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https://seekingalpha.com/article/4114237-hottest-topic-shipping?ifp=0

The Hottest Topic In Shipping

Oct. 18, 2017 9:59 AM ET

About: Ardmore Shipping Corp (ASC), CMRE, CPLP, DAC, DCIX, DHT, DLNG, DRYS, DSX, EURN, FRO, GLNG, GLOG, GLOP, GMLP, GNK, GNRT, GOGL, NAP, NAT, NM, NMM, NNA, PXS, SALT, SB, SBLK, SFL, SSW, STNG, TGP, TK, TNK, TNP


James Catlin

Long-term horizon, macro, commodities, maritime trade

Summary

2020 may sound far off but it's only 27 months away.

Shippers face some tough choices with the introduction of the 2020 Sulfur Cap.

This mandate requires shippers to invest in expensive retrofits to continue burning HFO, Heavy Fuel Oil, or to consume more expensive MGO, Marine Gas Oil.

Note: This article was originally published October 2nd on Value Investor's Edge, a Seeking Alpha subscription service.

Overview

An industry insider recently told me that this topic "seems to be all anyone can talk about at conferences here in Singapore."

The decision to implement a global sulfur cap of 0.50% m/m (mass/mass) in 2020, revising the current 3.5% cap, was announced by the International Maritime Organization, IMO, the United Nations regulatory authority for international shipping on October 27th, 2016. This will affect as many as 70,000 ships.

The IMO provided guidance on how the maritime industry might comply:

"Ships can meet the requirement by using low-sulphur compliant fuel oil. An increasing number of ships are also using gas as a fuel as when ignited it leads to negligible sulphur oxide emissions. This has been recognised in the development by IMO of the International Code for Ships using Gases and other Low Flashpoint Fuels (the IGF Code), which was adopted in 2015. Another alternative fuel is methanol which is being used on some short sea services."

Ships may also meet the SOx emission requirements by using approved equivalent methods, such as exhaust gas cleaning systems or "scrubbers," which "clean" the emissions before they are released into the atmosphere. In this case, the equivalent arrangement must be approved by the ship's Administration (the flag State).

This mandate impacts all shipping companies including but not limited to Ardmore Shipping (NYSE:ASC), Costamare Inc. (NYSE:CMRE), Capital Product Partners L.P. (NASDAQ:CPLP), Danaos Corporation (NYSE:DAC), Diana Containerships (NASDAQ:DCIX), DHT Holdings (NYSE:DHT), Dynagas LNG (NYSE:DLNG), DryShips (NASDAQ:DRYS), Diana Shipping (NYSE:DSX), Euronav (NYSE:EURN), Frontline (NYSE:FRO), Golar LNG (NASDAQ:GLNG), GasLog (NYSE:GLOG), GasLog Partners (NYSE:GLOP), Golar LNG Partners (NASDAQ:GMLP), Genco Shipping (NYSE:GNK), Gener8 Maritime (NYSE:GNRT), Golden Ocean Group (NASDAQ:GOGL), Navios Maritime Midstream Partners (NYSE:NAP), Nordic American Tankers (NYSE:NAT), Navios Maritime Holdings (NYSE:NM), Navios Maritime Partners (NYSE:NMM), Navios Maritime Acquisition (NYSE:NNA), Pyxis Tankers (NASDAQ:PXS), Scorpio Bulkers (NYSE:SALT), Safe Bulkers (NYSE:SB), Star Bulk (NASDAQ:SBLK), Ship Finance International (NYSE:SFL), Seaspan Corporation (NYSE:SSW), Scorpio Tankers (NYSE:STNG), Teekay LNG Partners (NYSE:TGP), Teekay Corporation (NYSE:TK), Teekay Tankers (NYSE:TNK) and Tsakos Energy Navigation (NYSE:TNP).

HFO Vs. MGO

Bunker fuel or bunker oil is a generic term given to any type of fuel oil used aboard commercial ships. There are two main types: distillate fuels and residual fuels.

Commercial applications of this fuel are much different than recreational applications.

Typically, recreational vessels have far more stringent guidelines on environmentally acceptable fuels, usually mandated by government agencies, like the EPA here in the USA for example.

Commercial marine businesses utilize fuels that involve less refining (leaving higher amounts of sulfur in the fuel), and are therefore less costly than other diesel fuels.

The most basic way to comply with the new mandate is for shippers to switch over from Heavy Fuel Oil, HFO, to Marine Gas Oil, MGO.

Source: Bluebird Marine Systems

Heavy fuel oil, which is high in sulfur content and environmentally unfriendly is the traditional source of energy to power ships. It is 3,500 times more sulfurous than road diesel.

Marine gas oil has a reduced sulfur content but is quite a bit more expensive.

The Math

Exhaust cleaning scrubbers will be the cheapest way for larger ships to comply with the 2020 International Maritime Organisation’s 0.5pc sulfur cap on marine fuels, according to BP.

A scrubber is a device installed in the exhaust system after the engine or boiler that treats the exhaust gas with a variety of substances.

The math is quite compelling when broken down.

On September 26th, the global 20 ports' average for HFO380 comes in at $343/mt. That same average for MGO comes in at $560.50/mt. This represents a difference of $222.50/mt.

Now, let's look at a medium-sized bulk carrier for our example. Assuming it would take around 45 mt per day while sailing and 2–3 mt in harbor and the vessel sails for 250 days and rests 115 days in harbor in a year average consumption would be like this:

250 X 45 + 3 X 115 = 11,250 + 345 = 11,595 mt

For a ship consuming 12,000 mt/year, the additional cost of switching to MGO comes in at $2,670,000/year.

If installing a scrubber costs $3 million for this vessel, the cost can be recovered in just over a year at current prices.

A VLCC burning 70 mt of fuel for 250 days with 5 mt in 115 days at harbor looks like this:

250 X 70 + 5 X 115 = 17,500 + 575 = 18,075 mt

So for this vessel, it would cost approximately $4 million per year to switch to MGO.

A $10 million scrubber cost could be recovered in approximately two and a half years.

But here's a big catch. The drop in HFO demand coupled with the sudden increase in MGO demand should widen that spread considerably, meaning costs to install a scrubber could be recovered in the first year alone.

In fact, Wood Mackenzie recently estimated that in a 100% compliance scenario, the price of MGO could skyrocket by 4 times that of 2016 prices, increasing overall fuel costs for the industry by approximately $60 billion/year.

But for those opting to install scrubbers, the good news is not just potentially lower HFO prices, but the infrastructure for HFO is in place around the world. Right now, there is a real risk that MGO availability could be restricted in some ports and not even available in other. Furthermore, vessels using scrubbers won't be subjected to potential variations in MGO quality, which could jeopardize compliance.

The Switch?

Even though scrubbers may be the most cost-efficient method of compliance, many companies seem to be shunning this option.

In fact, on September 27th, Ship & Bunker reported that there were only 375 emission abatement units in place or on order. That is a tiny drop in a huge bucket.

Recently, Maersk, the largest container shipper in the world, has indicated that they will be complying through the utilization of MGO.

Maersk recently stated that "in our opinion, scrubbers will not be the way forward for our fleet. Whilst the business case for investing in scrubbers may look appealing at first, it is not a long-term solution to place such complex machinery on our vessels."

Other shippers have also made similar announcements such as Hapag-Lloyd, which operates 172 container ships, and Gener8 Maritime, which has a 39-vessel fleet comprised of 25 VLCCs, including one newbuilding, nine Suezmaxes, three Aframaxes and two Panamax tankers.

In fact, an indication of where the market is headed can be found on the OOCL, Hong Kong, the largest container ship in the world, christened in May of 2017, which was built without a scrubber and utilizes a diesel-electric propulsion system.

A survey in early 2017 by UBS found that 74% of shippers are leaning towards the MGO option, with 19% planning on installing scrubbers, and 5% looking at LNG conversions.

Perhaps some shippers are looking ahead to future regulations. After all, if CO2 regulations come into force in 2025, as some suspect they might, Savvas Manousos, global head of trading at Maersk Oil Trading, noted that "scrubbers would be stranded assets after only five years."

Or maybe some fear another case like here in California that introduced its own 0.5% sulfur restrictions back in 2009. It was initially possible to meet the low sulfur mandate by using alternative options but following a challenge in court by the Pacific Merchant Shipping Association, the California Air Resources Board readopted its low sulfur regulation and dropped the ‘alternative’ option clause, so it is currently not possible to use a scrubber in California.

Of course, then you have the UK where the government has committed to help fund innovative technologies and fuels to reduce maritime emissions, ultimately helping create a zero-emissions sector.

Bottom Line

A switch to MGO will have an immediate impact on direct operating costs.

For companies with vessels out on long-term charters where the charterer pays for bunkering, that impact will be minimal. But for companies that operate in the spot market, where bunkering is often paid by owners, these additional costs will have a significant impact on the bottom line.

The first draft of this section was very dry and full of numbers, so I reworked it to keep it short while providing a few different examples of how companies will be impacted.

Of course, this is formula can change based on several factors but this seems to be a fair estimate.

Let's turn to individual companies with a look at Maersk, which already indicated that they will likely taking the MGO route. In their Q1 and Q2 earnings reports, where bunker averages came in at $320 mt and $313, respectively, they showed that every $100 increase in bunker fuel price would have an approximate $400 million impact on their underlying result for the full year. Therefore, if MGO comes in at the low $600's, something that is quite likely, this would represent a $1.2 billion impact on the company.

Note that current MGO costs are just under what HFO was costing in 2008 and in 2011-2014, so if Scorpio does go the MGO route, we can expect a return to those higher operating costs seen over those years.

So, using 2016's numbers, if Star was to experience a 65% increase in bunker costs, approximating today's spread, that would come out to approximately an $18 m increase for voyage expenses.

Now, let's take a moment to remember that Wood Mackenzie recently estimated that in a 100% compliance scenario the price of MGO could skyrocket by 4 times that of 2016 prices.

Equilibrium?

A well known 2016 IMO study indicates that the refining capacity will be sufficient to provide adequate quantities of low-sulfur marine fuel by 2020. A more recent study out of Columbia University concluded that "expectations that the IMO sulfur standards will restrict bunker fuel availability and cause product markets to rally are likely overblown."

However, there are others that are more skeptical, pointing to the fact that desulfurization is technically difficult, costly and may discourage refineries from such investment.

Remember that refiners do not choose to make fuel oil – fuel oil production is a consequence of the processes that you have in the refinery. For maritime trade, the utilization of fuel oil has been a wonderfully convenient for all these years. But meeting MGO demand won't be so convenient.

After all, the IMO adopted this on October 27th, 2016. Exxon points out that investing in technology to convert fuel oil into distillates is not only expensive, costing $1 billion plus, but also time consuming taking between 5-7 years to develop. They are quick to point out that there will be price spikes if there are shortfalls. Meaning if refiners have not already taken those decisions, any such changes will not come onstream for 2020.

In terms of demand, Wood Mackenzie’s data showed that MGO sales are currently at approximately 700,000-800,000 barrels per day (bpd), and they forecast an increase to 2.8m bpd by 2020. Demand levels for HFO, on the other hand, are at around 3.2m bpd and are projected to plunge to 700,000 bpd by 2020.

Jack Jordan, editorial lead for bunker news, thinks demand may be even higher and also issued a stark warning from a supply and demand standpoint. "We can expect to see just 1.4 million barrels per day of global middle distillate supply being added between 2016 and 2020, while demand is set to increase by 3.7 million barrels per day. That developing shortage should keep 0.5% sulfur bunker prices pretty high, so the savings for a ship using a scrubber could be quite big."

On the other hand, the potential drop in HFO demand led Eni's vice president for proprietary technology, Massimo Trani, to predict a "crash" in HFO prices, which may cripple refineries with large outputs of HFO.

Kurt Barrow, vice president of downstream research at IHS Markit and Sandeep Sayal, senior director of refining and marketing research at IHS Markit, are two authors of an IHS Markit report entitled Refining and Shipping Industries Will Scramble to Meet the 2020 IMO Bunker Fuel Rules. In this report they find:

"While the IMO is taking positive action to address the environmental impacts of air pollution from ships, the rapid change creates significant disruption for both the refining and shipping industries. The two industries are vastly unprepared. Neither has made the necessary investments for compliance, which means that the 2020 implementation date will result in a scramble. Both industries are taking a wait-and-see approach until firm signals are in place by the IMO for compliance with the regulation."
They conclude:

"Shippers will face significant compliance costs by having to upgrade equipment or switch to more expensive fuels. Refiners will experience significant price impacts as they shift production to deliver more lower-sulfur fuels to the market and, at the same time, find a market for the higher-sulfur fuels they produce. Refineries, like ships, do not turn on a dime, so it takes significant investment and market demand to retool a refinery to deliver new supply."

Michael Cobb, LNG Venture Advisor for Exxon Mobil points out that refining economics dictate product output. He notes that ‘what a refiner can do and what a refiner will do are two different things – and the “will do” is driven by economics.' The question of long-term investment incentive is obviously still being debated among even the largest in the industry.

Finally, my industry insider in Singapore told me "we’re hearing that there will be a fuel shortage if everyone switched overnight to MGO, trying to get this stuff out to the main bunkering ports around the world."

Compliance

The fact is that compliance will come at a high price and some may willfully choose not to comply. "Not only is it hard to enforce compliance in the open seas, but it is still uncertain if sufficient supplies of compliant bunker fuels will be broadly available in all ports," Sayal said.

Anna Larsson, Vice President and Global Head of Sustainability at WWL and Chair of the Trident Alliance explained, the experiences in relation to ECAs have shown that enforcement can be a piecemeal affair with little punitive effect. ‘The fines are so low that it is actually not much of a deterrent at all. Even if you are calculating on getting caught and paying the fine, you are still saving so much money from not complying.’

She also pointed out that: ‘We have also seen that when the IMO regulation is transposed into national regulation and integrated into the legal systems of different countries, it doesn’t always work well – it is difficult to get violations through the legal system.

There are exceptions, notably California, where the penalties for noncompliance in local waters is significantly higher, up to $75,000 per day for each violation.

But open ocean compliance and other regions can be tough to police. Additionally, they may lack the resources or even will to enforce these regulations.

Conclusion

It's not just shipowners that face difficult decisions. Refineries need to start looking at their configurations and feedstocks. Terminal owners will need to adapt or add large fuel oil storage facilities. Port authorities must decide how to accommodate a more fragmented bunker market to properly address demand. Finally, regulators will need to come up with an enforcement system that works in the high seas as well as their territorial waters.

At this point, concern is mounting for this seismic shift in the shipping industry. Scrubber orders remain low, large companies have expressed their desire to switch over to MGO, and the capacity for producing enough fuel is in doubt. After all, investment decisions on desulfurization units will be made by individual refineries. One study indicates that "refining capacity will not be sufficient in 2020, estimating that 60%-75% additional sulfur plant capacity needs to be built by 2020, compared with planned projects."

If a shortage materializes this could be bad for companies but also global trade, which may be restricted based upon fuel availability.

This significant demand shift to MGO from HFO will be reflected in prices. Companies that are responsible for bunkering costs will be hit hard. But the magnitude is still uncertain since estimates vary widely. However, let's be honest here, an increase of up to 400% would basically cripple industry profitability and potentially render some companies nonviable. Jack Jordan points out that "there was a high-profile bankruptcy last year when Hanjin Shipping collapsed, and it wouldn't be surprising to see some more cases like that, especially once bunker costs jump in 2020."

Following a historic downturn in the shipping industry, many companies may not have the resources or ability to access credit for a scrubber, so they will be forced to utilize MGO. Whether they’ll be in a position to take a hit from higher fuel bills in 2020 is another question altogether.

Which brings up another point often talked about and that is credit for higher fuel bills. Will the credit be available? Poul Woodall, Director for Environment & Sustainability at DFDS, notes "if the gap between traditional heavy fuel oil and the new 0.50 percent product climbs to $400 as some are predicting, we are talking an extra bill to industry of $80 billion per annum." Will suppliers and banks allow that? Remember, Hanjin left a lot of unpaid bunker bills in its wake. It's possible that those extending credit may see things like Mr. Jordan and expect that many weaker companies won't be deemed creditworthy.

Finally, this 2020 sulfur cap could be just the beginning of a new and more strict set of environmental regulations for shippers. There is talk of addressing NOx emissions, carbon emissions, and black particulate matter, just to name a few, in the coming years.

This all sounds pretty bad for shipping so let's try to end on a positive note with a quote from James Corbett, a professor of marine policy at the University of Delaware, and a member of the IMO’s steering committee. He pointed out that any predictions of global fuel price increases need to fully reflect demand elasticity.

"There are number of reasons to think higher prices would cause a reduction in demand,” Corbett said. “If you’re holding demand constant, or rate of efficiency of all other segments, you’re going to get a wrong prediction. That the market is too stupid to respond to price increases, and has to suffer them without innovation, seems to be a potential flaw."

This means that if the price differential between low and high sulfur fuel oil widens significantly post-2020 with middle distillates becoming more valuable, this will be a temporary situation and the market will readily adjust to meet new demand.

Thank you for reading, and I welcome all questions/comments. If you would like to stay up to date on my latest analysis, I invite you to follow me on Seeking Alpha (click the "Follow" button next to my profile picture at the top) as I continue to cover all aspects of maritime trade.

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Disclosure: I am/we are long NMM, GNK, GOGL, SALT, STNG, HMLP.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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