Worldwide diesel pain may be just six weeks away

In light of the introduction by the International Maritime Organization (IMO) of a 0.50 per cent m/m (mass by mass) limit for sulphur fuel oil on board ships, effective from 1 January 2020, ship owners will have now decided between retro-fitting exhaust gas cleaning systems (known as scrubbers) or relying on low sulphur fuel oil (LSFO) supply. The marine sector currently accounts for half of the total global fuel oil demand, meaning that the switch from high sulphur fuel oil (HSFO) (the largest component of marine fuels) will result in much greater demand for middle distillates, with a knock-on effect on other sectors. The global diesel market, in particular, is set for significant periods of volatility. The International Energy Agency (IEA) predicts that demand for diesel will double once ship owners begin to transition to LSFO globally.

Background

A substantive dialogue on air pollution from ships can be traced to the 1973 MARPOL Convention. Building on this, MARPOL Annex VI came into force in 2005 to limit pollutants and ozone depleting substances in ships' exhaust gas. Additional 2008 amendments included an agreement to reduce sulphur limits from 4.50 per cent to 3.50 per cent by 1 January 2012, and again to 0.50 per cent from 1 January 2020. This latest reduction was subject to an availability review, which was completed in October 2016 and concluded that LSFO supply would be sufficient. Until now HSFO has made up 84 per cent of the marine bunkers fuel mix, which will now need to be either de-sulphurised or replaced with alternatives like marine diesel or bio-fuels.

Adopting LSFO

Ship operators opting to switch to LSFO must contend with incompatibility issues and a restricted supply. In fact, some estimations put current coverage of the industry's predicted global needs of LSFOat less than 50 per cent, despite both ExxonMobil and Shell committing to produce the fuel earlier this year. This commitment comes in the face of warnings from the International Chamber of Shipping in July 2019, in its guidance for shipping companies, about the safety and stability of blended fuels. Consequently, those ship owners opting to burn LSFO will not only have to factor in safety issues and supply restrictions in bunkering ports around the world, but also higher prices for fuel. We have started to see customer advisories from shipping lines to their clients advising of LSFO recovery charges to be levied on dry bulk from 1 December this year.

Any shortfall in supply may force ship owners to use more expensive marine diesel fuel to tide them over, creating global demand that is predicted to double by the end of 2020. Even if LSFO supply holds up at main bunkering ports, price volatility will drive the need to re-evaluate long-term investment strategies by ship owners, operators, financiers and refiners, as the IMO prioritises greenhouse gas emissions reductions goals.

The alternatives

While the majority of ship owners (some 95 per cent of the world fleet) will bank on the availability of LSFO, others have opted for scrubbers, which remove sulphur and other discharges. Critics of this technology have noted that open loop scrubber systems simply move the pollutants from the air into the water, and that allowing their use creates an unfair two-tier market in an industry that has traditionally been cited as an example of perfect competition. Even these ships, however, may be forced to occasionally burn marine diesel if more ports follow Singapore, Fujairah and Norway in imposing restrictions on the use of open loop scrubbers. 

In addition to pollution concerns, costs associated with the installation of scrubbers can be high, and these may only represent a short-term solution to a larger and long-term environmental issue. The IEA has indicated that investments aiming to reduce only local pollutant emissions run the risk of being stranded as pressure grows on shipping to come into line with the transition to low-carbon targets and the IMO's 2050 target to reduce the total annual GHG emissions by at least 50 per cent by 2050 compared to 2008. Signalling a gradual change, one major dry bulk charterer has recently indicated an intention toward LNG-fuelled newbuilds to transport 10 per cent of its cargo from 2021.

Geopolitical challenges

Compounding the production challenges of LSFO and predicted volatility in marine diesel prices, tensions in the Strait of Hormuz could limit crude supply, as around half of all seaborne crude oil is transported through this area. This may open up market opportunities for Gulf Cooperation Council states to adjust to IMO rules and capitalise on recently increased production capacity.

However, the enforcement of the sulphur cap comes at a testing time for certain other Gulf states, with Iran exhibiting a fall in oil consumption of 44 per cent from 2014 to 2017. The re-imposition of US sanctions will make it even more difficult to find a market for HSFO of Iranian origin. Iraq has other difficulties following damage to the Beiji refinery and low domestic power sector demand for HSFO. Consolidation in the bunker supply market may be unavoidable as many medium and small operators are challenged to manage unpredictable price changes in marine fuels.

Consequences

The IEA's view as of September 2019 is that over time, the impact of the IMO 2020 sulphur cap will be gradual and manageable. The outlook for advanced refineries and oil companies is positive, although for ship owners and consumers of diesel worldwide it is uncertain. Unusual demand for marine diesel fuel may challenge middle distillate supply across a broad spectrum of industrial, mining, power generation and agricultural uses.

Currently, on the eve of the IMO 2020 sulphur cap coming into force, one of the greatest unknowns is the spread between HSFO and LSFO and the impact on operating costs. Ultimately increased fuel costs will be passed on in the form of higher freight rates.

Tramp-bulk trades, representing 84 per cent of world seaborne trade by cargo-tonne miles, will be more exposed to these variations due to their itinerant nature and higher number of remote and diverse destinations where bunkering choices are restricted. 

Dislocation in the supply and volatility in the price of marine fuels at the start of 2020 will work to stimulate interest in fuel efficiency and reducing energy use. Ultimately the IMO 2020 sulphur cap foreshadows even greater changes in store for global shipping, in the race to lower greenhouse gas emissions. 

Authors

Hazel Brasington, Consultant, Julia Derrick, Partner and Nicholas Chant, Graduate.