Shipping's 2020 Sulfur Cap: A Popular Question Is Answered

by: James Catlin

There has been significant interest in the 2020 sulfur cap and how it might impact the market.

A previous report of mine noted that owners were likely to utilize low sulfur fuel to comply with the mandate. But this may lead to surging fuel costs.

Several VIE members have rightfully raised the question: Could this lead to decreased vessel speeds in order to save money? Could major shipping routes be in danger of substitution?

Note: This article was originally published on January 22nd on Value Investor's Edge, a Seeking Alpha subscription service.


Before we begin, it's important to have an understanding of shipping expenses.

Now if this particular segment is a bit too technical, don't worry, because it is explained in a much more digestible manner further on in the article. But for those looking for an answer utilizing accepted industry fundamentals and verbiage, this part is for you.

Shipping expenses fall into two categories: fixed daily costs and variable costs.

Fixed daily costs occur regardless of the movement or employment of the ship. They can include depreciation, capital cost, crewing, technical maintenance (including drydocking), insurance and general administrative expenses.

Variable costs are the costs related to a voyage (sailing the ship, positioning or even waiting to load or discharge a cargo). They can include bunker costs, port costs (including agent costs), canal transit fees, towage and pilotage. While variable costs can also occur daily, they vary depending on the service being undertaken, laden voyages, ballast voyages, canal transit at slower speeds, stopped in port, etc.

For voyage-specific sailings, the variable costs of any voyage are deducted from the freight lump sum (paid by the cargo owner) to derive a net freight amount. This is because these costs are variable with the particularities of the voyage performed, i.e., cargo size, distance, number of ports, etc. The net freight amount can then be divided by the number of days that the voyage took to perform (including the time and voyage expenses of positioning of the ship from the last port it discharged a cargo to the port where it will take a new cargo), and this establishes a daily rate of income which is called the Time Charter Equivalent Earnings (TCE Earnings), expressed in USD/day.

The single largest variable cost of a voyage is fuel (bunkers), and this varies in direct relationship to the speed at which the voyage is performed. Now this might lead to the conclusion that ships should sail as slow as possible. But consider the trade-off. The slower a ship sails, the longer the voyage. So the calculation of the TCE will be affected in two ways (as the freight lump sum remains the same). The net freight will go up because of the savings made on the fuel, but at the same time, it will be divided by more days, taking the TCE down. Therefore, a ship should only go slower if the cost of fuel, saved by slower sailing, offsets the reduction of the TCE caused by the increase in the number of days the voyage lasted. In short, there is an optimal speed to achieve cost savings, but just where is that sweet spot?

If all that went over your head, you're probably not alone, so relax and read on because a much more palatable explanation is coming, along with real-world examples.

But first, a bit of a recap as to why this discussion is relevant.


The decision to implement a global sulfur cap of 0.50% m/m (mass/mass) in 2020, revising the current 3.5% cap, was announced by the International Maritime Organization (IMO), the United Nations regulatory authority for international shipping, on October 27th, 2016. This will affect as many as 70,000 ships.

Ships can meet the requirement by using low-sulfur compliant fuel oil, and the majority of owners are expected to take that route. Heavy fuel oil, which is high in sulfur content and environmentally unfriendly, is the traditional source of energy to power ships. It is 3,500 times more sulfurous than road diesel. Marine gas oil has a reduced sulfur content and will meet these new guidelines, but is quite a bit more expensive.

In December 2017, Platts was kind enough to put forward a useful graphic illustrating just how these costs would impact typical voyages.

(Source: Platts)

On January 16th, according to Ship & Bunker, the Global 20 Ports Average for HFO 380 is $398.50/mt, whereas the Global 20 Ports Average for MGO is $645/mt, which is much higher than the first-half 2017 averages used for these figures.

Now consider that Wood Mackenzie estimates that in a 100% compliance scenario, the price of MGO could skyrocket by 4 times that of 2016 prices, increasing overall fuel costs for the industry by approximately $60 billion/year.

But Senior Research Scholar Antoine Halff, of Columbia's Center on Global Energy Policy, believes "expectations that the IMO sulfur standards will restrict bunker fuel availability and cause product markets to rally are likely overblown."

IHS Markit forecasts the new low-sulfur fuel will cost between $500 and $650 per metric ton by 2020, indicating very little change from today's environment.

Platts reports:

Estimates of how much the extra costs for shipping would be vary widely, ranging from modest a $5 billion to $70 billion a year, which clearly shows how much uncertainty surrounds the whole issue.

In the past, when bunker costs went up due to high crude oil prices, the industry responded with a collective move to slow steaming. This past behavior has led many to speculate that slower speeds may be in our future as owners and charterers try to curb voyage costs once this mandate is active.

Why Slow Steaming Matters

The theory behind slow steaming is relatively straightforward on the surface. Slower vessel speeds consume less fuel and, therefore, produces voyage cost savings. But as we will soon see, there is a limit to this trade-off.

The reason why this should interest investors it that as slow steaming is introduced, it takes longer for a vessel to deliver a given cargo, thus impacting available vessel supply.

Think about it like this. There are only so many vessels on the water with a given number of days available to transport cargo. There is also a given amount of cargo that needs to be transported. This composes the basic supply/demand side of the equation. Prices, in this case charter rates, are determined by this balancing act. Taking longer to transport a cargo would create a shift in that equation, resulting in higher prices/charter rates.

So what would be the impact on supply if vessels slowed down even further? That is a tough one to answer, since it would require an extensive examination of the number of vessels involved in each route and the impact on voyage days for those routes at current speeds and then the new slower speed.

But let's take an example showing a specific class and route. In May 2015, Genscape created a “TD3” steady state simulation, assuming a constant demand of 6.5 million barrels per day to measure the impact speed has on effective fleet size.

Table 1 shows the last major slow steaming shift, moving from 14 knots, both Laden and Ballast, to a slower speed results in more VLCCs necessary to satisfy a given oil import demand.

(Source: Genscape)

Of course, the opposite is also true, and an increase in speeds on both Ballast and Laden voyages from 11 knots to 14 knots results in a decrease of 33 VLCCs (18 percent) necessary to satisfy the considered requirement.

History Of Slow Steaming

History has already provided us with a guide on this issue. It wasn't long ago that we faced high crude oil prices which translated into higher HFO prices.

Let's start with what inspired slow steaming. Higher oil prices leading up to 2008 was the first catalyst.


Brent Crude Oil Spot Price data by YCharts

But other factors soon emerged, such as the global economic downturn and a substantial order book for new tonnage, both of which led to falling charter rates.

The biggest single cost factor in merchant shipping is the fuel oil, and the easiest way to reduce this cost is to reduce the ship’s speed. Ship speeds have dropped significantly over the past decade, from about 25-27 knots to approximately 10-12 knots today. That 10-12 knot average was fairly well established by the time oil prices were at elevated levels again, before turning down in the second half of 2014.

But here's where things get interesting. Two different vessel segments faced very different environments over that time.

First, let's consider the bulker segment. The Baltic Dry Index hit a historic low of 290 on February 10th, 2016.


September 25th, 2013, saw Capesize rates at around $42k/day, which represented a fairly healthy level. By February and March of 2016, those rates were now firmly in the $2,000 range. These historic lows, which resulted in massive losses, would have been an ideal time for vessels to further slow as a cost-cutting measure. However, over that time, vessel speeds remained fairly consistent, indicating that further slowing wouldn't have resulted in any significant savings.

(Source: VesselsValue)

Now let's consider crude tankers, which not only benefited from a decrease in bunker costs but also from an exceptionally high spot rate environment in mid-to-late 2015.

(Source: Mathias Owing Maanum & Henrik Prøsch Selnes)

This improving environment would have been an ideal time to deviate from slow steaming and speed vessels up. But let's take a look at speeds over that same period.

(Source: VesselsValue)

Tankers seem to be a bit more responsive, but not by much. In fact, laden speeds changed less than 1 knot from when crude fell from above $110 to below $30 as charter rates skyrocketed. In fact, according to a model presented below, these sort of market conditions could have inspired a 4 knot increase in speed, but that failed to materialize.

As many have noted prior to the decline in crude prices and even after, slow steaming is here to stay, and shipping has found that approximate optimal trade-off point.

Slow Steaming Limits

As Wärtsilä notes, the power required from the main engine correlates disproportionately with the ship’s speed.

(Source: Wärtsilä)

There are other considerations. As fuel costs are reduced, certain fixed costs remain and other expenses may increase.

Notice that as the speed drops, fuel costs do indeed drop, but other costs remain fixed or even increase, indicating this sort of trade-off has its limits - which leads us to optimal speed.

Determining Optimal Speed

A dissertation entitled "Speed Optimization for Very Large Crude Carriers (VLCCs): Potential Savings and Effects of Slow Steaming," by Martine Erika Biermann Wahl and Eirik Kristoffersen of The Norwegian School Of Economics, provides some useful insight on the methods used to find optimal speed.

In their thesis, the authors utilized the Haugen Model as the basis for a general cost-minimizing speed model. Developed by Petter Haugen in DNB Markets, the Haugen Model is based on a ship’s resistance, a speed/consumption model and the financing cost of the cargo. While one of the more complex models, it does well to account for several factors to arrive at optimal speed.

Given the conditions presented in their thesis (TCE, bunker costs, cargo financing), the authors were able to demonstrate that finding an optimal speed was possible, and any significant deviation from it would produce higher costs, though slight deviations produced relatively small cost changes.

It is noteworthy that in this thesis, the authors assessed their results with real-world optimal speed data provided by Frontline’s Operational Manager, Per Gunnar Asheim, around the same period, and that data confirmed their findings.

This specific example depicts a VLCC on route TD3. The Laden voyage includes cargo financing costs and port costs.

(Source: Wahl, Kristoffersen)

The next shows the optimal speed for the ballast voyage where port and financing costs are not included.

(Source: Wahl, Kristoffersen)

But as noted earlier, we have seen significant shifts in the VLCC market over the past few years, first with a drop in bunker costs starting in late 2014, followed by a significant rise in spot rates in mid-to-late 2015, and the speeds failed to change significantly.

This is likely because we have arrived at a generally accepted optimal level for a wide range of market conditions. Remember, the further we deviate from the optimal speed the steeper the curve. But around the optimal speed level, the curve is very slight, indicating some leeway.

Furthermore, in the matrix developed for the VLCC market in this report, bunker prices at the $1,000+ level (which is the higher end of estimates for full compliance in 2020) would have to be met with extremely low charter rates in order to inspire further slow steaming.

(Source: Wahl, Kristoffersen)

However, it is noteworthy that ballast speeds according to this formula will be more responsive to market shifts.

Now, higher bunker prices do seem realistic, but as 2020 approaches, we should see an increase in older vessels being scrapped, reducing available vessels and leading to an increase in charter rates.

In this scenario, it becomes unlikely that we will see additional slow steaming.

Ton Mile Demand

But what is the potential for a decrease in ton mile demand based on products being sourced closer to end-users in order to cut down on shipping costs?

Of course, any decrease in ton mile demand would be a negative for the shipping segment, so let's take a quick moment to explore that issue. Here we will be comparing one of the more cost-sensitive segments in that regard, bulkers, along two routes, Australia to China and then Brazil to China. The former represents about a 15.4 days at sea traveling at 11 knots, while the latter comes in at about 56.7 days at 11 knots.

Now, it's time for some rough math using 40tpd of fuel use. It's important to note these are just estimates and will not be taking into account different speeds for laden versus ballast journeys or fuel burn associated with cargo loads.

The Shanghai Shipping Exchange currently quotes a rate for iron ore of $5.622/mt and $14/mt for Australia to China and Brazil to China, respectively. A roughly 50% increase ($600/t) in bunker costs would translate into an approximate $1.46 per ton increase for the round trip for the Australian route. A 100% increase ($800/t) would come out to approximately $2.91/ton.

Brazil, since it is further away, would see even larger jumps. They would see a $5.75/ton increase if bunkers rise to $600/t and approximately an $11.5/ton increase if they are moved to $800/ton. Initially, this sounds pretty scary for Brazilian cargoes, and I would even be tempted to believe it might result in some Brazilian cargoes being dropped in favor of Australian.

But the market has one thing going for it that might serve to negate any sort of major shifts, and that is a commodity bull market which has iron ore pricing well above breakeven costs. This gives Brazilian miners the ability to take a hit on pricing as they continue to provide China with iron ore. After all, shipping costs are factored into the end price, and as long as Brazil can remain competitive on that front, overall volume shouldn't drop significantly.

As before, we should look at history as a guide. After all, in the last five years, we have seen high bunker prices retreat to extreme lows and then begin a climb again. If bunker price swings have a significant impact on volumes transported along certain trading lanes, it would show up in this data.

However, looking at volumes transported out of Brazil to China in the capesize class from the period of January 1st, 2012, through now, we observe a negligible correlation to bunker price swings. In fact, something interesting is that during the recent low crude oil prices, we actually saw a bit of a stall in ton mile demand growth out of Brazil to China over that same period.

So then we look at Australia to see if there was any sort of a correlation there indicating that a majority of new iron ore demand in China was being supplied by Australia. Once again, we observe a negligible correlation between higher bunker prices and volumes out of Australia to China.

This seems to confirm that in the past ton mile, growth along these two routes was not impacted, even as bunker prices went from high to low and are now trending higher.

Finally, let's also recognize that these comparisons are being done using a capesize vessel. The VLOCs that transport iron ore from Brazil to China benefit from economies of scale, and several deliveries are on the horizon.


Many VIE members have been asking if the upcoming 2020 sulfur cap could bring further slow steaming into the picture given the probability of higher bunker costs.

Historically, when conditions arise presenting the opportunity for increasing or decreasing speeds, there has been minimal change. Examining the bulker and crude tanker segments showed that even radically different conditions, predicated by major market shifts, failed to induce much change.

The Haugen model suggests there is some room for further slow steaming, but only with much higher bunker prices, coupled with an extremely poor, even catastrophic, charter market. But as we saw in the historical examples, these opportunities to shift speeds based on this model didn't quite play out as expected. In fact, speeds remained fairly consistent even as market conditions shifted wildly for both charter rates and bunker prices.

Optimal cost-minimizing speeds have been in effect for several years now, and while there is room for speeds to decline further given a horrible charter market coupled with high bunker costs, it seems unlikely to happen - and even if it does, those declines will pale in comparison to past declines.

Thank you for reading, and I welcome all questions/comments.

If you would like to stay up to date on my latest analysis, I invite you to follow me on Seeking Alpha (click the "Follow" button next to my profile picture at the top) as I continue to cover all aspects of maritime trade.

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