The disaster scenario for the International Maritime Organization’s 2020 fuel rule (IMO 2020) goes like this: Ships without exhaust-gas scrubbers must switch en masse to more expensive low-sulfur fuel on Jan. 1. To meet demand, refineries produce more distillate-based marine fuel. That marine-fuel demand competes with diesel and jet fuel for distillate refining capacity. All else being equal, fuel prices surge, not just for ships, but for trucks, trains and airplanes. In the trucking sector, higher diesel prices spark more bankruptcies.
But there’s a big “if” embedded in this doomsday scenario – that all other factors remain equal. What if they aren’t?
What if global distillate demand declines prior to and during the regulation’s implementation phase due to an economic slowdown or headwinds related to trade tensions? What if IMO 2020 incremental demand is created exactly as predicted, but it turns out that it merely offsets non-IMO 2020-related demand losses and we’re just back to where we started?
There is increasing evidence that this much more optimistic fuel-price scenario is at least partially possible.
In its new monthly oil market outlook, released Sept. 12, the International Energy Agency (IEA) disclosed that it had changed its view on IMO 2020 fallout and now believes that “the start of the IMO 2020 implementation could well be much smoother than expected” and that “the oil market is likely to be better supplied than we thought.”
The key reason for the change of heart is that demand has indeed pulled back ahead of the bunker (marine) fuel switch to low-sulfur fuel. “The trade slowdown weighs on fuel oil demand and helps IMO 2020 fuel switching,” asserted the IEA.
When the agency assessed the IMO 2020 threat back in March, predicting shortages and price hikes, it was expecting global oil demand to grow 1.4 million barrels per day (b/d) both this year and in 2020. Today, it expects just 1.1. million b/d growth this year and 1.3 million b/d growth next year.
When the IMO 2020 rule kicks in, ships with scrubbers will continue to use the standard 3.5% sulfur heavy fuel oil (HFO) currently in use. Those without scrubbers will switch to 0.5% sulfur fuel, known as either low sulfur fuel oil (LSFO) or very low sulfur fuel oil (VLSFO), or alternatively, 0.1% sulfur fuel including marine gasoil (MGO).
For the broader transportation industry, including trucking, the big question is how much new distillate demand will be created by shipping’s use of MGO and VLSFO, and to what extent that will increase the price of diesel.
In its March forecast, the IEA said it expected that the IMO 2020 rule would create a gasoil (MGO) shortage of 200,000 b/d, leading to a price increase of around 20%. At that time, it warned of inland diesel price consequences, stating, “We expect middle-distillate prices to rise relative to other oil products in 2020 due to higher marine demand, thus encouraging fuel switching and rationing in the inland sector.”
The tone in the Sept. 12 report is markedly different. The IEA said the 200,000 b/d gasoil draw is about 10% of total OECD middle-distillate stocks and “in principle, this level of stock draws seems possible without major implications for pricing.”
Moreover, the draw may be minimized by shipping companies like Euonav (NYSE: EURN) that are pre-buying compliant fuel and storing it for future use. “Complaint fuel and blendstocks in floating storage accumulated by industry players amounted to about 35 million barrels in early September, with volumes likely to rise further before January,” reported the agency.
The IEA is now confident that the global refining system should be able to handle demand for both more MGO/VLSFO for shipping and maintain diesel production for land-based users. “The levels of diesel cracks observed in recent years indirectly confirm that in principle, middle-distillate production capacity is far from stretched, and likely there is spare capacity before factoring new units coming online,” it said.
There is little evidence yet of any IMO 2020 effect in the physical diesel market. In fact, despite the ramp-up in preparations for the switch to IMO 2020-compliant bunker fuel, the price of diesel is actually falling. It’s down 11.5% since May 14 (SONAR: ULSDR.USA).
Heavy fuel oil fallout
In the ocean shipping sector, unlike other transportation sectors, IMO 2020 is not about how the price of low-sulfur fuel will change.
Rather, it’s about the spread between HFO on one hand and VLSFO/MGO on the other, and how that spread will affect spot and time-charter rates given that a portion of the global fleet will be equipped with scrubbers and using one type of fuel, and the remainder will be using the more expensive compliant fuel.
Ocean shipping cares very much about what happens to the price of HFO, because that affects the spread. It’s widely expected that the price of HFO will fall sharply as a result of IMO 2020, because most of the global fleet will not have scrubbers and will not be able to consume it, causing a collapse in demand (the IEA estimate is for a 57% demand drop).
HFO demand is already falling, according to the IEA, but for a different reason: trade and economic issues, not regulations. “In the first seven months of 2019, global fuel oil demand fell by 225,000 b/d year-on-year, the biggest fall for any oil product,” it said.
“The worsening economic outlook and weaker trade growth are key factors,” it continued. “The decline was seen in bunker hubs such as China (-30,000 b/d), Singapore (-75,000 b/d), South Korea (-50,000 b/d) and the Netherlands (-10,000 b/d), as well as in countries that consume fuel oil for power generation.”
Consequently, the price of 3.5% sulfur HFO is declining well before the IMO 2020 deadline. The Ship & Bunker IFO380 Index for the top 20 ports is down 12% since July 12. The Ship & Bunker MGO Index is down 7% since May 20. In other words, MGO will likely go up after Jan. 1 and HFO will likely go down, but they’ll probably both be starting from a lower base than previously expected.
The IEA tacitly implied a change in its position on marine-fuel pricing in its new bunker-fuel demand forecast.
In its March forecast, it said that bunker fuel demand has grown by an average of 2.5% per year for the last 10 years, “reflecting expanding global trade.” It estimated at that time that bunker fuel demand would increase this year by 2.6%, then slow to just 0.3% next year “as vessel owners face rising fuel prices.”
However, the new report said that as a result of weaker economic growth and trade demand, the IEA now expects bunker demand growth of just 0.4% this year – far lower than the previous estimate. For 2020, it expects growth of 3.7%, much higher than its previous forecast.
The reason for the increase in 2020, it explained, “is mainly due to the lower density of gasoil relative to fuel oil, meaning that more fuel will be needed to produce the same amount of energy. So, most of the growth in 2020 will come from this volumetric expansion rather than an underlying increase in transport demand.” Tellingly, it made no mention, as it had previously, of low-sulfur fuel demand being curbed by high prices to vessel owners.