Adding uncertainty in an uncertain market

Analysts at ClipperMaritime look at what new sulphur regulations will bring to the industry.

As the deadline for switching to lower sulphur marine fuels looms, it is becoming increasingly difficult to argue that the new International Maritime Organization’s new standard will not be implemented on time. The IMO itself has repeatedly confirmed it is sticking to January 1, 2020, and most larger shipowners are actively preparing for the switch. Some of the smaller shipping companies, however, are still acting as if the problem will go away if it is ignored for long enough.

With non-enforcement becoming a more distant possibility, non-compliance is being advanced as a way for ship owners to meet the challenge of lower sulphur fuels. The argument runs mostly like this: Who will control what ships burn in the middle of the ocean? Who has the capacity to monitor fuel use and then who will enforce limits? The answer is that there is no need to enforce compliance on the open seas. All IMO members need to do is to control the sale of high sulphur fuel to ships that have not installed scrubbers. And even if nation states fail to enforce the rule, sellers of fuel oil will face reputational risk.

Certainly there will be some leakage on minor routes between small ports in locations with lax shipping rules, but any vessel calling on ports in North America, eastern and southeastern Asia, as well as Western Europe, will have to comply. Given the patterns of world trade, the majority of ship traffic will therefore fall within the jurisdiction of strict policing.

How to comply?

A minority of ships have been fitted or retrofitted with scrubbers, enabling them to burn high sulphur fuel oil and still stay within the emission limits. Very few container shipowners seem to have made the decision to retrofit scrubbers as of April 2018. Estimates vary, but outside the cruise ship fleet, the ratio of scrubbed vessels relative to the total number is in the single percentages.

A number of factors dim the attraction of scrubbers: Ships have to be idled for extended periods. The installation itself is expensive – $5m to $10m depending on the complexity of the process. And scrubbers don’t reduce carbon emissions, which are now also being targeted by the IMO. Shipowners may pay out millions of dollars for a scrubber only to find that the engine is obsolete because it is inefficient and emits too much carbon per shipping unit. Last, open loop scrubbers discharge a sulphur and seawater slurry into the ocean, while closed loop ones have to find a way to dispose of the residue from washing the sulphur out of the flue. One option is unattractive from an environmental point of view, while the other is expensive and perhaps even impractical.

For container vessels currently on order and due for delivery by 2020 and afterwards, owners and operators are making provisions for the new regulations and dual fuel ability (LNG) or scrubbers will already be built into the newbuild price. A number of smaller container vessels aimed at deployment in Jones Act trade lanes have the ability to utilise LNG and the recent order from CMA CGM for nine 22,000 teu vessels with a Chinese yard is an industry first for a major carrier to opt for LNG. The French carrier has agreed deals with energy suppliers Engie and Total to secure adequate LNG provisions for the future.

A few key issues remain for operators who intend to utilise LNG as the primary fuel for 20,000 teu ships on the Asia to North Europe route:

  • The choice of potential bunkering ports is at the moment limited and LNG bunkering ships are in short supply.
  • The time taken to re-fuel the specially designed tanks of 18,000 cu m is much more than for conventional ships using IFO.
  • The much larger tanks mean that CMA CGM for example will lose 400 teu slots used for carrying commercial cargo.

A second path is to burn liquefied natural gas instead of fuel oil. LNG is a clean-burning fuel that emits less carbon per mile and has only trace amount of sulphur, if any. Expense is also an issue here because engines cannot be easily switched from a liquid to a gaseous fuel. The infrastructure to refuel ships is also lacking. Only very few ports have LNG supply for ships, creating the maritime equivalent of range anxiety experienced by electric car owners.

Low sulphur fuel oil supplies are limited and expensive. Refineries require a lot of desulfurization capacity, or start out with a low sulfur heavy crude, to produce significant amounts of low sulphur fuel oil. We have already seen prices for heavy, low-sulphur crude soar relative to lighter, higher sulphur grades.

Some oil companies are pushing the repurposing of vacuum gasoil (VGO) – a product left over after crude oil has undergone distillation first under regular atmospheric pressure and then under vacuum – as the solution. At the moment, most VGO is fed into crackers, where it is turned into gasoline or diesel. If it were to be diverted to desulfurization units instead, the output would be a low sulphur heavy oil.

The problem is that this sets up competition with road transportation fuels, which traditionally command a much higher price than maritime fuels. A refiner will decide where to direct the VGO based on the highest price for the resulting products, and that means significantly higher fuel oil prices.

Ultimately, ship operators may have to pay the road transport price anyway. The most likely scenario, and the one chosen by some of the biggest shipowners, is to switch to marine gas oil. The investment in engine reconfiguration is small – mainly an adjustment of the lubricants used – and gasoil is already being produced in large quantities.

This solution is not without its problems though. There are doubts that there is enough marine gasoil to go around, especially in parts of the world that consume more middle distillates (gasoil and jet fuel) rather than light distillates (gasoline and naphtha) – like Asia. The International Energy Agency estimates a gap between supply and demand of diesel of up to 1m barrels per day.

The effect on shipping

In the end, all problems are solved by price. Desperate ship owners will pay whatever it takes to keep their vessels moving. The question is who ends up footing the bill. Margins in shipping have been wafer-thin, and ship operators are not going to be able to carry that extra burden. Container operators are already paying significantly more for IFO 380 at the moment compared to early 2017 and current commercial pricing does not cover the additional cost either via all-in rate structures or established bunker surcharges paid by shippers which usually lag physical costs by as much as three months as well.

Our most recent analysis of fuel costs from Argus Media shows the variance at a major North European bunkering port for MGO (marine gas oil) compared to 3.5% sulphur fuel since early 2016. The average price of 3.5% fuel up until mid-April 2018 is $266 per tonne which compares to $467 per tonne for MGO. Current MGO prices are $650, approximately $200 per tonne more than 12 months ago. This differential should make the industry stand up and take notice – owners and shippers.

Working on the assumption that MGO could be the fuel of preference for many owners and operators with effect from January 2020, the impact on their future business strategies is huge. Operators’ exposure to rising fuel costs is clear to see in the financial statements seen in the public domain so far this year and all carriers highlight the importance of bunker costs.

As an example, Maersk Line spent $3.3bn on bunkers in 2017 compared to $2.1bn in 2016. This is based on an average fuel price of $320 per tonne in 2017 compared to $223 in 2016. So far in 2018, average IFO 380 fuel prices have reached about $355 per tonne and ocean carriers are not necessarily recovering this additional cost in the ocean freight when compared to average spot freight rates from the SCFI. Using the Asia to North Europe route as a key proxy trade lane, spot rates had declined by 34% year-to-date in 2018 versus just over 20% in the same period in 2017.

Maersk Line highlights in its financial reports that any variation or increase in fuel costs of +/- $100 per tonne results in a $500m impact on the bottom line. Given also that Maersk Line will carry more containers as it aims to improve overall market share, the cost impact is huge for operators and discussions with their shipper clients should be forward thinking to understand how the additional burden will be borne in annual contracts. Many shippers have traditionally used their own formulae or floating BAF in contracts, but these will need to be re-worked.

The OECD’s International Transport Forum estimates the total annual increase in container shipping costs will reach $30bn after the new fuel requirements come into force. Large shippers, who have been demanding better environmental stewardship from all their service providers, including shipping companies, will have to pay the majority of this extra cost. In the end, the surcharge will be passed on to the consumer.

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