage and purchase discounted heavy fuel and turn it into more valuable lighter products, thus increasing refinery margins. Complex refiners, including Exxon, Repsol, Neste, and Saras, are strategically placed to benefit from this new regulation.
“The spread between diesel and high sulfur fuel oil has opened to more than $40 in October, driving the trend for IMO, boosting the margins of deep conversion refiners like Repsol,” Josu Miguel said.
Saras CEO Dario Scaffardi also explained, “a complex refinery has its economics which are directly linked to the difference between these two values [diesel and HSFO]. So a higher spread means higher refinery margins for a complex conversion refinery.”
Neil Hansen, Exxon VP of Investor Relations stated, “as you can see, the spread is expanding with the forward curve and third-party estimate ranges showing further widening, which will favor more complex refiners with the capacity to upgrade heavier sour crudes to cleaner products.”
We can see the diesel/HSFO spread widen in Exhibit 2.
Exhibit 2: Diesel vs. HSFO Spread
Miguel also provides insight into Repsol’s preparation ahead of IMO 2020. “Repsol’s refining team is perfectly positioned to capture the higher margins resulting from the new IMO regulation. We own 25% of the total coking capacity in European Union, while only 6% of the total distillation capacity. Our refining system is fully invested for IMO and our accelerated maintenance schedule in 2019 will allow us to maximize the availability of our system during the period of maximum impact of the new regulation. At the moment, all our refineries in Spain can operate without producing any high sulfur fuel oil at all, due to a high conversion and the flexibility of our system.”
We have discussed low sulphur oil extensively up until now, which is likely to be the most preferred method. However, there are other ways for ship owners to be compliant with IMO 2020 regulation, including:
Source: Refinitiv Oil Insights – Countdown to IMO 2020
OPEC anticipates an 85% compliance rate when the regulation comes into effect, rising to 90% by 2024.
Some ship operators may try and wait until the very last day to continue purchasing HSFO, given the significant cost savings. AP Moeller-Maersk, the largest container shipping company in the world, has already alluded to the impact LSFO purchases are having on working capital. CFO Carolina Happe states, “our cash flow will be impacted in the second half, though, of preparations towards IMO 2020. And that is really because we are starting to buy more expensive fuel towards the end of the third quarter and in the fourth quarter so that will impact our working capital.”
Once the regulation comes into effect, penalties will be assessed on both ship owners and ship staff who are not using compliant marine fuel, possibly ranging from fines to imprisonment.
Aside from using LSFO to comply with IMO 2020, the use of scrubbers is the second most viable option. Scrubbers are sophisticated units installed on a ship designed to reduce sulphur emissions. The main benefit of this approach is that ships will still be able to use high-sulphur fuel oil and remain in compliance. The downfall to this approach is the significant one-time cost involved with installing a scrubber on an existing vessel, which can range from $1 million to $5 million, according to Refinitiv Oil Research. This can be an expensive option, especially for companies with a large fleet.
AP Moeller-Maersk states in their 2018 annual report, “in total, US$263 million has been contractually committed for the installation of scrubbers and retrofitting on a selected part of the fleet as part of the plan to comply with the new sulphur regulations from January 2020. Continued CAPEX discipline remains a key focus area, with no new large vessel orders or new major terminal investments expected until at least 2020.”
Refinitiv Oil Insights believes that 2,500 vessels will have scrubbers installed by 2020, a large drop compared to initial estimates of 4,000 vessels. Wartsila Oyj, a manufacturer of scrubbers, highlights the challenge around adoption. “Customers today remain unwilling to commit to scrubber investments due to uncertainty on fuel price development and fuel availability,” said CEO Jaakko Eskola. Executive VP Roger Holm also had a pessimistic outlook: “We have hopes that we will still see increased activities in scrubbers going into next year. But at the moment, that’s very silent.”