The lower limit of 0.10% m/m currently applicable in waters known as Emission Control Areas, such as the North Sea, English Channel and Baltic Sea, will remain unaffected.
IMO 2020 is set to have an impact across the oil and gas value chain, including crude producers, traders, refiners and customers, in addition to the shipping industry. The ultimate impact of IMO 2020 on the energy sector will not be seen immediately and the answer will depend on the implementation strategies chosen by the shippers driving the fuel demand and the responses of the refiners driving the supply. Uncertainty is likely to persist during the initial stages of implementation, as the regulation gives shippers multiple options (including non-compliance) and the enforcement is left to multiple jurisdictions.
How Can Shippers Respond to IMO 2020?
Shippers can pursue various strategies in response to the new limit, including:
– switching to compliant fuels (e.g. marine gas oil (MGO), very-low sulphur fuel oil with less than 0.50% m/m of SOx (VLSFO) or ultra-low sulphur fuel oil with less than 0.10% m/m of SOx (ULSFO));
– refitting ships to alternative fuel engines (e.g. liquefied natural gas (LNG));
– installing scrubbers (i.e. exhaust-gas cleaning systems) allowing the continued use of high-sulphur fuel oil (HSFO); and
– non-compliance with the regulation.
It is expected that at least initially, due to the high capital expenditure (CAPEX) and supply limitations of refitting to alternative fuel engines and installing scrubbers, the majority of ships will respond by using compliant fuel.
This implies that the most likely short-term outcome of IMO 2020 will be an increase in demand for MGO and low-sulphur oil with less than 1.00% m/m of SOx (LSFO), which can be used to produce VLSFO, and a surplus of HSFO.
Short-Term Impact on Fuel Market
Global bunker fuel demand accounts for only 4-5% of global oil demand (with 70% HSFO, 28% MGO and 2% other fuels) (McKinsey & Company). Nevertheless, the Council of Economic Advisers of the United States of America has warned in the Economic Report of the President that the new SOx limit "may cause significant disruptions in specific product markets, with consequent price movement for all uses of fuel."
However, according to 'Assessment of fuel availability' conducted by IMO itself: "the refinery sector has the capability to supply sufficient quantities of marine fuels ... while also meeting demand for non-marine fuels.”
The IMO findings have been confirmed by the International Energy Agency, which predicts a smooth implementation of IMO 2020 in its November 2019 report. The report further notes that major bunker hubs, including Fujairah, Rotterdam and Singapore, have large volumes of compliant fuel available, although smaller ports may not have compliant supplies in sufficient quantities.
Overall, volatility can be expected in the prices of HSFO, LSFO and, to a lesser extent, MGO, especially during the first quarter of 2020, until the global marine fuel supply chain is more stabilised. Meanwhile, the spread between HSFO and compliant fuels continues to grow, with the spread of USD 30/bbl between HSFO and LSFO in Northwest Europe in October 2019, as opposed to just under $3/bbl last year. Ultimately, increased costs of fuel production are likely to be passed on to the end-users in the form of higher shipping rates.
Impact on Refiners
The main options for refiners in response to IMO 2020 are:
– continuing to produce HSFO for ships with scrubbers and more complex refineries as feedstock recognizing that the level of demand will be lower;
– changing crude inputs to sweeter crude oil (with less SOx) to improve the production of compliant fuels and/or distillates;
– continuing to use the same infrastructure and making operational changes to decrease the amount of SOx in output product;
– blending existing residual oil (if originally close to 0.50% m/m) with low SOx distillate to produce compliant fuel;
– adding desulphurisation, coking or hydrocracking equipment to further process HSFO and produce IMO-compliant fuel (requires high CAPEX and 3-4 years to go online).
The impact on IMO 2020 on refiners will, therefore, depend on the refinery type. Global refineries can be classified into the following categories based on their ability to process residual materials into lighter products:
i. Topping (able to process HSFO);
ii. Cracking (able to convert crude oil with a boiling point of 350-570°C into light products via fluid catalytic cracking (FCC) or hydrocracking processes); and
iii. Full Conversion (able to convert materials with a boiling point of 350-570°C and above into light products via coking, visbreaking or hydrocracking with small amount of residual-type material produced).
Generally, Full Conversion refiners that already made the necessary investments to upgrade technology will benefit from IMO 2020 and the expected fall in the price of HSFO.
By contrast, simpler refineries are likely to see negative impacts due to the potential over-supply of HSFO and limited disposal options. To mitigate the risks, such refineries may contract with ship owners for HSFO supply in return for the refiner investing in vessel scrubbing equipment installation. Alternative outlets for the additional HSFO that will no longer be used in the shipping sector include the global power industry and production of carbon black and asphalt.
In terms of the global spread, generally, the refineries in the Middle East, Asia and US Gulf are classified as complex, while the refineries in Russia, US East Coast and Northwest Europe are smaller and may experience difficulties in maintaining current profitability levels.
Longer-Term Impact on Fuel Market
The longer-term effect of IMO 2020 is difficult to predict as many shippers have adopted a 'wait-and-see' approach to refitting the ships to alternative fuels or installing scrubbers to see how the fuel market reacts first.
Lower HSFO price will incentivise more shippers to install scrubbers. Scrubber-equipped vessels currently account for approximately 4% of the global fleet. According to Wood Mackenzie, this number will rise to about 7% by 2025. In addition to their high upfront CAPEX (US$2m+), scrubbers come with the uncertainty over their legality in the future, as there is a possibility of further environmental regulations restricting their use or imposing additional limitations over emissions (e.g. certain types of scrubbers have already been banned in some jurisdictions).
LNG, on the other hand, is the cleanest form of burning marine fuel. The use of LNG as a marine fuel has significantly lower levels of SOx, nitrogen oxides (NOx), carbon dioxide (CO2) and particular matter (PM) emissions when compared to HSFO and MGO. Furthermore, LNG prices are lower and more stable than those of HSFO and LSFO. According to a new report released by SEA/LNG, LNG is "the most mature, scalable, and commercially viable alternative fuel currently available for the maritime industry." That is not to say that LNG does not come with its own challenges, including high CAPEX for retrofitting (US$6m+), limited bunkering infrastructure at international ports and the space required to accommodate LNG tanks on a ship.
The full extent of the impact of IMO 2020 on the energy sector is yet to be seen and will depend on the compliance mechanisms adopted by the shippers, responses of the refiners to the changes in fuel demand and future environmental regulations. Overall, the industry players need to recognise the universal movement towards greener energy sources and factor the potential future environmental restrictions into their long-term strategies and contracts.