FreightWaves to shipping analyst: “So, we’re doing a follow-up story about IMO 2020 and scrubbers …”
Analyst to FreightWaves: “Oh, Jesus.”
IMO 2020 is the Y2K of ocean shipping. After years of dire warnings on fallout to world trade — and dubious pitches on stocks poised to profit — the IMO 2020 regulation ended up being a damp squib. What went so wrong with all the forecasts? And is this story really over for vessel owners, cargo shippers and stock investors?
The short answers are “coronavirus” and “not yet.”
For the longer answers, FreightWaves analyzed scrubber-installation data from Clarksons Research and conducted an in-depth interview with Richard Joswick, head of oil pricing, refining and trade flow analytics at S&P Global Platts.
What was supposed to happen
On Jan. 1, the IMO 2020 rule required all ships to switch from 3.5% sulfur heavy fuel oil (HFO) to either 0.5% sulfur fuel known as very low sulfur fuel oil (VLSFO) or 0.1% sulfur marine gasoil (MGO). Ships equipped with exhaust-gas scrubbers could keep burning cheaper HFO.
Virtually everyone predicted that there would be a gaping spread between HFO and VLSFO and that ships with scrubbers would reap formidable savings. It was predicted that VLSFO would be much more expensive than pre-2020 marine fuel, that there may not be enough VLSFO to go around, that there would be mass scrubber installations, and that there would be no place to dump all the unwanted HFO.
Many feared higher fuel costs would have a severe cost consequences for container lines and force bulk ships to sharply reduce speeds. They expected carriers to pass along costs to consumers, spurring inflation.
What did happen
As it turns out, there’s plenty of VLSFO to go around.
The average price of VLSFO at the top 20 ports on Thursday was $329.50 per ton, according to Ship & Bunker. One year prior, the price of HFO was $462 per ton. Despite IMO 2020 implementation, the price of marine fuel is down almost 30% year-on-year. Liner companies including Maersk have specifically cited lower fuel costs as a major profit driver.
The spread between HFO and VLSFO collapsed in March and has hovered at around $50 per ton ever since. The lower the spread, the longer it takes for shipowners to pay back the cost of installing scrubbers.
Scrubber installations have yet to pay off for investors in the shipping companies that installed them. Star Bulk (NYSE: SBLK) paid $212 million to install scrubbers on 114 of its 116 ships. Year to date, its stock is down 40%.
Scrubber retrofits wane
It costs $1 million-$2 million for a scrubber. But that’s just the beginning.
You have to get the ship to the yard (usually in Asia), often accepting a low-priced voyage charter to get there and back. Then there’s the opportunity cost of having the vessel out of service for over a month, foresaking potentially lucrative spot rates. And there’s the interest on the debt used to pay for the scrubbers.
The narrow HFO-VLSFO spread makes a scrubber much less attractive. Even so, data from Clarksons Research confirms that a significant number of installations went forward this year.
As of Jan. 13, Clarksons data shows that 22% of very large crude carriers (VLCCs, tankers with capacity of 200,000 deadweight tons, DWT, or more) in service had scrubbers. As of this past Monday, the share was 30%, due to both retrofits and newbuild deliveries over the past eight months.
The share of on-the-water Capesizes (bulkers of 100,000 DWT or more) with scrubbers was 25% in January, 37% this month. Of containers ships with capacity of 15,000 twenty-foot equivalent units or more, 46% in service as of January had scrubbers, 66% as of this month.
But the number of VLCCs and ultra-large box ships with pending scrubber retrofits fell 33% between the two dates, and pending retrofits for Capesizes plunged 56%. This shows that retrofits have been completed over the past eight months but few if any fresh retrofit deals have been signed.
“No one’s going to go out and say ‘I need a new scrubber at a $50-per-ton spread,” Randy Giveans, analyst at Jefferies, told FreightWaves. “If you have a forced drydocking and you’re going offline anyway and you already put the deposit down on the equipment, you’ll probably still do it. But for those who planned to pull a drydock forward to do it, installations have either been delayed or canceled.”
Scrubbers and IMO 2020 “got trumped by a much larger issue [coronavirus],” Michael Webber, founder of Webber Research & Advisory, told FreightWaves. “Without laying blame, it would be interesting to go back and do a post-mortem.”
Asked for his take on what happened and what’s next, Joswick of S&P Global Platts explained, “Platts and virtually every other analytics organization expected there would be a very large price spike for VLSFO and a very depressed high-sulfur fuel price.”
In the fourth quarter of 2019, those forecasts were playing out as predicted, with the HFO-VLSFO spread at $300 per ton.
“Then two things happened,” said Joswick. “First, one of the warmest winters on record, which reduced demand for middle distillates by 900,000 barrels per day, roughly the size of the increase in gasoil use for marine fuel, not just for MGO but also the gasoil content in VLSFO.
“And then came COVID.”
Why HFO held up better than expected
“COVID didn’t depress demand for marine fuel, but it did reduce refinery runs because demand for jet fuel was really down and [initially] gasoline and everything else. So, when refineries cut back, they made less high-sulfur fuel. As a result, they had more than enough capabilities to destroy that high-sulfur fuel [to produce refined products].”
The thinking last year was that if too few ships consumed HFO, refineries would be stuck with too much high-sulfur residual fuel. Other uses — such as asphalt production and heating in the Third World — wouldn’t compensate for lost shipping demand. Refineries would face a high cost to break the high-sulfur residual down into something sellable. The price of HFO would therefore collapse, widening the HFO-VLSFO spread.
The price of HFO is down, but not as much as expected. “Because we’re making much less high-sulfur fuel oil, we don’t need to use all the high-cost steps to destroy it. There were enough low-cost steps,” Joswick explained.
There were also some refineries — particularly in the U.S. Gulf Coast and in India — that were better geared to break down the HFO. Other refineries that weren’t as adept sold their HFO to those that were. “There’s plenty of capacity on the U.S. Gulf Coast and in India to handle this right now,” said Joswick.
Why VLSFO didn’t surge — and fell instead
The Ship & Bunker top-20 ports data shows that the HFO price has fallen by around 40% year-on-year. The reason the HFO-VLSFO spread is so slim is that the VLSFO price has fallen as well.
“Today, the absolute price of everything is lower. Instead of $75-per-barrel crude, we’re at $40 and that brings down the price of all bunker [marine fuels]. In and of itself, when the absolute price gets lower, the fuel spreads will narrow,” said Joswick.
There is also ongoing pressure on jet-fuel demand, which, indirectly, is a headwind for VLSFO pricing.
“When you lose demand for jet fuel, you can take some of the molecules that would have gone into jet fuel and put them in your diesel pool. And when you do that, you now have plenty of diesel to take some of the heaviest components with higher boiling points and put those into your VLSFO,” he noted.
“For every barrel of jet fuel you have to get rid of, around 70% of it will wind up going towards diesel and 30% might wind up going towards gasoline. Of the amount going towards diesel, some components get pushed down towards VLSFO. So, it’s not a one-to-one of [lost] jet fuel to [gained] VLSFO.”
The turnaround to come
“The VLSFO-HFO spread is not going to stay at $50 a ton,” Joswick affirmed, citing several reasons.
“First, demand will recover and we won’t have as much spare refining capacity. We will see higher prices for gasoil, which means higher prices for VLSFO,” he said.
“The question is how quickly the airlines recover. Petrochemicals are doing fairly well, because everybody’s making things. Gasoline is now doing pretty good, relatively speaking, and diesel is OK. Jet fuel is the worst and will take the longest to recover.
“But it should recover. I don’t think all the airlines will go bankrupt and we’re never going to fly anywhere again. People will fly when it becomes safe.”
At the same time, getting rid of all the excess HFO will also become more difficult. Bigger refinery runs will create more HFO, which refineries will need to dispose of.
“Also, as you run more crude, where’s that crude going to be coming from next year? Mostly from OPEC. The U.S. shale, which is lower in sulfur, is expected to decline because people have stopped drilling.”
The higher sulfur content of the OPEC crude and the higher volumes of HFO overall should be a headwind for HFO prices at a time when the VLSFO price should increase, widening the spread. “The spreads won’t move as much as we had initially feared, but they will react,” said Joswick.
‘Moving along a different line’
Some analysts and shipping executives have maintained that as the price of crude rebounds in 2021, the VLSFO-HFO spread will widen and the business case for scrubbers will improve.
According to Joswick, it’s more complicated than that. “It’s common knowledge that if you plot the price spread of diesel versus fuel oil as a function of the price of Brent [crude], they would fall in line. But there are different [correlation] lines.
“When you don’t have enough refinery capacity, you tend to be on a very steep line,” he said. “When you have surplus capacity, it’s a much lower line. What people miss is that [the correlation between fuel spreads and Brent price] is a function of both the absolute price [of Brent] and the availability of refinery conversion capacity.
“We still have a lot of spare refinery capacity. Look at all the refineries that are shutting down. So, when prices do go up, we will move up the line, but it won’t be the steep line. It will be the shallow line.
“It’s like those movies where they go back in time and change something and you’re on a different timeline. That’s what happened here. Because we increased our spare capacity [due to the coronavirus], we’re moving along a different line. I think that is the story for bunker fuel post-COVID.”
Future spreads, scrubbers revisited
“I don’t think we’re going to see a $300 [per ton VLSFO-HFO] spread but we could see $100, and eventually people will start thinking about scrubbers again,” Joswick continued.
Asked about the timing of a spread recovery, he replied, “Not in 2020. We’re hopeful that the economy picks up and by the end of 2021 things look better and start to move again.” (Even so, he wouldn’t commit to a prediction of a $100-per-ton spread by the end of next year.)
According to Joswick, “People had said this year was going to be a tsunami [due to IMO 2020]. That this was going to be the bad year — pushing the limits of balancing things. Well, COVID solved that problem.
“When things get better and COVID is gone, we could be setting ourselves up for a second wave [of price movements]. But it will be a smaller wave. It won’t be as bad as we originally thought it would.” FreightWaves/American Shipper articles by Greg Miller
MORE ON IMO 2020: Coronavirus is decimating IMO 2020 scrubber savings: see story here. Book review: ‘IMO 2020: A Regulatory Tsunami’: see story here. Where will all the residual fuel go? See story here.