IMO 2020: Are the Predictions On Par With the Reality?

By
Mfame Team
-
1017

IMO 2020 is now in effect and is marking a massive shift in the industry. Seeking Alpha discusses as to how have the expectations fared with respect to the nature of this unprecedented mandate.

IMO 2020

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, or IMO, the United Nations regulatory authority for international shipping on October 27, 2016.

This will affect as many as 70,000 ships and went into effect on January 1 of 2020.

The IMO provided guidance on how the maritime industry might comply:

  • Ships can meet the requirement by using low-sulphur compliant fuel oil. An increasing number of ships are also using gas as a fuel as when ignited it leads to negligible sulphur oxide emissions.
  • This has been recognised in the development by IMO of the International Code for Ships using Gases and other Low Flashpoint Fuels (the IGF Code), which was adopted in 2015.
  • Another alternative fuel is methanol which is being used on some short sea services.

Ships may also meet the SOx emission requirements by using approved equivalent methods, such as exhaust gas cleaning systems or “scrubbers,” which “clean” the emissions before they are released into the atmosphere.

In this case, the equivalent arrangement must be approved by the ship’s administration (the flag state).

Background

Since the announcement of IMO 2020, I have spilled quite a bit of virtual ink as we attempted to divine what the market would do upon implementation.

With no guidance on how a shift of this magnitude would impact the shipping industry, crude oil prices, refiners, available vessel supply, and even the global marketplace at large, there were quite a few moving parts to cover.

While IMO 2020 was touched on several times in numerous reports, here are the main reports dealing specifically with IMO 2020 in chronological order.

Following these reports, my position had pretty much been publicly declared. I have repeated it several times that the market will solve the issue and therefore:

“The degree of retirements and/or slow steaming induced by this mandate will be directly related to the cost of bunker fuel and older vessel maintenance balanced against any rise (or fall) in charter rates.”

Since 2017, it was maintained that there will only be regional shortages of bunker fuel which will be solved quickly through astute arbitrage players. Bunker prices will not spike to the stratosphere and, therefore, slow steaming, based on economics, will be very limited.

Any retirements induced by this mandate will be carried out in more of an ebb and flow manner rather than a collective knee-jerk reaction.

A knee-jerk reaction in demos would create an equal knee-jerk reaction in pulling back potential retirements as charter rates would rise based on this sudden supply side shift, and owners would hold on to older vessels.

It was projected that there will be no mass scrapping leading up to or at the start of the year as market expectations at large continue to improve. Higher rates would mitigate/negate increasing on the water operating costs which could, therefore, actually serve to keep older tonnage on the water.

Speeds

Forecast: Published in January of 2018, a report entitled “Shipping’s 2020 Sulfur Cap: A Popular Question Is Answered,” concluded that it would be minimal unless there was compliant fuel prices spike well beyond levels.

Looking at average speeds from all of January 2019 compared to average speeds as of January 16, 2020, provided by VesselsValue, there was a magnitude of the speed shift.

Bulkers are showing a decline from 11.22 knots to 11.11 knots. This is a negligible difference and won’t lead to any sort of meaningful supply side tightening. Capesize vessels, specifically, are relatively unchanged moving from 11.17 to 11.18 knots.

The very solid rates in VLCCs have inspired a movement from 12.17 to 12.68 knots, possibly illustrating that the market sensitivity to high rates is surpassing concerns about increased bunker costs.

MR2 tankers are seeing a strengthening market, and possibly more urgent cargo demand from bunker hubs, which is leading to higher speeds, moving from 11.72 to 11.78 knots.

LPG has moved from 12.53 to 12.68 knots and LNG has moved from 15.05 to 15.45 knots. Both very negligible and unlikely to impact the market in a noticeable manner.

Finally, while containers show signs of improving rates in the mid-sized classes especially, average speeds have remained relatively unchanged, edging from 14.36 to 14.35 knots.

One reason could be that increasing ‘blanked sailings‘ used to support the larger vessel market is contributing to greater urgency for those vessels that do sail.

In fact, the ULCV class specifically has seen rise in vessel speeds compared to 2019, moving from 16.26 to 16.34 knots.

Also noteworthy is the dip prior to 2020 and the sharp recovery as the shift to compliant fuel was being made at large.

Compliant Fuel Costs

Forecast: Higher but not outrageous MGO prices at the onset.

Short-term regional shortages which will be solved quickly through astute arbitrage players. Bunker prices will not spike to the stratosphere and calls by some analysts of MGO prices quadrupling were, and are more than ever, irresponsible.

Capacity was going to be there for the most part in 2020 given the latest refinery additions and expected reconfigurations. Refiners are notorious for chasing margins, and calls for MGO prices quadrupling would be too much to resist.

Slowing global demand for crude and products in 2019, courtesy of a slowing global economy, also helped to ensure adequate supply leading into 2020.

MGO would be the traditional source of compliant fuel, but, due to the magnitude of the shift in bunker demand, other solutions had to be found.

VLSFO is largely a middle distillate blend that offers compliance and while there have been some isolated cases of fouling and such, for the most part, the introduction has been quite successful. Time will likely improve the product.

Looking at the Global 20 Ports Average MGO prices and their historic correlation with crude oil prices, it’s safe to say that $650/ton was a pre-IMO shift starting point. Since that time, it has spiked up to an average of $722/ton – that’s just over a 10% rise. It has since settled back down to $683/ton, representing just a 5% difference.

Notice the correlation between MGO and crude prices. Would the spike in MGO and VLSFO have been even less pronounced if we hadn’t been facing all this geopolitical turmoil amid renewed OPEC+ resolve? Likely, yes.

In short, there were some logistical and infrastructure issues that seemed to prove the most difficult at the onset. But for all the “crazy doomsday prophecies” surrounding this particular aspect of IMO 2020, from economic collapses, astronomical oil prices, a complete breakdown in the supply chain due to a lack of compliant fuel, etc. – this particular area proved completely and utterly boring, which is exactly what we predicted.

Demolitions

Briefly, 2019 demos were muted compared to previous years almost entirely across the board. While this call seemed easy for us to make, as we expected improving rates in 2019 and heading into 2020, many analysts didn’t seem to recognize the most fundamental of market relationships.

  • For example, an analyst had suggested that all VLCCs 15 years and older would become nonviable and would be scrapped. But they failed to realize that a shift in the supply side would also shift rates making for a new base case of viability with each passing demolition.

Rates respond to supply and demand. Not only were we expecting higher rates in 2020, but we also took into account the dynamic nature of the market as it responds to improving rates with every supply side shift.

2019 demos were waning as the market improved, even in the face of IMO 2020, as on the water cost increases were dwarfed by market improvements and future expectations.

Remember, bunkers are only a part of overall costs, so if charter rates move up X amount, bunker costs would have to move a magnitude greater in order to offset that X amount.

Demolitions are a function of the overall shipping market, specifically with regard to rates. A strong market defers demolitions and a weak market promotes them.

Right now, solid rates in product tankers, crude tankers, mid/small containers, LPG, and LNG are mostly overriding any increased on the water costs from bunkers or growing maintenance costs for older vessels.

Dry bulk could have been in that group right up until recently, but seasonality and a thick orderbook started taking its expected toll. Expectations here are also not great.

This isn’t a new phenomenon. Shipping has many economic sub patterns. Being the cyclical industry that it is, with records spanning hundreds of years, these sub patterns are well established for various parts of the cycle.

So, as older vessels are being kept on the water this creates a supply side reaction that smooths out the business cycle.

  • For example, if demolitions would proceed at a normal pace in a tightening market then the supply side removals would further amplify the strength of the market. However, keeping vessels on the water helps smooth out the bullish upturn.

This ensures three things, reactionary owners (along with the market) are kept in check to a greater degree than they otherwise would be. Again, if you are unsure as to what I mean when I say reactionary owners please read the aforementioned report.

Second, a relief valve is being built up in the market, in terms of removable tonnage, for when rates finally do turn in this cyclical industry. The longer, and stronger, a bull market becomes the greater this relief valve.

Third, and unique here, older vessels will be deemed uneconomic much more quickly post-2020 as on the water costs increase courtesy of higher bunker prices. This greater burden will induce retirements earlier on in a market downturn than it previously would have.

Owners with scrubbers can indeed look at this as another market support mechanism as those without scrubbers will be economically challenged first and therefore forced to be the primary movers.

However, that relief valve will be needed as these reactionary owners will likely do their part in eventually responding to this bull market in a magnitude leading to a similarly strong bear market down the road.

The supply side removals/additions are a classic market response mechanism at work and are therefore foreseeable to a degree if we have market clarity.

In the last half of 2019, as owners were basking in a strong spring and summer, we saw the impact on the demo market as just seven capesize vessels were retired.

However, in the first couple weeks of January we have already seen five capesized vessels sold for scrap. This compares to a total of seven vessels scrapped in all of January and February of 2019 when we similar seasonality unfold along with the second largest decline in the BDI on record.

In fact, for more on this please see my report, Trading And Investing In Shipping Part II: Focus On Supply Side, which discusses all these trends in depth with historic examples and much better charts.

Conclusion

The biggest call in a generation for shipping produced a great number of diverse opinions, analysis, and forecasts. Many, many got it wrong.

Over at VIE I believe we did a very good job navigating this unprecedented mandate which held the potential for a vast number of outcomes.

Our economics background and knowledge of the shipping markets laid the foundation for this seemingly simple formula: “The degree of retirements and/or slow steaming induced by this mandate will be directly related to the cost of bunker fuel and older vessel maintenance balanced against any rise (or fall) in charter rates.”

The knowledge of market cyclicality coupled with our macro forecasts, which tend to have a very high degree of reliability, led us to our views regarding the outcome of IMO 2020. Using the formula above we simply filled in the blanks with our own macro forecasts. They turned out to be largely correct.

The shock of IMO 2020 started late in 2019 as owners bunkered for 2020’s compliant voyages, and has now largely run its course. Only fine tuning is left and that will take place with much less fanfare.

So, what will the IMO target next? Carbon? Particulate matter? Emission free shipping by 2050? Whatever it is you can count on the market to dictate the outcome, and over at VIE.

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Source: Seeking Alpha