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Who's steering the ship?

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John Mayes and John Auers at Turner, Mason & Company examine what is next for the industry following the 2020 deadline set by the IMO for low sulfur bunker fuel

In October 2016, the International Maritime Organization (IMO) definitively set the transition date for the introduction of low sulfur bunker fuel to January 1, 2020. This action ended years of debate as to when the new regulations would take effect and has helped to galvanise attention on how the lower sulfur bunker fuel will be produced and the likely market effects which will result.

The IMO is an agency of the United Nations and has been given jurisdiction by the UN over environmental and safety issues in international waters. It is currently comprised of 172 member states. In 2005, the IMO developed its Annex VI requirements, which set a maximum sulfur limit for bunker fuel at 4.5%. This limit was reduced to 3.5% in January of 2012.
The Annex VI regulations also required a further reduction to 0.5% in January of 2020, but included an option to delay implementation until January of 2025. The maritime industry was concerned that the availability of compliant fuel in 2020 would be insufficient to meet global requirements. The Annex VI regulations mandated the IMO to conduct a study before the end of 2018 to evaluate the likely supply of low sulfur bunker fuel. If the study concluded there would be insufficient bunker supplies, the IMO was given the authority to defer the implementation until 2025.
The IMO likely assumed the global refining industry would produce low sulfur bunker fuel in the same manner as it complied with low sulfur petrol and diesel requirements; through catalytic hydrotreating. Rather than producing a low sulfur fuel oil, a refiner (with only a modestly higher investment cost) could construct a coking unit and entirely exit the fuel oil market. The global refining industry however, was wary of making any substantial capital investments in advance of an uncertain implementation date.
To expedite the process, the IMO conducted its supply analysis early and presented the findings in October 2016. Having concluded there would be ample supplies available in 2020, the January 2020 date was confirmed. With barely three years remaining however, the refining industry had insufficient time to react. This process has resulted in virtually no preemptive actions by the global refining industry.
In addition to the production of low sulfur bunker fuel, the IMO also allowed a second path to compliance. Vessels which install on-board scrubbers to remove sulfur and nitrogen compounds would be allowed to continue to burn higher sulfur bunkers.
The global maritime industry has been slow to initiate this process but expects significantly higher scrubber installations in 2019. The maritime industry is in poor economic health however, and most experts only foresee conversions of 15-20% of the global fleet by 2020. This dual path to compliance also contributed to the inaction by both industries in that each would prefer the other to spend the tens of billions of dollars for the required investments.

Rather than desulfurising existing fuel oils, the likely path to the production of low sulfur bunker fuel is expected to be through the diversion of large volumes of gas oils and distillates.
The International Energy Agency (IEA) has estimated that two million barrels per day (bpd) of distillate will be diverted into the bunker pool in 2020. This incremental supply will back out approximately 1.8 million bpd of higher sulfur fuel oil on a BTU basis. These demand shifts are expected to cause significant pricing gyrations.
Turner, Mason & Company estimates global distillate demand prior to the January 2020 implementation to be around 37 million bpd and rising by around 0.5 million bpd per year. If the IEA is correct, this distillate demand spike will be equivalent to four years of global demand growth. The pricing impacts could be dramatic.
Even more problematic will be the alternate disposition of the surplus fuel oil. The non-bunker fuel oil market is only about 4.6 million bpd and has been declining for decades. The sudden increase of another 1.8 million bpd in supply will present significant challenges to the refining industry. As of yet, a solution path to place this surplus material has not developed.
In addition to the product price swings, the crude oil markets are also likely to be impacted. Refiners will be stimulated to process lighter crude slates to minimise high sulfur yields. This will widen light/heavy crude differentials by increasing demand for light crudes and decreasing demand for heavier grades.
These pricing shifts for crudes and products will produce a wide variation of margin impacts for global refiners. Coking refineries will benefit from the higher distillate prices and the widening light/heavy crude differential while being relatively immune to the low fuel oil prices. Asphalt refiners would be in a similar position except that they could face new competition from fuel oil refineries entering the asphalt market. The most negatively impacted facilities will be global fuel oil refineries. While benefiting from the higher distillate prices, these refineries have the highest risk from either low fuel prices, or in the worst case, the inability to sell fuel oil.
Regionally, coking refineries have the highest concentration in the US, India, and China. As a result, these countries will see a net benefit from the IMO regulations. Fuel oil refineries in market economies (Europe) will see the greatest negative impact.

Now that the implementation date has been firmly set and the market has become more focused on the impending demand shifts, concerns on the likely pricing effects are growing. One question has arisen which involves the potential for a temporary waiver for the continued use of high sulfur bunker fuel to mitigate undesired pricing spikes. It is believed that this procedure could ease the transition process and reduce the magnitude of the pricing swings.
Turner, Mason & Company posed this question to a member of the IMO Secretariat. The email response indicated there is no current mechanism within the IMO to grant blanket waivers to facilitate the transition process. Such a mechanism could be introduced however, but it must be proposed by a member country and subsequently approved by the Marine Environment Protection Committee (MEPC) of the IMO. The IMO staff has no ability to initiate such an action. The email response also stated that a proposal from a member country would have to be approved at the MEPC 71 conference in July 2017 and adopted at the MEPC 72 conference in April 2018 to be in force for the January 1, 2020 transition date.
Early last year, before the 2020 implementation was set, Turner, Mason & Company posed a similar question to the IMO as to whether only 2020 and 2025 could be set as compliance dates. The response indicated the Annex VI regulations required one of these dates but stated other dates could be proposed through an amendment. An amendment to the Annex VI regulations however ‘would require a minimum of 22 months after approval before the amendment could enter into force’.
These responses present a disturbing image. While democratic, the procedures established by the IMO do not allow for quick counter-measures and responses to market disruptions. This result could produce a chaotic market in 2020 with no ability by the IMO to take corrective action.

This article was written by John Mayes and John Auers at Turner, Mason & Company.