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ESG Focus: Global Shipping, Disrupted Disruptor

ESG Focus | Jun 06 2019

FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future:

ESG Focus: Global Shipping, Disrupted Disruptor

-International Maritime Organisation slashes sulphur limits in shipping fuel by 85%
-Shipping, oil refineries, aviation, road transport and coal will be hardest hit
-Domestically, Australian LNG and coal exports to feel the repercussions

By Sarah Mills

It’s life Jim but not as we know it.

These iconic words from Star Trek’s Mr Spock could easily apply to the investment environment over the next two decades as environmental, social and governance (ESG) considerations bite.

ESG has, up until now, been a largely abstract concept, with the exception of sharply deteriorating funding for the coal industry.

But the world is about to feel the first shock of environmental regulation when the International Maritime Organisation’s (IMO’s) new limits on sulphur in shipping fuel come into effect on January 1, 2020.

Limits on sulphur fuel in ships slashed 85%

Under MARPOL Annex VI regulation 14.1.3, IMO has mandated an 85% reduction in sulphur levels in shipping fuel to 0.5% weight from the existing 3.5% weight. 

IMO has also banned the carriage of non-compliant fuel after March 2020, to stop ships switching fuel at sea. Ships will be inspected going in and out of port.

It is the largest sulphur reduction undertaken in one step in the transportation sector’s history.

Global impact

Global shipping has long been a sink for dirtier crudes, and the implications will be far reaching.

The shipping industry is responsible for half of global high-sulphur fuel demand, according to Forbes; and accounts for 80% of international trade, at least 3% of global emissions and 10% of global transportation oil demand, according to HSBC.

The bad oil

Shipping fuel is an extremely dirty, high polluting fuel, containing high levels of sulphur oxides.

Sulphur oxide is a potent greenhouse gas, and is also responsible for acid rain.

Sulphur levels in shipping fuel are roughly 3,500 times greater than standard road fuels in Europe, and one container vessel consuming 80 tonnes a day of high-sulphur fuel emits the equivalent in sulphur oxides of 46m light-duty diesel vehicles.

Limited preparation means concentrated impact

The major players have been aware of the coming changes since 2008. While some maneuvering has been taking place, most have taken a wait-and-see approach given it is difficult to know when disruption strikes, where and when to invest until the situation resolves itself.

For example, there is already talk that the sulphur levels could be cut further (another 80% to just 0.1% weight), which would change the game again.

This means preparations will begin in earnest from July 1, concentrating the bulk of the fallout into a narrow timeframe of roughly 18 months to two years.

Limited preparation means the industries will most likely opt for quick-fix expensive options as they scramble to comply before long-term capital investment restores the balance.

The regulators

The International Maritime Organisation is the United Nations body responsible for the safety and environmental performance for the shipping sector.

North America, the Eurozone and China are all on board and account for 90% of global shipping fuel demand. UAE is the only major non-signatory.

The initiative also has the support of major shipping companies through the Trident Alliance.

Oils aint oils

Given oil’s pivotal economic role, its repercussions will reverberate across the globe.Total global demand for major petroleum product is still expected to continue to grow between 1m to 14m barrels a year.

However, the usage of oil types is expected to change sharply and impact pricing for better and for worse across oil spreads.

Internationally, prices for middle distillate oil are forecast to rise, affecting the aviation and road transport industry, asphalt markets, petrochemical and feedstocks markets, bringing supranormal short-term profits for producers.

Shipping and oil refineries first in the firing line

The shipping and oil refinery industries will face a period of restructuring as players adopt a variety of survival strategies. As with all disruption, the regulation represents both threats and opportunities.

Starting with shipping, fuel represents 15% of total costs so upgrading global fleets to more expensive distillates will have a material financial impact.

The shipping industry only has three options. It can: switch to more expensive marine gas oil (adding 15% to fuel costs); install scrubbers to clean sulphur from the fuel; or invest in new ships designed for LNG, or renewables mixes.

It is expected that the market will opt primarily for marine-gas oil in the short-term, as installing scrubbers is expensive (about $3m to $5m per ship) and involves several months lead time and at least two months in dry-dock, resulting in a loss of revenue.

IMO had forecast that 3,800 ships (from the main global fleet of 60,000) would install scrubbers but pundits now estimate that figures could be as low as 1,000-1,500, according to Lloyds.

The installation of scrubbers also involves expensive operational, logistical, technical, regulatory and commercial issues.

This means that depending on the age of the ship, in many cases it will be more sensible to buy a new high-spec boat, including boats designed to run on liquid natural gas (LNG) or a renewable energy mix.

New ships cost roughly $120m to $160m, and the average life cycle is 20-25 years. Depending on which way the industry leans, this lifecycle could be reduced to as low as seven-12 years at considerable expense.

LNG vessels cost 15%-20% more than traditional bunker fuel vessels but there are concerns about its availability as a bunker fuel within the next five years. About 25 ports are equipped with LNG facilities and this is forecast to grow.

Meanwhile, ship-builders and scrubber installers and producers are likely to find themselves suddenly very busy. The shipbuilding sector should experience strong demand particularly for high-spec energy efficient vessels.

Scrubbers are expected to experience a 15% to 30% increase in cumulative incremental capital intensity (cici), according to Lazard.

An LNG retrofit of a vessel is expected to cost between $15m and $25m and have a 40%-80% cici. A new LNG vessel is likely to cost between $160m and $170m at 15%-20% cici.

The good oils

As neither scrubbers nor new ships are immediate fixes, the industry will have to use alternative fuels in the short term, which also have another short-term advantage.

Given shipping freight prices are at historical, cyclical lows (Lazard analysts estimate freight rates account for less than 5% of total goods shipped), it is expected that a high percentage of the fuel costs at least, can be passed on to consumers, at least until the cycle shifts.

Marine gas oil and diesel are the two main options, with LNG being a possibility for new-build ships. LNG is not available at all ports, and this is a major drawback, although many new LNG ships will allow for long hauls without refueling. LNG represents just 3% of marine fuels market and the cost of switching is high, and not all ports are equipped for it.

Marine gas oil uses the same hydroprocessing steps as low-sulphur fuel, which makes it attractive. However, straight diesels blend better with other diesels, which is important should a ship find itself in a situation where it needs to blend fuel. The oil refineries will keep a keen eye on which way the shippers lean.

The oil refinery shuffle

Next in line are the oil refineries.

As ships shift to marine gas oil (an extra 1m barrels per day) and other fuels, the more complex refineries will benefit from the sharp uptick in demand, leading to higher margins and profits.

Of these, those with deep conversion (mainly listed refineries) are forecast to experience strong margins and supranormal profits, and medium conversion refiners should also improve margins to a lesser extent.

It is estimated that there are insufficient refineries with the necessary equipment to produce higher value distillates, which means those that can, will be running at high utilisation rates, which increases costs.

While there is a huge incentive across the board to upgrade distillate facilities, and this will be a feature over the next decade given increased oil consumption, prices for higher value distillates may start subsiding temporarily within two years as the initial impact of the shipping regulation subsides, so the mid-term return on expenditure is less certain.

Oil refineries are multi-million pound long-term investments. Refineries can take up to five years to come on line (well after the peak demand is forecast) and they often experience building delays. So any projects now would miss the peak IMO run regardless.

Global shipping trade is forecast to continue climbing but given the international commitment to cut carbon and technological advances in alternative energy sources, the future of such investments is increasingly uncertain.

So there is unlikely to be relief from the oil refining quarter.

Then there is the problem of what to do with all the heavy sulphur-laden fuel. Shipping used to be a sink for high-sulphur fuels often left over in the distillation process. It is estimated the surplus will be at least 2m barrels a day. About 1m barrels may be used as refinery feedstock but refinery demand will be insufficient to destroy all the high sulphur fuel.

Basic refineries will also lose of their biggest markets almost overnight.  As this stock hits the broader market, an oversupply is expected to send prices spiraling downward.

This will also be an issue for more complex refiners who usually still have heavy crudes in the mix, placing further upward pressure on the middle distillates to enable them to recoup losses from weak high-sulphur products.

Some will turn high-sulphur fuel into products such as asphalt and petroleum coke for industries such as construction.

Volatility for oil commodities

Oil commodities markets are also bracing for widening spreads between crude mixes. Up to 290m tonnes of compliant fuel could be needed by next year, according to IMO.

Volatility is also expected to feature given small changes in supply and demand of as little as a few hundred thousand barrels are day can have major affects on price.

As noted, the shipping industry is responsible for half of global trade fuel demand. But marine gas oil, the higher value distillate, which is likely to attract that demand, only represents 5% of overall global oil demand.

Higher demand for gas oil will have to be met by higher crude runs placing upward pressure on global crude prices, distillate premiums to other fuels and refining margins in general.

Lloyds expects cracking margins for European Brent to rise US$3 a barrel. Markets expect sharp widening in the spreads between marine gas oil, crudes and even other distillates, creating a situation of contango in 2020.

Diesel prices to rise

HSBC predicts pressure on middle distillates means diesel demand will rise 5.2% by its 2020 peak, before returning to balance in 2025.

Lloyds says the spread between gasoline and diesel has traditionally been about US$4-US$6 a barrel. When diesel demand rises relative to gasoline, the spread rises to US$12, which the broker forecasts for 2020, before declining between 2021 and 2023.

Distillate inventories are already below the five-year average, which is expected to exacerbate price rises. Observers believe higher prices could hinder compliance.

High-sulphur fuel prices to tumble

Meanwhile, prices for high sulphur fuels are tipped to fall.

Traditionally, high-sulphur fuel is used in competition with natural gas in the power generation market, where it is used as feedstock. However, the dumping of shipping oil stocks could overwhelm this market, allowing it to compete with even lower-value coal in the Asian power sector.

This would mean it could fall to as low as US$15 a barrel, (from US$40), but demand would provide a floor at that level. Saudi Arabia has already signaled its intent to use high sulphur fuel to power its desalination plants, and Bangladesh is also a potential market.

Downstream industries feel the ripples

The global economy pivots around the oil price and the ripples of the IMO regulations will be felt across industries. Energy markets and industrial activity are expected to feel the brunt with petrochemicals buyers expected to be the worse off. Industries dependent on long-distance haulage are also vulnerable.

The aviation and road haulage industries are the largest buyers of middle distillates, and all things equal, are expected to face higher costs over 2020-21.

Agriculture also relies on low freight costs, which means prices could rise at the checkout. Higher freight costs are likely across most raw materials industries.

Certain metals industries are also expected to experience tighter supply of anode coke, which accounts for 10% to 15% of aluminium manufacturing. It is estimated this could add an extra 1% to 2% to costs on top of increased freight rates.

As noted above, the coal industry could suffer if the price of high-sulphur fuels drops low enough to make it competitive with coal. Oil has lower carbon-dioxide emissions than coal plus offers 50% more energy per unit.

Power generators could benefit from the regulations if more high-sulphur fuel finds its way into the feedstock market. Will ESG fund some of this? Talk to Tim Buckley. Shipping is one of the highest polluters in the transport sector, leaving it highly vulnerable to a carbon tax.

Australia caught in the cross fire

At a local level, Australia will suffer as low-quality crudes compete with coal in power generation markets. Exported LNG prices are also expected to take a short-term tumble before recovering post 2020.

This anti-intuitive state of affairs reflects the fact that Asian LNG contract prices are indexed against a basket of heavy crudes, the Japanese Crude Cocktail.

As the price of the cocktail falls and the spread against Brent crude widens, it should equate to a drop in LNG prices of about US$18 a tonne, according to The Australian Financial Review. Wood Mackenzie estimates the impact on the Australian LNG market at US$2.7bn.

The export prices of iron-ore and coal, representing 17% and 14.5% respectively of Australian export sales, could also be affected. Given both these markets are subject to other demand and supply forces which are outside the scope of this article, it is difficult to determine the net effect.

Countries with skin in the game

Countries most adversely affected will be producers of heavy crudes in Canada, Mexico, Venezuela, followed by Russia and Middle East. Winners are expected to be those producing medium weight low-sulphur crudes – north-west Africa, Brazil and North Sea.

Big investments will also be required in US and European refineries.

Compliance – to be or not to be

Many industry observers find it hard to imagine immediate and full compliance, but all agree 2020-2021 will pack a punch.

Wood Mackenzie estimates global compliance in 2020 will be 80%, while BP’s CEO, Bob Dudley, expects 50% non-compliance – quite a disparity. Many participants are reluctant to move given the possibility of further regulation.

Uncertainty reigns

Discussions are under way regarding the European Emissions Control area, which would include Mediterranean shipping to consider imposing an even more stringent 0.1% weight for marine fuels across European waters.

This would further tighten middle distillate supply. Some IMO members are also considering banning the use of fuel oil in the arctic where marine traffic is expected to rise.

A carbon tax remains on the agenda, as does ESG funding decisions down companies’ supply chains. IMO’s greenhouse gas strategy may hold back interest in LNG bunkering beyond the 2020s.  Adopted in 2018 and to be revised in 2023, it aims for a fast peak in emissions and then a halving by 2050, despite rising traffic.

This means zero green-house-gas emission vessels need to come into service at commercial scale in the 2030s, making investment in LNG ships less certain as new energy sources come on line, such as biomass, wind powered rotor technology, batteries or solar.

There has also been talk of slow steaming regulations – effectively speed limits that would incentivize adoption of zero carbon fuel. This would be of particular concern for perishable goods. Many decisions will likely hinge on future carbon-tax and emissions-regulation estimates.

Coal has a carbon intensity of about 1,000g CO2/kWh, oil is 800g CO2/kWh, natural gas is about 500g CO2/kWh, while nuclear, hydro, wind and solar are all less than 50 g CO2/kWh, according to the Renew Economy website.

Then again, perhaps it will be IMO that backs down and provides an extension, a distinct possibility a year or two into the regulatory period if the situation does not resolve itself satisfactorily.

The industry is literally “at sea”.

Technical limitations

If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.

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