Beginning in 2020, the International Maritime Organization’s (IMO) IMO 2020 air pollution regulations will force the estimated 45,000 ships in the international shipping sector to give up their long-held reliance on sulfur-rich fuels. There is yet no consensus on what new fuels and technologies will take their place. With the deadline for implementation less than two years away, ship owners are weighing the cost advantages of several options for compliance, keenly aware of the risks they face in choosing the wrong fuel or technology. As many factors and decisions remain yet to be determined, fortunes may be made or lost in an industry where fuel accounts for more than 50% of operating costs.
Oil refineries, too, must decide where to invest to meet future demand and have yet to make the long-term investment decisions required to meet the new IMO requirements. Marine fuels – commonly known as bunkers – comprise as much as 7% of global oil demand,1 and refineries hope to anticipate ship owners’ demand for different types of bunker fuels in 2020 to ensure there is sufficient supply. With so much uncertainty about how future supply and demand will affect bunker prices, ship owners have been reluctant to invest in engine retrofits or exhaust “scrubbers” that may commit them to burning a specific type of fuel.
Breaking Down the Bunker Fuel Market
Today’s ships burn cheap, heavy fuels that contain up to 3.5% sulfur by fuel mass and account for a significant share of the world’s pollution. It is estimated that the world’s shipping fleet contributes 8% of global sulfur oxide emissions, 15% of nitrogen oxide emissions and 3% of global carbon dioxide emissions.2 When emitted as exhaust, sulfur oxide catalyzes with nitrogen oxide to create sulfuric acid that manifests as acid rain. International regulators have long sought to reduce the effects of these fuels and, since 2015, several nations, including the United States, Canada and the EU, have limited the sulfur content of fuels to 0.1% for ships within their emission control areas (ECAs), which extend 200 nautical miles from the coast. When entering ECAs, international ships temporarily switch over to more expensive ultra-low sulfur fuels or turn on emissions scrubbers to comply.
Today, the market for bunker fuel is highly fragmented. Energy majors account for roughly one-third of global bunker volume, while independent traders, distributors and resellers comprise half of the volume. National oil companies have captured the balance. The Port of Singapore is currently the largest bunker market, having sold 50.6 million metric tons (MT) of bunker fuel in 2017, with an average sale consisting of more than 1,200 MTs (roughly 8,000 barrels or 336,000 gallons). Approximately 75% of the fuel sold was intermediate fuel oil with a viscosity of 380 centistokes – commonly known as IFO 380 – the industry standard, which is a blend of 88% residual oil and 12% distillate fuel with a consistency approximating corn syrup or honey at room temperature.
Planning for Compliance
With fuel costs comprising more than 50% of ship operating costs, operators are looking to the lowest cost solution to comply with the forthcoming sulfur regulations. The IMO rule is “performance-based” not “standards-based,” meaning shippers have flexibility in how they comply with the law. In theory, this should free private industry to innovate new technology solutions. In practice, however, it has created a game of wait and see, with shippers weighing several options:
- Scrubbers: Retrofitting vessels with exhaust gas cleaning systems, or “scrubbers,” would allow ships to continue to burn cheaper high-sulfur fuels like IFO 380. These scrubbers can cost between $3 million and $5 million per vessel3 to install and require ongoing expenses to refresh the unit’s caustic soda or magnesium oxide supply, which is used to purify the wash water that interacts with the exhaust. The most widely used scrubbers use an “open system,” where the effluent is washed with ocean water. Open systems have far cheaper operating costs than closed systems that store the effluent for shoreside disposal. There is concern, however, that open system scrubbers may eventually be banned, since they release sulfur into the ocean instead of the air.
- Adopting new types of bunker fuels, such as:
- Ultra-low sulfur fuel oil (ULSFO): The most likely short-term solution available to shippers, ULSFO is a desulfurized version of standard ship bunkers (IFO 380) that may require minimal engine retrofits but will not require scrubbers. However, it currently costs 40% more than its high-sulfur variant.4 Older ships with few remaining service years may adopt ULSFO rather than invest in scrubbers or new engines because those investments take several years to recoup their upfront costs.
-Marine gas oil (MGO): This is a lighter, more combustive fuel composed exclusively of crude oil distillates with similar properties to diesel fuel. MGO’s low sulfur content (0.5%) will allow ships to comply with IMO 2020 without scrubbers, though it currently costs 50% more per MT than IFO 380 and is optimized for medium- to high-speed engines. Minimal changes to fuel tanks, hoses and engines may be required.
-Liquefied natural gas (LNG): A still-nascent technology with scarce bunkering supply, LNG powered just 77 ships in 2016. Ships would need larger fuel tanks to accommodate LNG’s lower fuel density by volume, and the scarcity of LNG bunker suppliers means the most promising applications are for ships serving dedicated routes such as container liners or passenger ferries. The high cost and engineering difficulty of retrofitting ships with LNG engines and fuel tanks suggests that LNG will likely be a fuel that emerges over time as new ships are built. Industry experts estimate the cost for retrofitting an existing ship for LNG to be between $6 million and $21 million, depending on the tank and engine size.5.
- No action: While noncompliance sounds extreme, some shippers are hoping that the disruption to commerce will cause enforcement to be delayed for a period of time. This would reward ship owners that have delayed investments in new fuels and technologies. In addition, the IMO is a sub-agency of the UN that lacks enforcement authority in international waters. As the rules currently stand, the IMO will rely on vessels’ “flag states” to enforce the new rules. There is wide concern that these flag states lack the resources and will to enforce the new regulations. (Panama, Liberia and the Marshall Islands are the flag states for approximately 40% of ships worldwide.) As a result, major shipping companies and regulators have recently stepped up calls for a global enforcement program as a way to create a level playing field.6
A High-Stakes Game
Estimates for global bunker consumption vary, ranging from the International Energy Agency’s (IEA) present-day estimate of 4.2 million barrels per day to the IMO’s 2020 projections showing 5.9 million barrels per day. While ship operators can choose from several options to comply with the new rule, the decisions of their competitors and oil refiners will heavily affect any particular option’s success. If a sizable portion of the global fleet adopts any single new fuel solution (natural gas, marine diesel, ULSFO or others) or opts to keep the existing high-sulfur fuel and install emissions scrubbers, prices for that particular fuel could spike in the short term as demand outstrips supply. Using IEA and IMO global bunker fuel consumption forecasts, we can estimate the impact on supply and demand if all shipping companies were to shift to a new fuel en masse. While this scenario, in which all ships adopt the same new fuel, is far-fetched, it is a worthy thought experiment that demonstrates the conundrum facing ship owners and refineries.
The analysis shows that if all ships switched to compressed natural gas engines (a highly unlikely scenario but illustrative for its impact on the supply chain), the increase in demand would be equal to 7% to 10% of 2017 global demand. This would likely push up prices for the fuel dramatically in the short term until supply expands to meet the new demand. However, ships are typically fueled using the super-chilled LNG form of natural gas because its higher density requires less room for fuel and means more room for cargo. While the global market for natural gas is enormous, global liquefaction capacity is limited to just 339 million MTs of LNG per year.7 If all ships were to adopt LNG as a fuel source, liquefaction capacity would need to expand 65% to 90% to meet this new demand. This capacity would take years to build and require investments of hundreds of billions of dollars.8
Alternatively, if the entire global shipping fleet were to switch to MGO, a middle distillate fuel similar to diesel fuel, the growth in demand for diesel and distillate fuels would be equal to 13% to 18% of 2017 global demand. This would have far-reaching consequences for cars, trucks and other diesel users. A more likely scenario is ship owners adopting ULSFO. However, experts disagree whether refineries will have the desulfurization capacity to meet expected demand. A 2016 study found that an additional 60% to 70% of desulfurization capacity needs to be built to meet 2020 demand.9 This supply shortage may spike ULSFO prices, leading ship owners to consider other fuel types.10 Conversely, a large shift by the shipping industry to a new fuel like LNG, MGO or ULSFO may cause prices for high-sulfur fuels to fall significantly. Any ship owners who had not yet converted to a new fuel would then do well keeping the high-sulfur fuel and investing in expensive emissions scrubbers for their vessel.
The Best Move Is No Move at All
Ship operators are weighing these tradeoffs in an attempt to determine which fuels or technologies will provide the greatest cost advantage. No ship owner wants to commit to a new fuel or technology first, because the supply and demand dynamics of the market could shift dramatically as other shippers and refiners select different fuels. Enforcement could also be delayed, putting ship owners that have already invested in scrubbers or new engines at a serious cost disadvantage. In the end, there is reason to believe that firms will end up pursuing unique, customized solutions based on a vessel’s age, size, voyage length, ports of call and risk tolerances. Take, for example, a panama bulker ship that cost $25 million to build and is likely to be sold for scrap after 15 to 20 years for between $5 million and $6 million. Any vessel over 10 years old will likely be operated normally until the last possible day (December 31, 2019) and then will be idled to see how the market reacts. If many bulker owners decide to idle their vessels and freight rates rise significantly, owners may determine that paying the higher cost of ULSFO is worth it. If many ships are retrofitted and prepared for the new regulations, rates will not rise enough to justify the higher fuel costs, and any bulker over 10 years old may be scrapped. The cost of installing a scrubber, which can run between $4 million and $7 million, could not be recouped over the vessel’s remaining life.
At the moment, ship owners and refineries are awaiting market signals that will foretell how the supply and demand dynamics of bunker fuel are likely to change in the coming years. However, as the January 1, 2020, deadline approaches, all competitors face a first-mover disadvantage; the best move seems to be to continue the waiting game.
Brown Brothers Harriman & Co. (“BBH”) may be used as a generic term to reference the company as a whole and/or its various subsidiaries generally. This material and any products or services may be issued or provided in multiple jurisdictions by duly authorized and regulated subsidiaries.This material is for general information and reference purposes only and does not constitute legal, tax or investment advice and is not intended as an offer to sell, or a solicitation to buy securities, services or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code, or other applicable tax regimes, or for promotion, marketing or recommendation to third parties. All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed, and reliance should not be placed on the information presented. This material may not be reproduced, copied or transmitted, or any of the content disclosed to third parties, without the permission of BBH. All trademarks and service marks included are the property of BBH or their respective owners.© Brown Brothers Harriman & Co. 2020. All rights reserved. PB-03671-2020-05-18
1 Halff, Antoine. “Slow Steaming to 2020: Innovation and Inertia in Marine Transport and Fuels.” Columbia University Center on Global Energy Policy. August 2017.
2 Wassener, Bettina. “Challenges in Reducing Pollution from Ships.” The New York Times. April 25, 2010.
3 Includes the cost of lost vessel time during installation.
4 All prices quoted from Ship & Bunker Global 20 Ports Average on March 13, 2018.
5 Ralli, Pace. “Industry Insight: A Survival Guide for Evaluating the Cost of Converting a Vessel to Use LNG Bunkers.” Ship & Bunker. December 1, 2015.
6 Stillwater Associates.
7 “2017 World LNG Report.” International Gas Union.
8 Cost estimate based on six approved projects in U.S. expected to cost $51 billion and provide 52 million MTs per year of liquefaction capacity.
9 “Supplemental Marine Fuel Availability Study.” EnSys Energy and Navigistics Consulting. October 2016.
10 This could be a boon for U.S. refiners, where Gulf Coast refineries have advanced desulfurization technology from years of processing sour Venezuelan crude.