If you don’t work in international maritime or the oil industry, there’s a good chance you’ve never heard of IMO2020. To put it simply, it’s a regulatory change around the sulphur content of fuels, going from a limit of 3.5% to 0.5% sulphur content.
Sulphur oxides (SOx) are known to be harmful to human health, causing respiratory symptoms and lung disease. In the atmosphere, SOx can lead to acid rain, which can harm crops, forests and aquatic species, and contributes to the acidification of the oceans. — IMO
Ships generate a massive amount of sulphur oxide emissions (2–3% of global emissions), and in the fight against climate change, IMO2020 is essentially the front line. Right now, approximately 60% of the ~53,000 merchant ships on the planet burn a type of fuel known as High Sulphur Fuel Oil (HSFO). The rest burn a type of fuel called Marine Gas Oil (MGO), which is similar to diesel.
Why should I care
Complex systems are hard to understand. That’s why they are called complex systems. They involve a number of inputs that affect the outputs of the system in seemingly chaotic ways. We write models and simulations to try and understand complex systems, but when the variables are not controlled and we have no historical data to backtest against, it’s simply impossible to accurately predict what’s going to happen. International maritime trade is one such complex system, right up there with climate models and election predictions. Remember Brexit? Got that one wrong. Trump winning? That one too.
90% of all trade on the planet is conducted over oceans. One could easily argue that global shipping is the cornerstone of modern civilization. Yuppies in Brooklyn eat avocados from Brazil, and a yak herder in Tibet burns Nigerian oil. I’m writing this article on a computer designed in California and assembled in China, full of rare earth metals from all over the planet. I’m wearing a shirt made with organic cotton grown in the United States and wearing quick dry pants made in Bangladesh of materials from all over the world.
Global trade is complicated. If we could effectively model global trade, we would have seen the oil crash in 2015, or the financial crisis in 2008. Everyone would have bought bitcoin at ten cents and nobody would have spent it on pizza. The reality is, global trade is too complex to model for all the outcomes. We forecast things a few quarters out at the most and those forecasts are generally unreliable. Just this month, the EIA reported a drop of 1.7 million barrels of crude supplies, when supplies were forecast to rise by 4.7 million barrels. That’s a difference of 6.4 million barrels, over 6% of global daily crude usage. That’s huge.
Like it or not crude oil is the most important commodity on the planet. It’s the life blood of our civilization. Petroleum products are the enabling factor of nearly everything we do. The commercialization of oil as fuel enabled our rapid expansion to all corners of the earth and a 650% increase in human population in just 150 years. IMO2020 marks the most dramatic change to the oil industry in history.
“It is the biggest change in oil market history,” Steve Sawyer, senior analyst at energy consultant Facts Global Energy
Even small changes in a complex system can yield dramatic results. We’re talking about many simultaneous dramatic changes to a complex system. The results are impossible to forecast. At least in my mind, the only thing that is certain is uncertainty.
Regulators never saw anything they didn’t want to regulate, and never regulated anything they fully understood
I’m not saying that the legislation is bad scientifically. I’m sure nobody in Shanghai, Islamabad or Delhi would be disappointed with a little less smog.
The maritime arm of the UN drove this regulatory change. In fact, the regulations were announced just about three years ago to the date. But who would be responsible for implementation? Since the regulations are around fuel standards, the implementation burden primarily falls upon:
- Crude and refined product transporters
- Fuel storage providers
The changes were ratified at precisely the time when these players were the worst equipped to handle them. Do you remember the epic energy crash at the end of 2015? Here’s how the oil industry was doing back then:
XLE, the primary index of energy companies (mostly producers and refiners), had just fallen off a cliff. There were over 400 energy bankruptcies in 2015 and 2016.
Product tankers fared even worse. Many companies saw their share prices collapse to all time lows in 2015, after already being in the midst of one of the worst bear markets in history:
Granted, most of these companies were doing poorly due to their own over investment and speculation in previous years, but the point is that these companies were asked to make massive changes to their operations at a time many of them were struggling for survival.
Nonetheless, they are trying. Refineries around the world have invested billions retooling their systems to be able to produce the new compliant fuel. Tankers have bunkered compliant fuel in advance and installed “scrubbers” to remove sulphur from oil (essentially, mini refineries on the boat).
As industry is responsible for making the changes, industry is who you should look to in order to get a sense of how things are going and what will happen next.
With roughly 2 months to go, how’s it going?
January 1, 2020 is a hard deadline. Industry has been rushing to meet it, and the rules are going to be enforced. So how are people in the industry feeling? From what I can see, there’s a sense of great uncertainty, with a lot of variables at play.
There’s uncertainty about supply of the new fuel (LSFO). The strait of Singapore is currently full of tankers hoarding compliant fuel. These are speculators anticipating enormous price spikes. LSFO is already trading at a massive premium to the old fuel, a spread that could continue to increase:
“For the fourth quarter, given a drop in high sulphur fuel oil prices and a rise in gasoil cracks, it seems shipping companies are disposing high sulphur fuel oil and stockpiling IMO-compliant fuels,” Cho Yong-kuk, S-Oil treasurer
The pricing dynamics are changing rapidly. Industry players have different ideas about outcomes and are implementing differing strategies.
While it seems major ports will have enough compliant fuel, it is a concern that smaller hubs will not have enough compliant fuel.
“The availability of compliant fuel products is just one of the issues facing IMO 2020,” — TradeWinds news, October 2019
In an interview from just a few days ago, Alan Gelder of Wood Mackenzie stated that he foresees a shortfall of 1 million barrels a day of LSFO, and an increase in marine gasoil demand:
Shipping consumes 3.5 million b/d of high-sulphur fuel oil (HSFO, sulphur content capped at 3.5%). Refiners globally will be able to deliver 1.5 million b/d of VLSFO (very-low sulphur fuel oil, capped at 0.5%) by our reckoning….That leaves around 1 million b/d looking for marine gasoil (similar to diesel) which is more expensive — so shippers will pay more for their fuel.
Others are more optimistic about the LSFO supply picture:
“The good news is there will be sufficient supply of low-sulphur fuel oil (LSFO),” Steve Saxon, McKinsey, TPM Asia conference in Shenzhen last week.
There’s uncertainty as well regarding the future availability of HSFO. Many ships installed scrubbers so they could burn the old fuel. With prices crashing, that seems to have been an excellent choice from an economics perspective. But this complicates trade routes, refining, and bunkering strategies. For years, the industry has used mainly two types of fuel. Now we’re looking at four fuels which will be competing starting very soon. The price of HSFO went from all time lows to all time highs in just a month. LNG (Liquified Natural Gas) has also come into the mix as an option, with new LNG bunkering options springing up, and LNG freight rates at very high levels.
When you consider adoption, things become even more complex. Even if there is ample supply of LSFO, given that so few ships have adopted LSFO so far (only 5% of the global maritime fleet is using LSFO right now), there is no data regarding long term LSFO usage, and some in the industry are concerned as to whether or not there will be adoption issues. New lubricants are needed. Different maintenance cycles are required. Refinery quality may not be consistent.
“Other than sulphur content, new fuels also need to have consistent viscosity and stability, otherwise ship engines and other equipment onboard could be damaged.” — TradeWinds News
Remember, this change has JUST NOW begun its implementation in earnest:
Storage tanks began converting to supply lower-sulfur fuels in August and demand for the fuel could reach 50pc of the fleet in November — Jeff Dietert, VP of investor relations, Phillips 66
Shell just released a white paper reminding of “the risks posed to engine performance by fuel switching, stressing the need for intense focus on condition monitoring in equipment management”.
The VP of supply at Valero just said “VLSFO might not be ready for prime time.” He recently said:
“But we have also seen that there [are] a lot of challenges being able to blend this 0.5% material,”
“I think there is a good chance that initially ships will run marine gasoil and then gradually transition to the lower sulfur bunker material.”
Just think about it. New fuels. New supply paths. New storage models. Mini refineries aboard ships (scrubbers). New maintenance lifecycles. We’re introducing a host of changes simultaneously, and nobody, not the analysts, not me, not ship operators, not refinery or production executives, knows exactly what effects all these changes will have.
When a process doesn’t change for a long time, it gradually optimizes. It becomes a commodity. Margins become thinner and thinner. Oil production and refining, and international maritime, have been in a gradual optimization process for a very long time. And with IMO2020, that all changes.
“As many as half of world refineries cannot produce fuel that meets the new regulation…They cannot reprocess a high-sulfur diesel fuel to a low-sulfur diesel because their facilities are inflexible.” — Philip K. Verleger
The world is simply not prepared.
A world of possibilities
Here’s what’s we know is happening now. It does not appear things are going as planned.
- Crude imports are up 30% this month in India, after hitting a 15 year low just last month
- As mentioned above, The EIA reported a massive surprise crude inventory fall. They were off by 6.5 million barrels, a huge error.
- Scrubber installs (to use the old HSFO fuel) are taking longer than expected and have resulted in a fewer number of ships installing scrubbers than analysts expected, and not just fewer, 90% fewer.
- A large and growing number of ships are hoarding IMO2020 compliant fuel in Singapore.
- Tanker rates spiked to all time highs, with the cost of transporting crude oil increasing more than 1000% over the course of weeks (rates have since corrected, but remain high, 300–400% higher than over the summer). This happened after the US announced sanctions on crude tanker company COSCO, tightening an already tight supply picture.
I think the only thing that we can expect going forward is the unexpected. Economist Philip K. Verleger has predicted $200/barrel oil next year. The IATA put out a study warning the aviation industry that jet fuel prices could be greatly affected. They said:
IMO 2020 is a unique event that is expected to bring an historically unmatched demand shift in the global oil market. This means that historical information might not be enough to estimate the overall effect of the limit on the jet fuel price.
The trucking industry is thinking about this, too. Werner Industries CEO Derek Leathers recently said (while tempering concerns a bit):
IMO 2020 will have a material impact on fuel surcharges next year, so it would be unwise for shippers to ignore the topic.
If global shipping is greatly disrupted, it will definitely have spillover effects into many other corners of the economy. It could be much more expensive to deliver goods. Diesel fuel prices could spike to record highs. There could be more mechanical breakdowns on ships, which will disrupt the transportation of commodities at perhaps the most inopportune times.
Even if compliance is laxly enforced, or market participants just don’t follow the rules, refineries and fuel storage participants have already invested billions in drastic changes. These were not organic changes based on incremental improvements. This is a major disruption forced on industry by regulators. The variables have already been irreversibly altered, and no one really knows what will happen. I’m not predicting economic collapse. I’m not predicting everything will go smoothly. I don’t think anyone can, and that’s the point. Add in the US/China trade war and sanctions, and things become even less predictable.
Winners and losers
While I have no idea what the exact effects will be, I do have some predictions. Any time an economic system changes, there are always those who benefit from the changes and those who are harmed by the changes. Imbalances in nature cause extinction in some species, and proliferation in others.
I believe civilization (as a whole) will ultimately bear the cost of this historic transition. Consumers will face higher prices for some goods and services. Curious pattern changes will crop up. Even something (seemingly) completely unrelated, like electricity rates to consumers produced by wind or hydro power, could increase, simply because the maintenance inputs increased. Nearly everything we use today came from somewhere else, and we are witnessing a historic distortion to how “came from somewhere else” happens.
The climate could be a winner long term, and it might not be. Big changes and disruptions may paradoxically result in a less efficient system which creates more emissions. Anyone who tells you they can predict the total outcome, at least in the short term, is either lying, stupid, or has an agenda.
I think in the short term, I will speculate on some winners:
- Technologically advanced refineries (US and Korean refineries)
- Companies that transport crude oil and fuel oil (also known as crude tankers and product tankers). Of these companies, those who installed scrubbers may benefit on the bottom line in the short term, but may face other challenges in the long term.
- Companies that transport liquified natural gas (LNG), another alternate fuel
- Companies that store maritime fuel oil (also known as bunkering)
- Companies that provide service, support and logistics for consumers of the new fuel (Mostly oil majors)
Losers are more difficult to speculate on, but I think it’s possible that virtually all other maritime companies suffer in the short term due to higher costs. However, some analysts have pointed out that shipping thrives on disruption, which allows them to become price setters rather than price takers. Regardless, I think ship operators definitely bare the cost that they can’t pass down the chain. This includes vessels being off charter for scrubber installs or other maintenance, increased operational challenges and disruptions, and perhaps increased fuel costs. The top analyst in the space is bullish on many sub-sectors, but has the largest allocations to product tankers. After the last boom / bust cycle, there has been a huge lack of investment in the shipping space, which most in the industry believe will positively impact shippers. Many analysts see a secular bull market in at least some shipping segments beginning now.
In the slightly longer term, I think the push for lower SO emissions will likely continue, and the value of sweeter, heavier crudes will skyrocket while the value of heavier crudes plummet. In this case, the big winners are producers of sweeter crudes. The big losers are heavier crude producers, and less sophisticated refineries (like in China and India) that cannot retool to produce new fuels without significant investments. We will continue to see more optimization in lowering harmful emissions and increasing efficiency. Maersk, Shell, Norsepower and ETI, for instance, just concluded trials from radical new “sails” that increased fuel efficiency by 8.2%.
In the very long term (think 2030–2050), we will almost certainly see much lower crude demand and a move to alternate fuels. Maersk is already experimenting with alcohol, biomethane and ammonia to reduce emissions. Perhaps there are more nuclear powered vessels one day. I would definitely bet on alternative energy and fuel.
I am not a maritime expert, nor an economist. However, as an amateur historian and someone with a lot of experience with complex systems, I can tell you that big changes always create “bugs” and “glitches”. From the information I have access to, I can see that dramatic changes are being made to a very complex system. This will certainly yield uncertainty.
I will continue to monitor the situation, and plan on attending some maritime industry events and hanging out near the Panama Canal zone to get more “ground floor” information on developments, as well as continue to monitor the oil markets. Thank you for reading, and as normally disclaimed by anyone in finance, do not construe anything in this post as investment advice. Please inform me of any factual mistakes in this posts, or information that should be included.