The oil market has already tightened significantly this year, pushing prices higher and putting pressure on producers to increase output. But the impact of new international regulations on maritime fuels set to take effect at the start of 2020 could disrupt the market even more dramatically.
The International Maritime Organization (IMO) will require significantly lower concentrations of sulfur used in global maritime shipping beginning on January 1, 2020. The new rules will drastically reduce demand for high-sulfur fuel oil commonly used in container ships. While there are multiple alternatives available for ship-owners, the rules are likely to significantly reshuffle the slate of fuels available, with far-reaching implications not just for shipping, but also for refiners, consumers and the global oil market.
IMO rules target sulfur
The new IMO regulations will lower the sulfur limits for marine fuels from 3.5 percent to 0.5 percent. This will lead to the elimination of significant portion of high-sulfur fuel oil (HSFO) demand as ship-owners will be forced to look elsewhere. Shippers have a few options at their disposal in order to comply. First, they could switch to LNG as an alternative fuel source. Second, ships could begin using low-sulfur marine gasoil (MGO), which is a distillate similar to diesel, or ultra-low sulfur fuel oil (ULSFO). This would require no modification to the existing shipping fleet. Third, they could still use HSFO, but would need to install scrubbing technology to remove the sulfur.
LNG would require expensive retrofits and refueling infrastructure, which makes this an unattractive option, at least in the short-term. There is also a chicken-and-egg aspect to a transition to LNG as a shipping fuel: There are relatively few ships using LNG, so there is little incentive to build the infrastructure, and vice versa.
Scrubbers present a steep upfront cost, but precisely because demand for HSFO is expected to fall off a cliff, futures prices are already heavily discounted. The yawning gap between gasoil and HSFO, which has reached as much as $40 per barrel for 2020 delivery, suggests there is an opportunity for ship-owners to pay the cost of installing scrubbers and then make their money back over time as they use heavily discounted HSFO.
The use of scrubbers is expected to increase beyond 2020 as costs come down and engineering capacity expands. But in the short run, most of the industry will lean on low-sulfur fuels such as ULSFO, diesel and MGO.
However, with the deadline approaching, analysts are noting that the industry is unprepared for this course of action. “Shippers and refiners have barely reacted yet,” Bank of America Merrill Lynch said in a note, an indication that relatively few may opt for this route. “In our view, this means that the majority of the fleet will need to shift from HSFO to ULSFO/MGO almost overnight or fail to comply.” The use of scrubbers is expected to increase beyond 2020 as costs come down and engineering capacity expands. But in the short run, most of the industry will lean on low-sulfur fuels such as ULSFO, diesel and MGO.
The final option for shippers is to simply not comply with the regulations and face monetary penalties, although the precise extent of the fines remains unclear. Goldman Sachs predicted in a September report that full compliance “is unlikely early on,” predicting a compliance rate of around 80 percent, a figure that will rise towards full compliance in the ensuing years.
Disruptions in oil market
As the shipping industry flocks to these middle distillates, supply could tighten significantly. Demand could surge by 1.3 to 4 million barrels per day (Mbd) by the time the IMO regulations take effect, according to BofAML. Middle distillates are much more expensive than HSFO, but it would require no cost to modify the ships, and the additional fuel cost will likely be passed on to consumers.
The reshuffling in fuel use will have a knock-on effect on the refining industry. The shipping industry accounts for about 5 Mbd of global oil demand, 70 percent of which is HSFO. By 2020, demand for HSFO could plunge by 3.2 Mbd, according to the IEA. Refiners will have to dramatically retool their slate of refined products to meet this shift. A Reuters survey of 33 refiners found that about 70 percent of them plan on cutting back on HSFO production. Production won’t fall to zero, however, as some HSFO will be used in ships with scrubbers and some might find its way onshore to compete with coal for power generation, especially as HSFO becomes extraordinarily discounted.
There is uncertainty over how significant the effects of IMO regulations will be on fuel prices and the shipping industry.
Still, refiners are expected to ramp up production of middle distillates, which could increase demand for crude oil. “The potential surge in crude demand from refiners ahead of IMO may add a further bullish twist to the Brent market,” BofAML said in its report, citing the already tight market for crude as a result of dwindling supplies from Iran.
There is uncertainty over how significant the effects of IMO regulations will be on fuel prices and the shipping industry.. Goldman Sachs said that complying with the rules will be “challenging, but solvable.” Other analysts see a larger disturbance ahead. “[T]he disruption IMO 2020 will cause to both the energy markets and to industry seems likely be acute in the short term,” Standard Chartered wrote in a note on October 3.
In a separate report last month, Bank of America Merrill Lynch cited the IMO regulations as one of three major factors—along with Iran sanctions and pipeline bottlenecks facing U.S. shale—that could contribute to an oil price spike “akin to the one observed in 2008.”
“[R]efiners have already maxed out their distillate yields, setting the market up for a dislocation. With diesel inventories in the OECD sitting at the low end of the range, the transition to a lower sulfur fuel specification will not likely be smooth,” BofAML concluded.