Uncertainty shrouds impact of IMO 2020
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This article first appeared on Forbes.com on February 25, 2019.
The International Maritime Organisation’s (IMO) major change limiting the airborne sulphur dioxide emissions from international shipping is now less than a year away.
On 1 January 2020, the sulphur dioxide emission standard tightens to limit the emissions to burning the equivalent of fuel with a sulphur content less than 0.5 %. This is a massive reduction from the current levels of 3.5 wt%.
If this was delivered by the refining industry alone, it would be represent the biggest ever one-time removal of sulphur in a transport fuel. A key issue is that this legislation is not an obligation on the shipper, not the refiner.
But certainties are few and far between, with more unknowns than knowns.
Known impact of IMO 2020
The few things we can say with certainty are:
- The cost of ocean freight - and so international waterborne trade - will increase as shippers need to invest or buy more expensive fuels;
- Refinery earnings should improve, as tighter fuel quality standards requires higher activity levels by the refining sector, for which it will earn a margin;
- The relative value of crude oils will change, as high sulphur, 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;
- 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;
- Airborne emissions from the shipping sector will fall, but overall environmental performance may change little as the pollutants can be diverted into the marine environment;
- There is a wide range of potential outcomes depending upon how the shipping and refining sectors respond to this legislative change.
Why governments and investors play a key role in determining impact
Government capabilities to monitor adoption and their appetite to enforce this regulation, as this will determine overall compliance. At present, the regulation will be enforced by the countries ships dock at port. It will be illegal for a vessel to have non-compliant fuel on board, but not all ports have the capability to test the quality of marine fuels and not all countries have ratified this IMO regulation into their national legislation.
Refinery investments will also be important, as refiners could undertake major projects to supply 0.5% sulphur 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.
The early market signals associated with the supply of 0.5%S fuel oil indicate it is not likely to be readily available, nor priced at a discount to crude (typical of the current 3.5% S grade). This is influencing ship owner decisions, as they seek to secure a low-cost fuel.
Ship owners’ investment behaviour also needs watching. After a “phony war” that lasted a year after the announcement, ship owners are now investing heavily in vessel exhaust treatment systems, called scrubbers. These systems typically “wash” the vessel exhaust gases with sea water, which reduces airborne emissions. There are now over 2,000 scrubbers on order, mostly destined for large, long-distance vessels. This is modest in a global shipping fleet that numbers over 90,000 vessels.
In spite of the legislation coming into force in less than 12 months, the range of potential outcomes still remains very wide, as neither potential boundary case has been fully eliminated.
One boundary case is that the regulatory enforcement is strict, delivering high global compliance. This would be disruptive for the refining sector, as it would be unable to process all of the displaced high-sulphur fuel oil as a refinery feedstock. The surplus fuel oil would need to compete its way into the power sector by pricing at comparable levels to coal.
The surge in gas oil demand would require refiners to process more crude and we would be in an era reminiscent of the early 2000s, when strong demand growth for clean fuels drove up the global price of crude oil, distorting crude pricing and product pricing relationships. This would deliver enormous profits for the refining sector, but history suggests such distortions are often short-lived.
The other boundary case is that a number of key governments co-operate to stall the pace of adoption. In late 2018, a group including the US government proposed an “experience building” phase to reduce the potential disruption on the shipping sector and ultimately the consumer. The proposal was not passed, but if a similar proposal is passed later this year when the global economy could be stalling due to regional trade wars, there may be little or no impact on the refining sector.
Our base case is reliant upon high, but not full, global compliance and the shipping sector swapping 1 million barrels per day of high-sulphur fuel oil demand by a similar volume of marine gas oil. Our analysis of the refining sector suggests the refining system will absorb the displaced high-sulphur fuel oil volumes as feedstock and will then largely supply the necessary distillate. However, prices would change, rewarding those ship owners that have invested in scrubbers.
In this scenario, refiners will do better financially, but there will be a wide variation in earnings performance. Broadly put, the oil majors will do well, as after years of high-grading their portfolio, they have high-quality refineries that are well configured for this legislative change. Some majors may even see their refining earnings double in 2020.
Given the legislation comes into force on 1 January next year ship owners will need to take action soon. We are expecting to see this new market reality emerging late in the northern summer, but legislative clarity will not appear until early in the fourth quarter, as that will be the last meeting of the IMO at which a compromise could be adopted.
Only at that point, will the fog of uncertainty start to lift.