Marine Industry Regs Could Send Shock Waves Through World Economy

June 7, 2018

In recent weeks news outlets have been full of stories of rising vehicle fuel prices. A USA Today headline worried that “Gas prices could hit $3 nationwide Memorial Day weekend”, while the Boston Herald cried that “Rising gas prices fuel worry.” Pundits were opining on the impact of what many saw as a 25% – 30% increase in prices at the pump since Memorial Day 2017. CNBC apprehensively reported that “Higher gas prices could hurt already weakening home sales”, while a spooked New York Post agonized that “Rising gas prices are killing one-third of Trump’s tax plan benefits.”

Across the U.S., observers are again worried that energy prices were going to empty people’s wallets at a time when most were hoping for a bump to the U.S. economy.

Yet, the slight bump in pump prices we are experiencing now may pale in comparison to the costs consumers will be paying in a year and a half.

The slight bump in pump prices we are experiencing now may pale in comparison to the costs consumers will be paying in a year and a half.

On January 1, 2020, a transformational event will occur in the marine industry, a change that will dramatically reduce the air pollution that comes from the world’s ocean-going vessels. However, this boon to breathers who live and work around the world’s ports may also have a cataclysmic impact of the price of diesel across the planet, the reverberations of which may be felt in every corner of the world economy.

And most people are unaware of the coming storm.

The IMO and Their Rulemaking

The transition that is being referenced here is the imposition of the International Maritime Organization’s (IMO) requirement that all fuel used to power the planet’s marine vessels contain no more than 0.5% sulfur, down from the current cap of 3.5% sulfur by mass. The IMO, an agency of the United Nations created in 1959 to regulate international shipping, has authority over a variety of maritime issues, including safety, vessel efficiency, maritime law and, of course, environmental concerns. This includes fuel quality for marine vessels, and the 174-member states of the IMO are imposing strict sulfur limits on marine fuel.

Pollution from marine vessel has long been a significant international issue. In the early years of the IMO, the primary concern was oil spills from accidents, the improper discharge of ballast water and the routine dumping of engine room and oil tank wastes.

After the Torrey Pines oil spill in the English Channel in 1967, the IMO’s member states created the International Convention for the Prevention of Pollution from Ships, also known as MARPOL (short for “Marine Pollution”). MARPOL developed in the 1970s and was primarily concerned with ocean pollution. Over the last twenty or so years, however, the impact of marine vessel operations on air quality and climate change have emerged as major foci of the London-based IMO.

The low sulfur fuel regulation was first approved by the IMO in 2005, and it has been reaffirmed by the world body multiple times since. The most recent reaffirmation occurred in February 2018, the last time that the IMO had the opportunity to delay implementation of the 0.5% fuel requirement to a later date. In fact, not only did the IMO uphold the original target date, but it amended the MARPOL Convention to prohibit ships from carrying non-compliant fuel.

There are three primary ways for marine vessels to meet the 2020 low sulfur fuel cap:

  1. They can continue to bunker (the term used to describe fueling a marine vessel) their ships with high sulfur fuel, but they must then be equipped with exhaust gas cleaning systems (also called “scrubbers”) that will remove enough sulfur from the exhaust that the vessel achieves the functional equivalent of the requirement. Only ships with scrubbers would be allowed to carry non-compliant fuel.
  2. They can convert their vessels to a low sulfur alternative to traditional petroleum derived bunker fuels, such as liquefied natural gas (LNG).
  3. They can simply fuel their vessels with compliant fuel. The use of low sulfur fuel appears to be the choice of the vast majority of the world’s vessel operators, and therein lies the potential problem.

The use of low sulfur fuel appears to be the choice of the vast majority of the world’s vessel operators, and therein lies the potential problem.

 Middle Distillates Impact on the Diesel Industry

Industry observers estimate that the world’s maritime industry will require about 5 million barrels a day of low sulfur fuel. For the most part, the fuel that will meet the IMO’s requirement will be what the industry calls “middle distillates”. The high-sulfur fuel presently used in marine vessels come from the bottom of the oil barrel, and do not require the processing that are necessary to produce fuels like kerosene, gasoline or even diesel.

The middle distillates necessary to meet the IMO’s 2020 fuel standard (also known as marine gas oil, or MGO) are same kind of fuel, essentially, as diesel, and will be derived from that part of the oil refinery that produces diesel. Thus, for all practical purposes, on January 1, 2020 the world’s demand for diesel will increase substantially.

The problem is that the oil industry is not prepared for this transition.

The problem is that the oil industry is not prepared for this transition. Most of the world’s oil refineries have not made the investments in new MGO refining capacity that are needed to meet this huge new demand. Such investments are expensive (typically $1 billion plus per refinery) and take many years to build (5 – 7).

In addition, many of the world’s ports are still trying to get a handle on the infrastructure necessary to store and supply MGO in addition to the heavy fuel oil (HFO) that is currently in use, and which will continue to be used by approximately 20% of the world’s ships that will comply through the use of scrubbers.

There is much speculation as to why the industry is so unprepared for the new regulation. The IMO first announced its intention to require low sulfur fuel nearly 18 years ago. Many suspect that the oil industry believed that the IMO would back down, and delay the implementation of the 0.5% cap to 2025, thereby giving the industry more time to make the needed investments in new MGO refining capacity.

Unfortunately, those who were betting on delay may be caught flat footed, and their procrastination may cost the rest of the world dearly.

Ramifications on World Oil Markets

In 2016, the total daily production of diesel was 34.6 million barrels/day (mbd). Demand for MGO is expected to increase from anywhere from 2 to 4 mbd. Another way to look at this shift is that the marine sector will increase from 3% of total global diesel demand in 2015 to 10% of total global diesel demand in 2021.

A respected industry analysis, Martin Tallett, projects that not only will about 3 mbd of diesel be diverted from conventional on-land uses to fueling ships, but that the demand for low sulfur oil, the product most easily converted in to low sulfur end-use fuels, will increase by 2.3 mbd, putting more pressure on oil prices.

Morgan Stanley predicts that oil will surge to over $90 a barrel in 2020 (from today’s Brent Crude price of roughly $77/barrel), while the head of Global Analytics for S&P Global Platts ominously warns that “This is going to be the most disruptive change to hit the refining industry in its history.”

Higher Prices for Everyone

The inevitable end result of this increased demand for diesel from the marine sector and the industry’s lack of refining capacity to meet this upswing in demand will be higher prices for everyone.

The inevitable end result of this increased demand for diesel from the marine sector and the industry’s lack of refining capacity to meet this upswing in demand will be higher prices for everyone. According to Wood Mackenzie, the shipping industry alone can expect its fuel bill to increase by $24 to $60 billion in 2020.

Few researchers have dared to project the impact on land-based diesel prices, but if the recent run up is any indication, a 20% to 30% increase from today’s prices would not be out of the question. This would push motor vehicle pump prices to levels not seen since the summer of 2014, when some parts of the country were suffering under the weight of $5/gallon diesel.

For the alternative fuel and electric vehicle makers and fuel providers, business increases with the price of oil. The oil price forward curve, pushed by increased global instability (Venezuela, Iran) as well as emerging mega trends (increased world oil consumption and the upcoming imbalance in supply of middle distillates), point to a period of rapid growth for our industry.

The adverse impact on everyone, however, for the oil industry’s lack of preparation for a regulation they saw coming for 15 years, will be severe.