The piece below was sent to subscribers of SONAR. It is part of the “Deep Dive” series of special weekly reports that looks into the inner workings of markets. Given the importance of IMO2020 to the entire diesel-fueled supply chain, we are sharing it here with all the readers of FreightWaves.
As the days dwindle toward the implementation of IMO 2020, the number of conferences dedicated to the subject rises.
And the models are getting more specific. That was the case at a recent forum on IMO 2020 held by TradeWinds in New York, where an analyst from one of the leading refinery consulting companies in the country tried to spell out how the conversion is going to go when it hits in full next January.
First, a recap of the rule and why it matters to the trucking sector: the fuel oil that is now burned in ships–known as bunker fuel–can contain as much as 3.5 percent sulfur. Even that is tighter than earlier restrictions that put it at more than 4 percent, or the free-for-all that existed historically when the most sulfur-laden heavy crude in the world was used to create bunker fuel. On January 1, that limit will drop to 0.5 percent. In some key port areas, it is already at that level.
The concern that the trucking sector has is that an alternative to the high sulfur bunker fuel now being consumed will be several forms of distillate that go under the name of marine gasoil (MGO) or marine diesel (MDO), or that diesel will be blended into bunker fuel to make a compliant product. Either of those choices could mean a concurrent loss of diesel supply. The resultant tightening of the diesel market is the worst case scenario for IMO 2020’s impact spilling out of the shipping market and into trucking.
The analyst at the TradeWinds meeting, Charles O’Brien of the refinery consulting firm of Baker & O’Brien, built a model barrel by barrel that attempted to show how the switch away from high sulfur bunker fuel was going to take place. Here’s some of his math:
He starts with estimated worldwide demand of 3.2 million barrels per day (b/d) for high sulfur bunker fuels, which we’ll abbreviate as HSFO for high sulfur fuel oil. Because of an energy density difference, that needs to be converted into 3.4 million b/d of low sulfur bunker fuel.
Several steps help get the market there on a global basis. Scrubbers, which allow the burning of high sulfur fuel oil whose emissions are “scrubbed” of sulfur for later disposal, will account for 700,000 b/d of demand, according to the Kemp model. Changes to refinery capabilities through upgrades will be another 200,000 b/d.
Kemp also cites another 200,000 b/d through changes in energy density of the new fuels. Add all those together and you’re still anywhere from 1.2 to 1.4 million b/d away from the 3.4 million b/d demand for low sulfur bunker fuel.
The big wild card in the formulation is outright non-compliance or non-compliance where some sort of waiver is granted. Kemp estimates that at about 700,000 b/d.
After that is where it gets tricky. Kemp sees about 225,000 b/d of diesel being blended into higher sulfur fuel oil to make an IMO 2020-compliant fuel oil product, known increasingly as very low sulfur fuel oil (VLSFO). His model has two other categories that are significant–crude slate shifts and increased refinery throughput. Having a full degree in refinery engineering would help allow people to understand what’s going on in those categories but what you need to know is that they are both factors that will reduce the supply of over-the-road diesel. Add those two categories to the 225,000 b/d cited earlier and according to Kemp you’re looking at a reduction in diesel supplies of anywhere from 500,000 b/d to 700,000 b/d.
Let’s put that into perspective. The global market for all distillates–diesel, jet fuel and kerosene–is about 34 million b/d. So what would be another 700,000 b/d of demand? The answer is that it could have a significant impact, because you’re diverting about 2 percent of world distillate supply into an entirely new category of demand. In balanced markets, a shift of 2 percent is significant on either the demand or the supply side of the equation.
But there are those who see the Baker & O’Brien estimate as conservative. For example, John Auers of Turner, Mason, a company similar to Baker & O’Brien, said their internal estimates are more like 1.5 million b/d.
The model Kemp presented is more for a longer-term structure of how the world gets to where it needs to be. In the shorter term, based on some statements made at the TradeWinds meeting, the risk appears to be that the low sulfur fuel oil solutions will be spurned, at least in the beginning, in favor of marine diesel or marine gasoil, existing products that originate in the same distillate pool as ultra low sulfur diesel.
On a separate panel from Kemp’s, several shipping executives talked about the early days of IMO 2020 and wondered just how these new low sulfur fuel oil products–which are essentially a new offering designed for the new era, so there’s no history–will perform. They were referred to, not always in a positive manner, as “cocktails,” with the concern that in the beginning at least, how the cocktails would work in their ships would be a concern. “Nobody wants to take the risk of the cost of an engine breakdown and having to discharge fuels,” Gary Vogel, the CEO and director of Eagle Bulk Shipping, said. “We have experienced problems this year with heavy fuel oil and it is not very beneficial, so we’re erring on the side of caution.”
And what may mean is that ship owners will turn to a “safe harbor” in the form of the existing products of marine gasoil or marine diesel. Paul Pathy, the CEO of shipping company Fednav Ltd., said that given the concern over the safety of his fleet’s engines, “we’re going to go with what has been working for years.” As confidence grows in lower-cost solutions, “you might look at them, but on day one, we’re going to go with what works.”
Note that Kemp’s model calls for a solution to the burning of 3.2 million b/d of high sulfur bunker fuel. Some of the solutions won’t affect diesel demand, like scrubbers or non-compliance. But if the longer-term structural solutions laid out by Kemp take awhile to get in place, and in the meantime the market heavily moves to MGO or MDO, that’s the sort of situation that can cause spikes in price. Modeling a flight to safety is something that no forecaster can accomplish easily.
“On day one, we’re going to go with what works.”
– Paul Pathy, CEO of shipping company Fednav Ltd. on using marine gasoil or marine diesel to comply–at least initially–with IMO 2020.
Although the Baker & O’Brien model did not have a price forecast, a presentation by Justine Fisher of Goldman Sachs did. Its forecast for a generic distillate price in dollars per ton showed it dropping between 2020 and 2022, from $585/metric ton to $576. It also showed moderate “cracks,” the difference in price between crude or other benchmarks and the new low sulfur fuel oil. Apocalypse avoided.
But that sort of model does not attempt to predict what sort of spikes might occur during the transition to a new world. Eagle Bulk’s Vogel noted at the conference that January 1 is not some magical date at which the transition will happen. The process needed to clean a ship of all high sulfur material will happen months before, because a ship owner can not always know the next time a particular ship might be in port. “By September you’re going to see the impact of ships changing over,” he said.
And if the price of that fuel soars at that time, Pathy indicated that maybe it’s no big deal. Like trucking, shipowners try to categorize fuel as a pass-through to its ultimate customers. “I don’t mind if we have to spend extra money as long as everybody else has to do it,” he told the conference.
One might say that about the trucking business as well. The difference, of course, is that while there are not a lot of alternatives to moving the goods that now are transported on ocean-hauling ships, there is very much an alternative to trucking: rail. One of rail’s advantages has always been that its energy efficiency far exceeds that of a truck. At relatively low prices, that advantage means less and the advantages of a truck become magnified. At prices that might be driven higher by IMO 2020, it could mean a lot. Although railroads would be buying the same higher-priced fuel as trucks, their inherent fuel efficiency means it hits their customers less hard. That is going to shape up as a possible concern for truckers.
What about the solution where refineries get upgraded to make more compliant fuels as part of their basic capabilities, and make more diesel, rather than needing to blend their way into a solution? As Kemp noted, refinery upgrades are only about 200,000 b/d of his road to converting 3.2 million b/d of high sulfur bunker fuels into low sulfur bunker fuels. But as he said to the audience, “Why haven’t they done that already?”
One reason is that up until what he said was 18 months ago, ship owners were unclear about whether they’d go with scrubbers or even attempt to comply with the regulation. (Enforcement of the regulation is a theme heard in discussion of IMO 2020–what if it gets ignored? What happens then?) Combine that with the now largely dead speculation that maybe IMO 2020 would be delayed and Kemp said it made refiners reluctant to spend the billions of dollars needed to install new equipment–a conversion unit called a coker is the most obvious example–that could produce less high sulfur fuel oil and more intermediate products to help make IMO 2020-compliant fuels. “It takes about five to seven years from the very beginning stages of ‘hey, we want to build a coker’ until it is put in,” Kemp said.