IMO2020: Compliance a key; IEA gives some hard numbers on distillate impact

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Given that IMO 2020 is being viewed as the largest regulatory change to hit oil markets since at least the introduction of reformulated gasoline in the early 1990s – and that was just in the U.S. – the subject received a surprisingly small amount of attention at the recent CERAWeek meeting in Houston.

But in a panel led by Sandeep Sayal, the vice president of downstream energy research at IHS Markit (of which CERA is a subsidiary), there were a few new observations about how the regulation might hit fuel markets, which could trickle – or cascade – down into the price of on-road diesel.

As has been mentioned previously, one of the biggest unknowns in the forecasts is how many ship owners will simply ignore the rule, at least for now, and continue to burn cheaper high-sulfur fuel oil and violate the IMO 2020 rule that marine fuels can be no more than 0.5 percent sulfur, down from the current level of 3.5 percent. The International Energy Agency (IEA) earlier this week estimated non-compliance at about 700,000 barrels per day (b/d). That number matches that of the consulting firm of Baker & O’Brien, whose estimates FreightWaves wrote about recently.

But Savvas Manousos, Maersk’s Global Head of Trading and Investments, said during the panel that he expects compliance with the rule to be in the 85 to 90 percent range. If the base of that estimate is the 3.5 million b/d of high sulfur fuel oil that the IEA estimates is the current market for marine fuels, that would take non-compliance down to about 525,000 b/d at the 85 percent number and about 450,000 b/d at 90 percent compliance, significantly less than the IEA estimate of 700,000 b/d.

Every barrel that does comply with the rule potentially means a barrel of some sort of distillate – the basic category of oil products that includes diesel – being diverted into the marine fuels market. Higher levels of compliance mean more barrels of distillate flowing that way to provide necessary feedstocks for blending or processing of new IMO 2020-compliant fuels, such as the new product offering known as very low sulfur fuel oil (VLSFO).

Another alternative is increased consumption of marine gasoil (MGO) and marine diesel (MDO). As was noted in the recent panel sponsored by TradeWinds at which Baker & O’Brien gave its estimates, given that the characteristics of MGO are known, and those of VLSFO are not, there may be an initial rush to MGO and MDO while the performance of VLSFO is fully vetted.

In its recent Oil 2019 report where the 700,000 b/d non-compliance forecast was issued, the IEA also put a number on how much MGO would be consumed to meet the IMO 2020 mandate. The Oil 2019 report’s estimates are probably the clearest so far of the supply/demand balance shifts in the distillate pool as a result of IMO 2020. The report, whose summary numbers are below, spells out the demand for various types of marine fuels, projected out over the first five years of the IMO 2020 mandate, as well as what is happening during the last two years before the rule kicks in.

As the table shows, increased use of distillate fuels in MGO and as a blendstock in VLSFO, when combined with existing uses (such as the category marked “inland gasoil”), will lead to a demand figure in 2020 and 2021 that will result in a gasoil deficit of 200,000 b/d in 2020 and 300,000 b/d in 2021.

 Source: IEA. Figures are in millions of barrels per day
Source: IEA. Figures are in millions of barrels per day

As the report notes, “This is small in the context of the 30 million b/d global gasoil market, although additional investments in new refining units are needed.” But what the model does not envision would be a surge in MGO demand at the beginning of the mandate while the industry gets acquainted with VLSFO.

One aspect of the possibility of a sudden shift to MGO is that not all ships are equal. Manousos, asked about a surge in MGO demand at the start of the mandate, said a ship with only one fuel tank and an auxiliary tank lacks “a degree of flexibility to burn (multiple fuels)… that is far reduced.” But by contrast, “if you’re a container ship and you’re loading 10,000 tonnes in Rotterdam to go to China and back, and you’ve got 81 fuel tanks, it isn’t going to be one size fits all,” Manousos said. “Size matters.”

Horace Hobbs, the chief economist of major U.S. refiner Phillips 66, said the futures markets are not yet showing any sort of big market shift that would incentive the production of MGO as a whole. But there might be more localized impacts; he said, “It will be different for every location.”

That the futures markets are not yet showing an impact is not entirely true. The spread between Brent and ultra low sulfur diesel (ULSD) on the CME yesterday closed around 38 cents per gallon for the comparison between the April contracts, the lowest level in months. But looking out and comparing December Brent to January ULSD (there was no January settlement for Brent Wednesday), the number widens out to about 47 cents per gallon. It’s a sign that the market is not unaware of the mandate and appears to be building it into its numbers, at least to a small degree.

On other issues surrounding IMO 2020:

– Manousos, whose estimate of non-compliance was less than the market’s widely quoted figure of 700,000 b/d, said insurance companies will be a key factor in forcing that compliance. “Insurance companies do not guarantee their coverage for ships not in compliance,” he said. Additionally, Manousos said port authorities should move to a system of detention of ships rather than fines for ships found in non-compliance. “The biggest deterrent is if a ship doesn’t get to go to the next port,” he said. “Fines may be less than what they [ship owners] saved by cheating.”

– Peter Tirschwell, vice president of Editorial and Publishing at IHS Markit, fresh off a company-sponsored conference on shipping that discussed IMO 2020, said there was a fear expressed at that event that the container market is so competitive “that they won’t be able to pass on the increased fuel prices and may choose to scrap some ships.” Tirschwell’s PowerPoint presentation highlighted a quote from Matt Cox, CEO of shipping logistics  company Matson, who said at the Tradewinds conference, “My sense is if the carriers don’t get a satisfactory outcome with regard to mechanisms that allow them to recover all or part of their fuel surcharge, they’re going to take a very hard look at deployed capacity.”

The goal established 13 years ago by the e-freight program was to cut delivery cycle times by 24 hours and eliminate nearly 8,000 tons of paper documents per year. Historical factoids abound to illustrate the mode’s challenges. The typical consignment booked by a forwarder and shipped in the belly of a passenger airplane takes five to six days to reach its consignee, though it takes less than a day to fly it to the destination market. The remaining time is often spent sitting in customs waiting for processing and clearance, or hung up in the web that also includes ground handlers, customs brokers, truckers and importers. The time that a shipment languishes on the ground nullifies the benefits of air shipping for which a shipper often pays a dear premium.

Then there’s the paper. According to an enduring factoid from IATA, each international air shipment required 30 or more paper documents to process and submit. Swedish telecommunications provider Ericsson, a big airfreight user at the time, caused a stir in 2013 when it said its annual required paper documentation could fill a Boeing 747.

 In his remarks, IATA’s de Juniac said that process modernization will be critical to “efficiently meet the doubling of demand expected over the next two decades.” Changes are already being demanded by customers of the industry’s two most promising growth markets – e-commerce and the transport of time- and temperature-sensitive goods such as pharmaceuticals and perishables, he noted.

 Another area of needed improvement lies in upgrading airfreight facilities, he said. “The e-commerce world is looking for fully automated high-rack warehouses, with autonomous green vehicles navigating through the facility, and employees equipped with artificial intelligence and augmented reality tools,” he said. The average cargo warehouse “is an impressive sight. But there is a huge gap to fill,” said de Juniac.

 The freight that moves in the bellies of passenger airplanes has been likened to the bar at a restaurant. It can’t generate all of the restaurant’s revenue, but it rakes in a goodly amount of profit. That’s because the aircraft needs to fly anyway, and the bulk of the revenue, and cost, is derived from passenger services. Yet unlike all-cargo carriers such as FedEx Corp. (NYSE:FDX), UPS Inc. (NYSE:UPS) and DHL Express, airline cargo departments play second-fiddle to the demands, schedules and, most importantly, the safety of travelers. That will never change.

 “It’s exceptionally tough to drive change in a global industry with a huge number of stakeholders, and where safety is top priority,” de Juniac said in his remarks. “But it is not mission impossible. I challenge stakeholders to find ways to drive critical change at the speed our customers expect.”

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John Kingston

John has an almost 40-year career covering commodities, most of the time at S&P Global Platts. He created the Dated Brent benchmark, now the world’s most important crude oil marker. He was Director of Oil, Director of News, the editor in chief of Platts Oilgram News and the “talking head” for Platts on numerous media outlets, including CNBC, Fox Business and Canada’s BNN. He covered metals before joining Platts and then spent a year running Platts’ metals business as well. He was awarded the International Association of Energy Economics Award for Excellence in Written Journalism in 2015. In 2010, he won two Corporate Achievement Awards from McGraw-Hill, an extremely rare accomplishment, one for steering coverage of the BP Deepwater Horizon disaster and the other for the launch of a public affairs television show, Platts Energy Week.

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