On January 1, 2020, in accordance with International Maritime Organization regulations, the sulfur content of fuel used to propel commercial ships outside of already controlled emission areas must not exceed 0.5%S m/m. The potential cost impacts to the maritime industry and its customers from the event commonly known as IMO 2020 have been well-documented, as the significant reduction of allowable sulfur content in maritime bunker fuel will increase fuel costs for about 75 percent of the fuel presently consumed by commercial vessels.
While there are obvious cost implications for the maritime cargo industry and marine fuel management, there are also questions about the impact the regulatory change could have to over-the-road (OTR) shipping and diesel prices. To what degree will this change affect transportation budgets?
Breakthrough’s Applied Knowledge Team is aware of the latest developments regarding fuel market dynamics and is taking the upcoming maritime regulatory changes into consideration while providing market forecasts to clients. Here is a high-level explanation of the coming fuel market changes and what shippers can expect.
Background: IMO 2020 Sulfur Cap
Beginning January 1, 2020, the IMO is calling for the reduction of allowable sulfur content in marine fuel from 3.5% to 0.5%S m/m. Despite the introduction of the coming regulatory changes over a decade ago – the regulation was first announced in 2008 and was later confirmed by a study during 2016 – the maritime and refining industries are seemingly in a scramble as they prepare for this fuel market evolution.
Vessel owners and operators need to ensure their vessels are compliant with the new regulations through the consumption of low-sulfur fuel, the use of exhaust gas cleaning technology (scrubbers) or other low sulfur emission alternatives such as LNG. Meanwhile, refiners will need to adjust their production by increasing their supply of low-sulfur fuels and managing their supply of high-sulfur fuels.
The sulfur cap will ultimately lead to higher capital expenditures and operating costs for these industries and will create operational uncertainty as 2020 approaches. You can learn more about these fundamental details from a separate article we have written about the 2020 sulfur regulations.
Current estimates state an additional 2.0-2.5 million barrels per day of low-sulfur fuel will be needed to meet the maritime industry’s demand. The IMO’s 2020 sulfur cap is therefore anticipated to be economically significant because it impacts a volume of fuel that is much larger than previous maritime sulfur regulations.
Despite scrubbers offering most of the maritime industry a viable alternative to consuming more expensive, low-sulfur fuel, most vessel operators have expressed their intentions to become compliant by consuming the new, low-sulfur fuel. The maritime industry’s shift toward cleaner conventional fuel carries significant price impacts for shippers, and not just for ocean freight.
Defining Demand for Diesel and Bunker Fuels
The impact of the sulfur emissions cap will be seen not only in the prices of maritime bunker fuels but will also affect the prices of other low-sulfur distillate fuels, like ultra-low-sulfur diesel.
A common misconception of the sulfur regulations is that they will cause vessels to consume 2.0 to 2.5 million barrels of diesel fuel daily to replace the high-sulfur fuel oil that is consumed today.
While it is perhaps possible for vessels to run on actual ultra-low-sulfur diesel, it is much more likely they will be consuming the 0.5%S m/m low-sulfur fuel that, like diesel, exists within a class of refined products known as middle distillates. Refiners will likely blend very-low-sulfur feedstocks with high-sulfur residual fuel oil – formerly the predominant maritime bunker fuel – to produce the new 0.5%S m/m, IMO compliant bunker fuel.
The anticipated practice of blending high and low-sulfur feedstocks to meet the new maritime low-sulfur fuel demand also explains how some of the residual fuel oil will be consumed post-2020, and why other low-sulfur fuels, like diesel, may experience upward price pressure.
Upward price pressure has already entered the maritime industry. The benchmark port prices shown in the chart show the difference in price between high sulfur fuel oil (IFO380) and low sulfur marine gas oil (LSMGO 0.1%S m/m) through August 2018. Notice the differential between these prices has grown over time, perhaps as the value of low sulfur fuels has appreciated.
Presently, more than 80 percent of global high-sulfur, residual fuel oil is used in maritime shipping for bunkering, which means the market for this product is largely evaporating. Since high-sulfur fuel oil is a residual product that comes from the production of other fuels, refiners are looking for ways to manage an expected oversupply.
In addition to plans for using residual fuel oil as part of low-sulfur blends that meet regulations, refineries are drawing down their inventories ahead of 2020. Refiners will likely push heavy fuel oil into the power generation sector at a discounted price. That is a limited market, however, and while it will not be overwhelming, there will be an inescapable surplus of high-sulfur fuel.
Conversely, low-sulfur refined products, like diesel, will certainly see increased demand. And, even though the IMO’s sulfur regulations will not require millions of barrels of diesel per day to meet marine fuel needs, the coming demand shock will put pressure on refinery feedstocks and existing inventories of low-sulfur fuel to produce IMO-compliant products.
The increasing demand for middle distillates, such as diesel, will help continue a recent renaissance for diesel following Dieselgate—theVolkswagen emissions scandal that encouraged the adoption of regulatory timelines for widespread bans on diesel and other internal combustion engines, particularly across Europe. The Energy Information Association (EIA) recently pointed out that since 2016 diesel’s value grew when compared against other refined products.
When examining the diesel crack spread, which measures the difference in the price of a barrel of crude oil and the price of a barrel of the fuels extracted from it, diesel cracks have been particularly healthy as a consequence of expanding global economies. Diesel, and other middle distillates such as maritime bunker fuels, are among the most market-responsive refined products since they are heavily dependent on consumer goods purchases and therefore freight markets for their consumption.
Historically, the U.S. has been a gasoline-centric nation due to passenger vehicle use, but refiners now have a growing economic incentive to produce more diesel. The strong US economy that contributed to tight labor and trucking markets is concurrently driving demand for diesel and pushing prices higher. Diesel will become even more valuable as demand increases due to the IMO sulfur regulations. As seen in the chart below, futures markets presently show the diesel crack spread growing out to 2020, placing perhaps another 10-15¢ per gallon premium on diesel as IMO 2020 approaches.
What Can Shippers Expect and What Should They Do?
Shippers should plan for increasing volatility in the market as we move closer to the IMO’s deadline. While several factors could impact just how much diesel prices rise, the general market consensus is that the IMO regulations will inevitably push prices higher. We may also see consumer prices increase, but likely not enough to experience the devastating economic impacts that have already made headlines.
The Applied Knowledge Team’s expectation is that diesel prices will begin to increase and maintain exceptional volatility during the second half of 2019 and prices will remain elevated into 2020. We project outcomes and prices will remain dynamic over the next 15 months as the maritime, refining, and transportation industries continue to act on economic incentives in the marketplace.
For that reason, it is wise for shippers to become navigators of their transportation energy strategy now, rather than react to changes in an uncertain market. This is an ideal time for shippers to evaluate opportunities to mitigate energy market risk. For example, shippers may choose to adopt an intermodal shipping strategy to reduce the total amount of diesel fuel consumed through more efficient freight movements. Breakthrough clients who have been on a Fuel Recovery program for a full year can also gain budget certainty through our fixed price fuel solution.
Find out more about Breakthrough’s growing suite of Fuel Management and Supply Chain Solutions. Discover how we leverage data to remove distortion, achieve transparency, and establish fairness for shippers.