By Andy Hipskind
While most people may not realize it, shippers and energy companies have spent the last four years readying themselves for this January. What could require years of coordinated preparation by these companies? In 2016, the International Maritime Organization (IMO) affirmed its decision to reduce the legal amount of sulfur in marine fuels to 0.5% from 3.5% starting in 2020. As a result, shippers and the energy industry have been positioning to comply with the stricter standards. The shift to IMO 2020 compliant fuels will have a wide range of effects for energy and midstream, including an expected increase in demand for the light sweet crude produced by the US. Today we'll explore shippers' paths to compliance, effects on global oil demand, and the related opportunities for US midstream.
What is IMO 2020?
IMO 2020 is the name given to the International Maritime Organization's call for reduced sulfur content in ship fuels by 2020. The IMO is a specialized, standard-setting agency of the United Nations tasked with regulating safety, security, and environmental considerations in international shipping. On January 1, 2020, the maximum amount of sulfur allowed in marine fuels will fall from 3.5% to 0.5%. This change reflects the IMO's commitment to reducing ozone emissions after previously cutting sulfur limits from 4.5% to 3.5% in 2012. For context, stricter standards are already in place in Emission Control Areas (ECAs), such as those in the Baltic Sea, North Sea, and North American coast, where sulfur content is limited to 0.1%.
How can shippers achieve compliance?
With the new sulfur limits imminent, shippers will need to adapt to comply. Ships that wish to continue burning non-compliant high sulfur fuel oil (HSFO) have two options. The first option is to use an exhaust gas cleaning system, commonly referred to as a scrubber. Scrubbers are attached to the exhaust system of a ship and essentially act as a filter, removing the sulfur normally emitted into the atmosphere. These systems entail large upfront expenditures, as they can cost anywhere from $1 to $7 million depending on the ship. The second way to continue buying HSFO is by blending. Blending entails mixing HSFO with a compatible fuel containing a low amount of sulfur and diluting it to the point where the resulting fuel is compliant.
Shippers may instead choose to fully shift to compliant fuels. The most popular substitutes for HSFO include low sulfur fuel oil (LSFO) and marine gas oil (MGO) or marine diesel, which is considered a distillate. LSFO and MGO, with sulfur contents below 0.5%, are both compliant fuel choices that require little to no modifications to the engines and fuel systems in each ship. Another fuel alternative is liquefied natural gas (LNG), which contains only trace amounts of sulfur, but like scrubbers, requires a large capital investment for the engine (around $5 million).
How will demand for oil be affected?
LSFO and MGO in particular are viewed as attractive alternatives to HSFO due to their compatibility with existing engines. According to the U.S. Energy Information Administration (EIA), low-sulfur fuel oil is expected to jump to 38% of US marine vessel bunkering1 in 2020, with that number increasing to 43% in 2025. Similarly, distillate (such as MGO) is predicted to account for 57% of US bunker demand in 2020, up from 36% this year. Looking at the graph below, this trend is expected to extend beyond the US bunker market as global demand for LSFO and distillate is forecasted to spike in 2020, replacing demand for HSFO. With demand rising for these fuels, their prices are expected to increase.
Source: Energy Information Administration
Global refineries are expected to process greater volumes of crude in order to meet rising distillate demand, which would be supportive for oil prices. Low-sulfur fuels are easier to produce with the light, sweet crude from US shale. Less complex foreign refineries will likely need more light, sweet crude to produce compliant fuels, which bodes well for US crude exports. The management of refiner PBF Energy (NYSE:PBF) estimates Atlantic Basin refiners alone may require an incremental 1 million barrels per day of light crude to comply with IMO 2020. Complex US refineries can run heavy, sour oil to make low-sulfur fuel and will likely not require a change in input. Complex refiners stand to benefit if differentials between light and heavy crudes widen2 as a result of IMO 2020 and a demand shift occurs favoring light sweet crude over heavy crudes.
How could IMO 2020 benefit US midstream?
While refiners and shippers may be the primary players in the IMO 2020 story, there is also an opportunity for US midstream. As discussed, incremental demand for light, sweet crude from less complex foreign refineries should be supportive of growing US crude exports. Several midstream companies have been developing crude export capacity (read more). For example, Enterprise Products Partners (NYSE:EPD) is expanding its Houston Ship Channel terminal and has entered long-term agreements with Chevron (NYSE:CVX), supporting development of EPD's offshore Sea Port Oil Terminal. As another example, Magellan Midstream Partners (NYSE:MMP) expects to complete an expansion of its Seabrook crude export terminal joint venture with LBC Tank Terminals in early 2020. Even more midstream companies are involved in bringing crude from the wellhead to the coast for exports. While US crude exports are expected to grow regardless of IMO 2020, the regulation is supportive for light, sweet crude demand.
Opportunities also exist beyond growing US crude exports. PBF Logistics (NYSE:PBFX) announced an agreement in February with shipping company Maersk to process crude using previously idled assets at a terminal facility in New Jersey to supply IMO 2020-compliant fuel to Maersk. The terminal and idled processing assets were purchased in 2018 with a view to adding marine storage ahead of IMO 2020, but the processing deal with Maersk drives incremental EBITDA that was not originally anticipated. On its 2Q19 call, PBFX indicated that processing would begin in October - two months earlier than originally planned - as preparations begin for compliance.
Midstream companies with marine product terminals may also benefit from IMO 2020. Exports of low-sulfur distillates from the US are likely to increase as shippers seek to secure compliant fuels. Storage levels could also be impacted, though perhaps in a more transitory way. As demand for high-sulfur fuel oil craters, storage of HSFO may increase until volumes can be sold for further refining or perhaps blending. Storage of distillates may increase in anticipation of needing extra inventories for compliance.
It is still unclear what the exact effects of IMO 2020 will be on the shipping industry as well as the implications for oil and refined product prices. Increased demand for light, sweet crude should be supportive for growing US crude exports, and distillate exports from the US are likely to increase as well. US midstream companies are positioned to take advantage of this increased demand due through their transportation, storage, and export assets.
1 Bunkering in this case refers to the type of fuel used on ships to power engines. Bunkering can also refer to the process for transferring bunker fuel on to a ship from a separate vessel or storage tank.
2 Complex refiners are able to process heavy crudes into products like gasoline and diesel. If heavy crude prices trade at a wider discount to light crudes (due to greater demand for light crudes as a result of IMO 2020), this would be a cost advantage for complex refiners (lower input cost).
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