The ocean shipping industry has long served as a veritable ‘garbage dump’ for the global refining industry. The dregs of the refining process, the residual high-sulfur fuel oil (HSFO) left at the bottom of the barrel when all the good stuff is sold off – that’s what ocean-going ships have been burning as fuel.
The IMO 2020 rule, effective January 1, 2020, will bar vessels from using HSFO unless they have an exhaust gas scrubber installed. Fuel and emission sulfur content will be capped at 0.5 percent.
Over the past few years, as the global cap on fuel sulfur content drew ever nearer, a common question at shipping industry cocktail parties, generally met with a bemused shrug, has been, “Where is all this crap going to go if we don’t burn it?” Refineries will still be creating HSFO as a byproduct of their production process, even after ship operators are driven away from buying it by environmental regulations.
“It [residual fuel oil] will have to go somewhere and the price is going to provide an incentive for vessel owners and refiners to do something about it. The problem is that they will not do enough about it by January 1, 2020.”Andrew Lipow, Lipow Oil Associates
The world is about to find out where all of this unwanted HSFO will end up. The question was addressed by Andrew Lipow, president of Houston-based energy consultancy Lipow Oil Associates, during an investor presentation by Ardmore Shipping (NYSE: ASC) in New York on May 30. His predictions implied unintended consequences that should make tanker transportation more costly in certain vessel categories.
“There are three markets for residual fuel,” said Lipow. “There’s the utility market, but if you look around the world, a lot of utilities are moving away from it, especially in the U.S. There is road construction, for asphalt, which competes with cement, which is more expensive but longer lasting, and the asphalt market is growing at quite a small rate. And then there is the marine fuel market.”
He estimated that for every 100 barrels of crude oil processed around the world, four barrels of HSFO are created. In the U.S., it’s two barrels for every 100. “The refiners just want to get rid of it,” he said.
There are currently pricing barriers to using HSFO for power generation. “In the Third World power market, if you want to talk about displacing coal, today’s value of high-sulfur residual fuel is around $57/barrel, and to reach coal parity it would have to be $25/barrel. So we are hugely far away from any utility thinking about converting from coal to HSFO, and in fact, they’re converting to LNG [liquefied natural gas].”
He estimated that the marine fuel market currently consumes about 3.5 million barrels per day (b/d) of HSFO. He further estimated that around 2,000 ships will have exhaust gas scrubbers as of 2020 and will continue to use HSFO, and that there will also be a certain amount of “cheating,” wherein the IMO 2020 rules are ignored.
Given those assumptions, he calculated that there will be over 800,000 b/d of HSFO that will be left over and will need to find a new home (he acknowledged that other experts have come up with estimates that are both higher and lower than that number).
“The bottom line is that this comes out to roughly 240 million barrels a year of HSFO that will have to be disposed of,” he said. “It will have to go somewhere and the price is going to provide an incentive for vessel owners and refiners to do something about it. The problem is that they will not do enough about it by January 1, 2020.”
Because refiners cannot avoid producing HSFO, excess production will have to go into storage until it is eventually cleared by the market. “First it will fill the onshore storage facilities – there are probably enough onshore tanks for the first six months. Then it will have to go into floating storage on tankers,” Lipow maintained, noting that storage contracts would go to the older vessels in the fleet first.
Stifel analyst Ben Nolan explained in a client note, “Due to viscosity, the product would likely need to be stored on ships with heating coils, with the expectation that those would be primarily Aframax-class crude or LR2 product tankers.” Aframaxes have capacity to carry about 750,000 barrels of oil; LR2 product tankers (the same size as Suezmax crude tankers) can carry around one million barrels.
“The issue is how many Aframaxes and Suemaxes are equipped with [heating] coils,” said Lipow, who noted that tankers used for HSFO storage “will be sidelined for a significant period of time.”
Asked how long he thought the situation would persist, Lipow answered that it could be “2023 or 2024 before the price reacts and refiners and vessel owners do something about it. Even if you wanted to add scrubbers on another 3,000 vessels, it would take two and a half to three years. The limitation is not manufacturing space; it’s [capacity limitations of] the naval architects, engineering and class societies.” He also noted that refinery coker projects to handle the HSFO are time-consuming and costly.
One analyst in the room pointed out that according to Lipow’s numbers, if the entire incremental HSFO volume went into floating storage through 2023, “that’s enough to fill the entirety of the global Aframax fleet.”
If HSFO is pushed in significant volumes into floating storage for a multi-year period, it could significantly reduce tanker supply available to transport cargo, which would increase freight rates, all else being equal.
According to Nolan, “It could cause a sharp spike in the demand for those ships specifically [coiled Aframaxes and LR2s], which would have a ‘waterfall’ effect on the entire product tanker market and to a lesser extent on the crude tanker market.” He noted that public companies with significant Aframax/LR2 exposure include Scorpio Tankers (NYSE: STNG), International Seaways (NYSE: INSW) and Tsakos Energy Navigation (NYSE: TNP).
Jon Chappell, the shipping analyst at investment bank Evercore ISI, cited the same upside possibility for tankers. He said, “Lower demand for HSFO will result in increased floating storage until the industry can find a way to utilize the residual fuel, removing ship capacity from the trading fleet and boosting utilization.”