IMO 2020: Making Way for a Cleaner and Greener Earth

Published on 03 Jul, 2019

Discharge of harmful chemicals in the sea, contributing to environmental degradation, has sparked concerns. To maintain ecological balance, in 2005, the International Marine Organization (IMO) imposed regulations aimed at reducing sulfur oxide (SOx) emissions from shipping/bunker fuel oil, under Annex VI of the International Convention for the Prevention of Pollution from Ships (also known as the MARPOL Convention). Thereafter, the global SOx limit has been revised only once in 2012, from 4.5% to 3.5%. In 2016, a deadline was decided to further bring down SOx level to 0.5% by January 1st, 2020. This was confirmed at the 70th session of the IMO’s Marine Environment Protection Committee (MEPC). The regulation, considered one of the most ambitious targets, is forcing the industry to re-calibrate its production and supply chain.

Current regulations classify SOx limit into two broad categories: 1% for the four emission control areas (ECAs); and 3.5% for rest of the global shipping routes. While ECAs’ current SOx level is already on the lower side of 1%, IMO 2020 intends to bring it down to 0.1%. This is likely to have a relatively minimal impact as ECAs account for just 19% (0.8 mbpd) of the global fuel demand by ships. Challenges in complying with 0.5% SOx content by January 1st, 2020 (from 3.5% currently) are far more tough for the remaining global shipping industry that primarily consumes low grade high-sulfur fuel oil (HSFO) and accounts for 81% (3.4 mbpd) of shipping fuel consumption in the world. Even though global marine fuel demand constituted just 4–5% of total oil demand in 2018, to establish the implications of IMO 2020, it is important to ascertain the industry’s preparedness and options shipping operators are evaluating.

These are:

  • Switching to low-sulfur fuel oil (LSFO) instead of HSFO which is used currently
  • Installing scrubbers or exhaust gas cleaning systems (EGCSs) in ships and continuing with HSFO
  • Using LNG as an alternative shipping fuel

According to a 2018 survey of ship owners by Congressional Research Services (CRS) on meeting the 2020 sulfur requirements, 74% respondents showed interest in purchasing LSFO directly from suppliers, 19% were keen to install a scrubber, 5% intended to switch fuels to LNG, while 2% had other unspecified plans.

We believe the feasibility of both capital-intensive options (2 and 3) above depends on two market variables: differential (spread) between LSFO and HSFO prices, and crude vis-à-vis LNG prices. Under both variables, if the long-term outlook on the differential spread is high, ship operators may consider incremental capex due to higher ROI from continued use of HSFO. Furthermore, lack of regulatory clarity on nitrogen oxide (NOx) limits in IMO 2020 increased the dilemma of ship operators with regard to taking concrete action. Capex on scrubbers may not be enough to contain NOx emissions. Hence, unpredictability and lack of clarity following the implementation of IMO 2020 has led most industry players to adopt a wait and watch approach. They have chosen to buy LSFO as an immediate option to meet the regulatory requirements of sulfur content in marine fuel.

We believe the real fundamental impact of IMO 2020 regulations will be more prominent higher up in the supply chain, which is the refining industry. Given the positioning of ship operators as end consumers of LSFO and clean fuel, considerable onus will be on refiners to adjust the supply side. Although the shipping industry consumes only 3.5% of HSFO produced globally, in terms of quality of fuel, it consumes ~50% of high-sulfur, low quality byproducts manufactured by global refiners. The key concern is who will be the end user of this low quality byproduct following the implementation of IMO 2020. Refiners around the world need to realign and re-calibrate their operations.

According to the International Energy Agency (IEA), high quality compliant fuels such as marine gas oil (MGO) and very low sulfur fuel oil (VLSFO) would together account for 3.0 mbpd (~70%) of marine fuel consumption in 2020. HSFO consumption would decrease from 3.4 mbpd (80%) in 2018 to 1.4 mbpd (~30%) in 2020; 50% of this (0.7 mbpd) is expected to be used by 4,000 scrubbers installed on large vessels and the remaining 50% by non-compliant ship operators. The drastic reduction in HSFO offtake is expected to pave the way for process upgrade, blending innovations and boost capital expenditure by less competitive refineries around the world. Such structural changes in industry dynamics could create more challenges for smaller and less advanced refiners.

While there is a wide variation in demand forecast by various agencies (composition of bunker fuels into MGO, VLSFO, blend and scrubbing), the industry is unanimous in forecasting a significant impact of the implementation of IMO 2020 on the prices of middle distillate products such as diesel and MGO. This is primarily due to the initial inclination of ship operators to replace HSFO with MGO and blended VLSFO, produced from vacuum gas oil (VGO) that is used to produce finished diesel. Some industry experts also foresee a shortfall in diesel production subsequent to the implementation due to the diversion of VGO toward production of VLSFO, instead of diesel. Several inter-dependent variables such as nature of capex by ship operators, production adjustment by refiners, sufficient availability of clean fuel, non-compliance, and regulatory clarity are expected to stabilize over a period of 12–18 months after the implementation of IMO 2020 regulations.

With regard to costs, we believe the cost metrics of ship operators would go north amid the increase in prices of clean fuels. According to the EIA, low sulfur gas oil is priced at a premium of US$20/barrel compared to high sulfur residual. However, the overall economic impact on shipping operators could be limited as the incremental cost would be primarily passed on to the end user. According to Wood Mackenzie, on some trade routes (for instance, Brazilian iron ore shipments to China), rates could increase by as much as US$6/ton (up 40%). From an end-user perspective, landed cost of global bulk commodities transported through shipping routes, such as coal, iron ore and non-ferrous metals, could increase and pressure on margins from input prices would be more visible.