The International Maritime Organization (IMO), first adopted in 1948 by the United Nations, is the international body devoted to shipping matters. In 1973, the International Convention for the Prevention of Pollution from Ships (MARPOL) expanded the powers of the IMO to regulate the environmental impacts of shipping. A MARPOL update in 2008 called for a reduction of the maximum sulfur content in marine bunker fuel from 3.50% to 0.50% in 2020, unless a supply study would conclude insufficient availability of compliance fuels and a delay to 2025 deemed necessary.

This study was commissioned in 2015 and awarded to consortium led by Dutch consultancy CE Delft. It concluded that there would be enough supply of low-sulfur fuel by 2020, but did not address residue disposition, pricing or transitional matters, since these items were not part of the IMO's terms of reference. On 27 October 2016, the IMO came to a broad agreement to implement the global reduction in the sulfur content of marine bunker fuel from 1 January 2020.

From a shipping perspective, IHS Markit estimates that about 55,000 ships of a total fleet of about 110,000 vessels burn heavy fuel oil bunkers, and that roughly 30,000 ships account for about 80% of global fuel oil bunker use.

Compliance with the new fuel specification will entail significant costs for both the refining and the shipping industries. For the refining industry, the regulation means that the industry will have to shift its product mix, increasing supply of low-sulfur bunker fuels while managing excess supply of high-sulfur residual streams that make up the majority of today's 200 million tonnes high-sulfur bunker fuel. Crude producers will see changes in refined product spreads affect their sales netbacks, while chemical producers would see the cost of their oil-based feedstocks change.

How the shipping industry adapts will influence refiners

The impact of the IMO specification change on refined product demand will depend largely on the compliance methods adopted by ships and the level of compliance in general. There are three main options for ships:

• Don't change anything to the vessel, and purchase compliant bunker fuel.
• Install on-board exhaust gas cleaning systems, known as scrubbers. These remove sulfur dioxide emissions from the exhaust, and allow shippers to continue burning high-sulfur bunkers.
• Make vessel modifications, and switch to alternative fuels such as liquefied natural gas (LNG) bunkers.

The first option drives up demand for low-sulfur fuels and complicates high-sulfur residue disposition. The second would be less disruptive for the refining industry and more aligned with the current refinery product slate but comes at a high initial investment for vessel owners. The third would reduce demand for both gasoil and fuel oil.

Several factors, including vessel ownership, type, route, size, design, and age, will determine the preferred compliance method. For the largest ships, which account for most bunker fuel demand, IHS Markit expects that scrubbers will be the preferred solution, as they would be economically attractive from 2020 onwards. Based on the IHS Markit price spreads between low-sulfur and high-sulfur bunkers, the payback period for installing a scrubber on the largest vessels would be two to four years in 2022-25, but less than one year in 2022-21. Smaller ships instead are expected to burn low-sulfur bunker fuel.

Currently only a small number of ships, about 400,have installed or ordered scrubbers. Adoption prior to 2020 is expected to be slow since there is currently no economic incentive outside of emission control areas (ECA), and uncertainty about enforcement and compliance remains. A rush on demand for scrubber installations just before and after the specification change becomes effective could be constrained by factors such as available shipyards and dry docks, and qualified crews. The capacity to install scrubbers is difficult to assess but IHS Markit assumes that these limitations would restrict maximum adoption to about 3,000 vessel retrofits per year.

LNG is expected to be applied to newly build vessels, particularly those that operate on fixed, predictable routes, or within a geographic area, particularly ECAs. Retrofits have been rare so far; a recent example is the WES Amelie, a container ship operating almost exclusively in the Baltic and North Sea ECA.The current infrastructure for LNG bunkering is limited and will need to rapidly expand if LNG bunkers are to become more common for the largest consumers.

IHS Maritime counts 218 ships fitted for LNG fuel in service or under construction, and another 123 deemed "LNG ready". Although the switch to LNG requires a higher up-front investment, lower LNG prices could enable a healthy return, while LNG also has lower carbon emissions, providing methane slip is controlled. LNG bunker consumption growth is expected to accelerate,yet by 2020, LNG bunkers will form only a very small percentage of total bunker consumption.

Laws without enforcement are just good advice

Besides the three main compliance routes, some level of non-compliance can be expected. There is significant uncertainty regarding the enforcement framework the IMO and its members will set up, and policing the sulfur cap on the high seas is not obvious. The IMO is a treaty organization and has no legal powers of its own. Its member states implement new legislation individually, and several countries with a coastline are not signatories. Flag states (where the ship is registered) have jurisdiction over violations in international waters, while port states could only fine vessels breaching the rules in their territorial waters.

Indications are that most IMO members are taking a firm position, and focus on consistent implementation and setting up a level playing field, rather than on exemptions. Compliance in the ECAs has been relatively high, with 2017 North Sea non-compliance as reported by EMSA only 8%. Although the available data is imperfect, inspections have increased and the estimates have become more reliable since 2015. The campaign for a level playing field is being led by the Trident Alliance, including high-profile corporations concerned about their reputation and ability to compete in a marketplace if compliance is lax. Based on this information, IHS Markit assumes reasonably high compliance in 2020, equivalent to 85% of residual bunker demand.

The IMO or individual signatories may allow for transitional arrangements targeted at smoothing the transition, such as grace periods or exemptions if a scrubber or LNG retrofit was already order before 2020. Another issue relates to dealing with unavailability of compliant bunker fuel in remote locations. The discussions are expected to continue in 2018, possibly even until 2019.

Overall, the IMO specification change is expected to increase demand for various types of low-sulfur bunkers and erode high-sulfur fuel consumption. IHS Markit refining balances indicate that there will be enough refining capacity to meet increased demand for low-sulfur bunker fuel, albeit with an increase in overall crude runs. New low-sulfur "hybrid" formulations will likely be developed to meet this new bunker market demand. However, some of these new fuels would be based on streams that come with handling and compatibility challenges. Suppliers will need to convince buyers that these new fuels are fit for purpose.

The main challenge for refiners will be disposing of the excess high-sulfur residue, containing some of the most difficult streams to upgrade. Although deep conversion units exist in refineries today, most are fully utilized, and new conversion units take several years to design and to build-far too long for a start-up by 2020. Still, there are some conversion projects currently under construction for start-up before 2020, and debottlenecking of existing units is likely, for instance during refinery maintenance in 2018-2019.

IHS Markit projects that the refining industry will produce an excess volume of high-sulfur residual fuel oil in 2020. In the short term, a significant portion of this surplus would have to clear into lower price tiers, such as oil-fired power generation- at prices which could be as low as thermal parity with coal.

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Hédi Grati, Director IHS Markit Oil, Midstream, Downstream, Chemical Consulting, IHS Markit
Posted 7 November 2017