"Your Cheatin' Heart" - Compliance Issues Cause Uncertainty About Low Sulfur Bunker Impacts

John R. Auers, P.E., Executive Vice President, Turner, Mason & Company

The decision last October by the International Maritime Organization (IMO) to go forward with the mandatory introduction of low sulfur bunker fuel in 2020 has been a major topic of discussion throughout both the refining and shipping industries.  Because many, in both industries, thought it likely that the IMO would delay implantation until 2025, they have done little preparation for the earlier date. 

As a result, it looks like there will be insufficient low sulfur heavy fuel oil available to meet the 0.5% specification, and distillates will be required in a big way to make up for the shortfall.  The market impacts on heavy fuel oil (HFO), distillates and different qualities of crude oil could be tremendous - a subject about which we've written in several previous blogs (3/1/2016, 3/8/2016, 9/27/2016 and 10/4/2016).  The volume of distillate required to replace noncompliant resid-based bunker fuel could approach 2 million BPD, with a similar amount of high sulfur HFO becoming surplus.  In such a scenario, distillate and LS HFO prices and margins would soar, HS HFO prices would crater and crudes producing those products would move in corresponding directions; however, a big and very hard to predict variable in this whole equation is the level of compliance that will be achieved. 

Certainly the incentive to "cheat" will be large, and the very nature of the shipping business (no central controlling authority, ships traveling thousands of miles over open water) makes enforcement challenging.  The potential also exists for waivers, but the exact protocol for the process of obtaining them is not clear.  In today's blog, we examine some of these issues and how they will play into the market impacts of the LS bunker regulations – or, to paraphrase old Hank Sr., what will (shippers') "Cheatin' Hearts Tell on You" (regarding market impacts)?

The Temptation to Cheat

The bunker fuel market in 2020 will be significantly different than what exists today.  When tighter sulfur regulations were imposed on other products in the past (in the U.S. and elsewhere), refiners simply desulfurized the existing material to achieve compliance.  This will not be the case for bunker fuel, which currently has a maximum sulfur level of 3.5%.  

When this cap falls to only 0.5% in January of 2020, bunker blenders are likely to produce compliant fuel by blending low sulfur distillates and gas oils into the bunker pool.  Low sulfur fuel oil will be available, but not in sufficient volumes to meet projected demand levels.  TM&C has been monitoring global refining projects for over a decade and there have been no announced resid desulfurization projects resulting from the IMO regulations; and at this point, there is really no time to execute such a project before January 2020.  Without a refining solution, the only remaining path to compliance is through distillate and gas oil blending.

While feasible, the blending of large volumes of distillates into the bunker pool will result in a spike in distillate demand and a corresponding increase in distillate prices.  The IEA estimates up to two million barrels per day of distillates will be diverted into the bunker market in 2020, equivalent to four years of global distillate demand growth.  

How high the price spike will be is not known, but it certainly has the potential to be dramatic.  Because the new low sulfur bunker fuel will be predominantly distillate-based, bunker prices will generally track ULSD prices and spike as well.  Even more impressive may be the collapse in high sulfur fuel oil prices.  This material will be backed out of the bunker pool with only a limited ability to find alternate markets.  These trends, along with rapidly rising bunker prices and plunging high sulfur fuel oil prices, are likely to create a massive temptation to cheat on the compliance with the IMO regulations.

Because of this potential for cheating, many of the large (and reputable) lines such as Maersk have become very vocal in their concerns.  Most of these companies have already pledged they will comply with the regulations.  Their ability to compete, however, is predicated on an even playing field and uneven enforcement is a troubling aspect of the transition to low sulfur bunker fuel.  As stated by Niels Mortensen, head of regulatory affairs at Maersk Maritime Technology:

"International shipping cannot operate on a skewed playing field where deliberate non-compliance puts some players at a competitive advantage, while others might be put out of business."

The Challenges of Enforcement

The IMO has no authority to monitor or enforce its own regulations, but rather has relegated compliance to the member states.  As a result, enforcement will be erratic and there are few details as to how this will unfold.  In the U.S., the EPA has been tasked with overseeing the program.  With little enforcement capabilities of its own, the EPA has enlisted the cooperation of the Coast Guard.  On its website relating to the Annex VI requirements, the EPA states:

"On June 27, 2011, the EPA and USCG entered into a Memorandum of Understanding (MOU) to enforce Annex VI MARPOL"  and follow with "The efforts to ensure compliance with Annex VI and APPS include oversight of marine fueling facilities, on board compliance inspections, and record reviews."

This language suggests the potential of rigorous enforcement.  The most far-reaching component of the compliance steps is with "record reviews."  The IMO regulations allow the use of higher sulfur bunker fuel in areas where there is no availability of compliant fuel.  It is likely that vessel operators will be tempted to claim this excuse to justify noncompliant fuel on board the vessel.  The vessel log book, however, should indicate where the bunker fuel was purchased and could be used to challenge the operator's claims.  

The Coast Guard has the authority to fine vessels or operators, and even in drastic conditions, ban ships from entering U.S. waters.  This threat could make compliance violations very expensive for vessel operators.  How active the Coast Guard will be in enforcement is unknown, as of yet.  While the Coast Guard has yet to fine any vessel for noncompliance with current ECA requirements, it is not known if any violations have actually been discovered or even if vessels are regularly inspected.

For Europe, the picture is even murkier.  The European Commission has recently stated that only 0.1% of the vessels visiting European ports are examined for fuel compliance.  Further compounding this issue is that some EU countries have indicated they may not be able to issue sanctions for violations outside their jurisdiction.  This raises the potential that a vessel could be fined only for the last 12 miles of a voyage even though it was not compliant for several thousand miles.

The Waiver Option

Perhaps a way to avoid both cheating and price spikes is through the use of a temporary waiver process to allow for the continued use of high sulfur bunker fuel in some cases.  This type of solution has been used in the past to smooth similar transitions to more stringent product specifications.  However, the problem in this case is that the IMO doesn't appear to have included this option in the regulations. 

To confirm this, we posed this question to a member of the IMO Secretariat.  The email response affirmed our reading of the rules that there is no current mechanism to grant blanket waivers to facilitate the transition process.  Such a mechanism could be introduced however, but it must be proposed by a member country and subsequently approved by the Marine Environment Protection Committee (MEPC) of the IMO.  Neither the IMO staff nor the MEPC have the ability to initiate such an action.  The email response also stated that a proposal from a member country would have to be approved at the MEPC 71 conference in July of 2017 and adopted at the MEPC 72 conference in April of 2018 to be in force for the January 1, 2020 transition date.

Early last year, before the 2020 implementation was set, we posed a similar question to the IMO as to whether only 2020 and 2025 could be set as compliance dates.  The response indicated the Annex VI regulations required one of these dates but stated other dates could be proposed through an amendment.  An amendment to the Annex VI regulations however "would require a minimum of 22 months after approval before the amendment could enter into force."

These responses present a disturbing image.  While democratic, the procedures established by the IMO do not allow for quick counter-measures and responses to market disruptions.  This result could produce a chaotic market in 2020 with no ability by the IMO to take corrective action.  As a result, considering the uncertain enforcement methods and capabilities we certainly could see "a cheating heart, which will make you weep." 

Undoubtedly, additional study is required to better quantify the likely surplus of high sulfur fuel oil in 2020 (or whenever the 0.5% bunker specification goes into effect) and the pricing implications for low and high sulfur fuel oil, distillates and heavy crude differentials.  Assumptions regarding compliance will be a key part of the equation.  

We are in the process of carrying out our analysis and will be including our assessment of the market impacts of the 2020 IMO rules in our upcoming 2017 MIDYEAR CRUDE AND REFINED PRODUCTS OUTLOOK.  This report, which will also consider the effects of other key developments, be they policy or market driven, will be released in July. These reports, which we issue on a biannual basis, discuss (in detail) our projections of global and regional petroleum supply and demand and provide a detailed 20-year forecast of both crude and product prices in all of the major refining and demand centers around the world.  Please feel free to contact either of us or visit our website to get more information on this publication or any of the other services TM&C offers to industry players and participants.