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The regulation capping sulphur content in marine fuels to 0.5% by International Maritime Organization (IMO) from Jan 2020 is a welcome change from an environmental perspective but it has significant implications elsewhere. Though the ship owners and refiners will be directly impacted, its reverberating effects will be felt across the world in manufacturing and trade encompassing the entire global economy and ultimately the end consumer.
The shipping industry which is already plagued with excessive capacities and low freights will reel under the additional burden of increased fuel costs. With limited negotiating power on freights, part of the increased costs will have to be borne by the ship-owners while some part will be passed on to the end customers.
Refiners have a challenging task to replace over 2.3 mn b/d of high sulphur fuel oil (HSFO) with compliant fuel globally. Though shortage of supply of compliant fuel may drive the prices up giving refiners more profits, the prices of surplus HSFO may crash and hurt refiners. This calls for a clearly defined action plan for refiners & marketers to capitalize on this opportunity to strategically establish New business opportunities and customers for the long run.
Climate change is a defining issue of our times. From shifting weather patterns that threaten food production, to rising sea levels that increase the risk of catastrophic flooding,the impacts of climate change are global in scope and unprecedented in scale. Today, the world is taking definite steps to mitigate climate change impact. The steps towards achieving ‘Sustainable Development Goals’ (SDG) and ratification of Paris Agreement under UNFCCC by almost all countries are some examples of the global community moving towards a greener future. One of the major contributor towards global air pollution is the Shipping Industry. As per IMO, the Shipping Industry while enabling 90% of Global trade volume contributes around 2.2% of global greenhouse gas (GHG) emissions including 16% of global SOx and 14% of global NOx emissions.
Formed in 1948, as a specialized agency of the United Nations, the 174 member strong IMO creates regulatory framework towards safety, security and environmental performance for the international shipping industry. The International convention for prevention of marine pollution under IMO, also famously known as MARPOL, consists of six annexes (chapters) each dedicated to the rules and regulations with respect to air pollution, discharge of oil, noxious liquids, sewage, garbage, solid wastes, and other harmful substances into the sea. Under each of the Annexes, various norms have been brought into force at different times over the last five decades. IMO targets to reduce the marine GHG emissions to 50% of 2008 levels by 2050.
The latest regulations have been issued under Annex VI in 2016, wherein IMO has capped the sulphur content in bunkering fuel (fuel used by ships) to 0.5% effective 01.01.2020. A momentous 86% reduction of sulphur from the existing level (3.5% Sulphur). It is also worth knowing that there a few notified areas known as “Emission control Area(ECA)” where the sulphur content for fuel is mandated to not exceed 0.1%. These stringent norms in ECA have been issued by select environmentally conscious nations for areas including the Baltic Sea, the North Sea, most of US and Canada coast, etc.
The new IMO imposed global sulphur norms will bring numerous benefits to public health. Trucost, a part of S&P Global estimates that this initiative will reduce two lakhs premature deaths globally. Further, the economic cost of sulphur emission emanating from health issues driving lower productivity is expected to reduce from $21.43 billion last year to $ 3.68 billion in 2020.
Shipping industry is the lifeline of global commerce and consumes fuel to the tune of 5 - 6 million barrel of oil equivalent per day (around 320 MMT per year²). The fuel used in ships is largely of three types (Fig.1)
Petroleum Derived Fuels
Marine Gas Oil (MGO)
Low Sulphur Fuel Oil (LSFO)
High Sulphur Fuel Oil (HSFO)
LNG
Alternate fuel (Bio Fuel, Methanol, etc)
Though LNG is a cleaner alternative, retro fitment for LNG is not yet established. There are only 125 LNG fuelled ships (0.2% of total ships in world) in existence and another 136 are on order. Ships using petroleum derived fuel will be required to continue using the same.
Fig.1 Fuel Consumption Split
HSFO forms 72% of the energy mix used in bunkering. There are two major options available with ship owners using HSFO. One is to use compliant fuel which shall be quite costly compared to traditional HSFO. The other alternative is to install scrubbers (Exhaust Gas cleaning system) which have high upfront capital expenditure cost.
Scrubbers clean the ships emission through treatment of exhaust gasses allowing it to continue to use HSFO and still comply with the emission norms. Alkaline water is sprayed into the exhaust to capture sulphur and other unwanted emission like particulate matter. Scrubbers require a capital investment of $2 to $4 million per ship. ROI of the investment in scrubber is calculated from savings by buying low cost HSFO over high cost LSFO/MGO. The payback period majorly depend on scrubber cost and fuel quantity used per day. There are three kinds of Scrubbers.
Open Loop: Sea water is taken in and wash water is discharged in open sea.
Closed Loop: Caustic Soda with sea water is used to wash and then safely discharged at ports.
Hybrid: the system can alternate between closed or open loop type.
For most large ships with daily fuel consumption of more than 30 tons per day, the payback period of a scrubber is 2 years or less (Fig.2). The largest 20% of the ships in the world currently consume 80% of HSFO.
Fig.2 Scrubber Economics
Source: Natixis, WoodMackenzie, Bloomberg
It is to be noted that many shipping companies are sceptical of fitting scrubbers due to concerns that IMO may expand the scope of regulations on emissions later to include NOx and CO2 or wash water discharges which cannot be addressed by scrubbers. Further Open Loop scrubbers, the most popular and cheapest of scrubbers are banned now in select ports including Singapore, California, Massachusetts, Belgium, and Germany as Open Loop scrubbers only shifts pollution from air to the sea.
Of the 3.8 Mn b/d of global HFSO consumption currently, 1 mn b/d consumption of HSFO is expected to be retained due to installation of scrubbers. Further, it is estimated that 0.5 mn b/d shall be consumed by non-compliant vessels. This leaves 2.3 mn b/d of demand which will have to shift to LSFO and MGO to comply with the new MARPOL regulations. The changing fuel mix is below (Fig.3)
Fig.3 Changing Fuel Mix
Source: Natixis, WoodMackenzie All figures in mn b/d
The high costs of scrubbers is not a cost effective solution for everyone, especially for ageing ships. Further there is currently an annual installation capacity of ~3000 scrubbers in the world (Current installations ~2500 ships). In view of the above, most shippers will have to use compliant fuel starting 2020. The compliant fuels are LSFO, High Flash HSD (HFHSD) with < 0.5% sulphur and LNG.
As per Platts analytics (Fig.4), due to the sudden growth in demand of compliant fuel, prices of compliant fuel are expected to shoot up. Operating expenses are expected to increase by 20-25% for ship owners. The prices of HSFO are expected to crash due to drastic drop in demand.The outlook for LSFO and HSFO is divergent and starts converging only after March 2020.
2.3 mn b/d of HSFO needs to be replaced with compliant fuel
Fig.4 Bunker Fuel Prices Projections
Source: S&P Global Platts
Shipping Freight rates (Fig.5) over the last decade have remained flat. The freights which took a huge plunge during recession of 2008, have recovered to only 50% of 2008 level.
Source: Clarksons, Danish Ship Finance
The heavy oversupply of ships leave the ship owners with limited negotiating power. Due to this Ship owners may not be in a position to pass on the entire increase in operating costs on to the customers. Further, issues of back haul (limited consignment availability for return trip), in-efficiencies of ageing fleet, lack of skilled manpower due to better job availability on-shore and undercutting of the freights by competition, are adding to the challenge for the shipping industry.
Refiners have to address two key challenges. How to supply the market with 2.3 mn b/d of compliant low sulphur fuel oil and what to do with the same quantity of HSFO currently being produced.
LSFO can be made by processing low sulphur crude oil (also called straight run) directly in the refineries or by blending heavier products with middle distillates (HSD, Kerosene, etc). In the immediate months following Jan’20, refineries will be required to run additional crude to make sufficient compliant marine fuel to meet the market demand.
As there are limited capabilities to channelize surplus HSFO, the prices are likely to fall drastically. The prices of new 0.5% sulphur fuel oil is expected to be close to MGO initially however these initial effects will dissipate in short term once refinery conversion capacity expands and further addition of scrubbers in ships.
Refineries will be seeking more of light, sweet crude in 2020 to meet the demand for LSFO. This is expected to drive the prices of Brent and WTI benchmarks higher by ~$7/bbl from current levels
Middle distillates cracks (the difference between product price and crude price) are predicted to peak in 2020 before declining in 2021 – 2023. Prices are likely to increase due to additional demand for blending purposes.
Part of feed for Petro-FCC unit (which converts Heavy Vacuum Gas oil to MS and other valuable products) will also be channelized for making LSFO. Due to this MS cracks will also see strength but much less compared to other distillates
HSFO cracks are expected to fall and remain low due to limited capability to channelize surplus HSFO. Over time, it is expected to stabilize with increase in use in power generation however the equilibrium is expected to be at much lower level than current.
LNGRefineries with deeper conversion are likely to see very strong margins as they produce essentially all light products and no fuel oil, and they can do that using cheap high sulphur crude feeds.
With lower production of MS from FCCU there will be a need to dip in into the virgin Naphtha pool through GTU (Gasoline treatment unit). This will likely pull both MS and Naphtha prices upwards.
Due to lesser runs of propylene from FCCU and diversion of Naphtha, petrochemical feed preference may shift towards LPG/Ethane.
With the downfall in prices and cracks of HSFO, the power and steel industry shall find it economical to run on FO than any other fuel. Even, bitumen production shall also be one of the preferred products for lesser complex refineries.
Due to shift from HSFO to LSFO, marine industry would demand more of Low TBN Lubricants (total base number).
The middle distillates cracks will start increasing in the 2nd half of 2019 and peak in 2020. The peak may not be in the start of 2020 as enforcement will tighten with March'20 HSFO carriage ban. While inventory levels of previously stocked LSFO will gradually be worked off. Allegedly, there are more than 28 mn bbl of LSFO stocked in ships near Singapore port acting as floating storages in expectations of windfall gains from spike in prices starting Jan’20.
One aspect which refiners need to look at carefully is blending. Blending incompatible products may lead to products getting separated and formation of sludge which will choke the filters of ships engine.
The older, simpler refineries primarily in Europe and former Soviet Union are the most affected since they are the largest producers of Fuel Oil. They have to take costly low sulphur crude to make in-stream LSFO. Many of the refiners like Shell at Pernis, Netherlands and Total at Antwerp, Belgium are putting up a solvent de-asphalter (SDA) and hydro crackers while others like ExxonMobil at Antwerp, Grupa Lotos at Gdansk, Poland are putting up delayed coker due to which they will be able to make cleaner transport fuels including IMO compliant MGO. Many more refineries including Preem at lysekil and Gothenburg in Sweden, Neste in Finland, ExxonMobil at Fawley, UK are upgrading their refineries.
With drastic drop of HSFO consumption in the shipping industry, the consumption in power generation and industrial uses is expected to drive the future of HSFO. In 2018, Saudi Arabia has started using HSFO heavily for power generation, desalination and air conditioning in the summers. HSFO is expected to displace 200 thousand b/d of crude burns for electricity generation in Saudi Arabia in 2020.
Bangladesh is another country which has been adding fuel oil and diesel fired power generation capacities to meet chronic power shortage. Bangladesh has a potential to absorb more than 150,000 b/d in 2020. In addition many of the small countries like Cuba, Sri-lanka, Madagascar, Lebanon, etc have smaller power generation units both on land and floating on water to meet peak power demand. The cheaper HSFO will be an attractive alternative to these nations for saving costs.
Iron ore: 68.4% of iron ore produced is exported globally. China accounts for 69% of iron ore imports. Freight accounts for 27 to 31% of the landed cost. Brazil and Australia are among the largest exporters of iron ore to China however with freight considerably higher from Brazil, the trade balance is expected to tighten. Every 100$/t increase in fuel oil price will make Brazilian exports dearer by 1.6% than Australia*.
Agriculture: The market for agricultural products is particularly reliant on low freight costs. Arbitrage flows covering a longer distance are most likely to come under pressure. Corn exports from Brazil and the US to Europe, Black Sea corn and wheat shipments to the Far East and biodiesel imports to Europe from China may all be under threat in 2020*.
Metals: Anode coke, a key component in the anodes to produce Aluminium is made from low sulphur residues in coking units. However with low sulphur residue being diverted to fuels, the prices may rise by 1 – 2 % which will be further compounded by higher logistics costs of both finished and raw materials around the world*.
The Turning Tides will be felt across the Global Trade & Supply Chain
India is strategically located in the world maritime route for bunkering sales, about 27000 ships call at Indian ports with a growth of 7% pa however only 1% of global bunker sales happen in India. Low sales is majorly attributed to high taxation, low infrastructure support in ports and supply chain constraints. To bring things into perspective, India's annual sales is equal to Singapore's weekly sales and Fujairah's fortnightly sales. As per MoPNG, Indian sales of marine fuel in an year is approx. 27.6 thousand barrel/day (1.38 MMT) of bunker fuel (excluding exports) at Indian ports. Market share of major players is as below (Fig.6).
Fig.6 Market Share
As per Indian shipping statistics 2018 issued by Ministry of shipping, there are 1400 ships in India of which only 456 ships runs overseas. Marine fuel sales in India are primarily driven by Indian ships undertaking domestic coastal voyage. Additionally 41% of Indian ships are more than 20 years old hence installation of scrubbers may not be a viable option for most Indian ships hence they will have to use LSFO. After implementation of GST on Marine Fuel, the sales have taken a huge dip across the industry. Kochi is strategically located for international bunkering. Favorable tax structure, government policies and infrastructure development can change Indian bunkering landscape.
On, the refineries front, 70% of Indian refineries are capable of upgrading the bottoms (Like BPCL Kochi Refinery ) , these refineries process 81.2% of crude in India. These refineries can swing between making blended compliant fuel or upgrade them completely to middle distillates basis cost economics post Jan 2020. Refiners with no bottom upgradation facilities will have to process more of sweet crude to minimize HSFO production at the same time make compliant LSFO. Margins however will be impacted due to higher input crude prices. One alternate available with these refiners is develop blending recipes to convert HSFO to compliant fuel and make larger margins.
BPCL R&D has made good headway in developing such blending recipes for Refineries.
The MARPOL regulations shall bring a paradigm shift in the industry. There are several possible scenarios which may shape up as a consequence of IMO 2020 on the basis of the following two key levers
Prices of LSFO and HSFO
Installations of Scrubbers by ship owners
Under the most likely scenario of high LSFO demand, the prices of low sulphur crudes, MS, HSD, Marine fuels, Petrochemicals, etc are expected to increase thereby impacting the entire global economy. Refineries can capitalize on the short term opportunity presented by MARPOL through optimization of the costs of LSFO production, maintaining a product slate having higher percentage of middle distillates and upgrading bottoms to earn higher margins.
https://www.un.org/en/sections/issues-depth/climate-change/
Assesment of fuel oil availability , final report by CE Delft
Turning tides, S&P Platts report Feb'19
Fuelling the maritime sector, IMO 2020 & beyond by KPMG
Basic port statistics of India 2017-18, by ministry of shipping
Indian Shipping statistics by Ministry of Shipping, transport research wing
PPAC analysis & reports
Natixis IMO 2020 update , March 2019
International Maritime Organization website
MoPNG analysis & reports
Images credits: Canva
Sh. Ravitej PV(ED-MR) Sh. Mamadapur DV(CGM-SCO) Sh. Ramesh Goil(DGM-I&C) Sh. Rengarajan S(DGM-MR) Sh. Rajeev Kumar(Ch. Mgr-R&D) Sh. Harinath V(Ch. Mgr-IT) Sh. Vaibhav Gandhi(Sr. Mgr-IT) Sh. Anuj jain(Sr. Mgr-SCO) Sh. Kalyan Mukherjee(Team Corporate Strategy)
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