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January 1st 2020 won’t just be the start of a new year or a new decade; it is a significant date for the international shipping industry as the most radical new rules for shipping fuels in decades are implemented. From New Year’s Day onwards, a 0.5% sulphur cap (or 500ppm) in fuel will be imposed globally, part of the International Maritime Organization’s aim to reduce greenhouse gas emissions from ships by 50% through 2050. Adopted in October 2016, the cap was already in discussion and debate long before it was codified. So there has been plenty of time to prepare. The question now is: is the shipping industry prepared for the new change?
But first, a little history. The first enforcement of global shipping emissions came through the IMO – a United Nations agency – in May 2005, when Annex VI of the MARPOL environmental convention came into effect. Earlier annexes of MARPOL dealt with other polluting factors, but Annex VI specifically addressed air pollution – including Nitrogen Oxides and Sulphur Oxides. Prior to this, shipping fuels and emissions were largely unregulated globally (although national and regional standards did apply). In 2008, the IMO set the global upper limit for sulphur in shipping fuels at 3.5% (or 3500 ppm), which came into effect 2012; the new 2020 cap is another great leap – possibly the greatest leap so far.
There are major challenges in meeting this new rules. For decades, ships plying international waters ran on heavy, high sulphur fuel oil. This itself was a change from the previous paradigm, where ships ran on coal. Why did the switch happen? Simple economics. As the world’s oil refining industries developed post-World War II, the focus was on producing high-value fuels such as gasoline, gasoil and jet fuel for the transportation revolution. If the crude oil processed was light and sweet, there wouldn’t be much left after refining. But if the crude was heavier and more sour, then there was a lot left over. This heavy fuel oil was embraced by the shipping industry as a more efficient (operationally and economically) fuel for ships. What was an unwanted by-product now had value. It was a boon for refiners, as they did not have to bother refining the HFO further. And it was a boon for shippers, a ready source of cheap fuel.
Heavy fuel oil – some with sulphur levels exceeding 15000 ppm – was used by shippers worldwide, especially in international waters where national emission standards would not apply. The IMO MARPOL Annex VI has changed that. There are two avenues to meeting the new 2020 standard –invest in an exhaust gas cleaning system (also known as a scrubber) that would allow the ship to continue to burn HFO, or switch to cleaner fuels – principally marine gasoil (MGO) or low-sulphur fuel oil (LSFO). The former seems less attractive – a Lloyd’s survey suggests only 19% of shipowners would go for scrubbers – and the latter has some restrictions… both technical (compatibility with engine systems) and logistic (requiring new blending and storage facilities). There is a third category – running on LNG – but that applies mainly to new ships. The vast majority will have to buy and burn compliant marine fuels.
Several questions are still up in the air. LSFO and MGO currently carry a US$250/ton premium over HFO, a major increase that shippers will have to pass on to their clients – using a tool known as the Bunker Adjustment Factor (BAF). Refiners – particularly those near key ports such as Singapore, Shanghai and Amsterdam – have already invested in capacity to produce more MGO and LSFO, so supply isn’t that much of an issue, outside of pockets of unavailability in smaller ports. Asian refineries, in fact, are already running a surplus of IMO 2020-compliant LSFO. But some countries are showing resistance, including Indonesia that opted out of IMO 2020 for domestic marine usage, citing the age of its fleet. However, in existing Emission Control Areas like the Baltic Sea, North Sea and the Caribbean Sea, an ultra-low sulfur limit of 0.1% (100ppm) applies – presaging a future where a similar limit will apply globally through an upcoming IMO resolution. But, and this is crucial to the success of the new policy, the IMO has not set out concrete fines and sanctions for non-compliance, leaving enforcement and penalties to the individual port authorities – a delegation of responsibility that could dilute the effectiveness of the mandate.
Adjusting to the new IMO 2020 rule will involve an intricate matching of supply and demand. And money. Money is at the heart of this issue, as refiners, shippers and ports invest money into meeting the new requirements. Shipping is about to get a lot cleaner, and more expensive. At stake, however, is the health of the planet itself. And it’s hard to put a price on achieving that, no matter how much money needs to be spent.
IMO 2020 Marine Fuel/Engine Regulations:
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Source: U.S. Energy Information Administration, Short-Term Energy Outlook (STEO)
In its January 2020 Short-Term Energy Outlook (STEO), the U.S. Energy Information Administration (EIA) forecasts that annual U.S. crude oil production will average 11.1 million b/d in 2021, down 0.2 million b/d from 2020 as result of a decline in drilling activity related to low oil prices. A production decline in 2021 would mark the second consecutive year of production declines. Responses to the COVID-19 pandemic led to supply and demand disruptions. EIA expects crude oil production to increase in 2022 by 0.4 million b/d because of increased drilling as prices remain at or near $50 per barrel (b).
The United States set annual natural gas production records in 2018 and 2019, largely because of increased drilling in shale and tight oil formations. The increase in production led to higher volumes of natural gas in storage and a decrease in natural gas prices. In 2020, marketed natural gas production fell by 2% from 2019 levels amid responses to COVID-19. EIA estimates that annual U.S. marketed natural gas production will decline another 2% to average 95.9 billion cubic feet per day (Bcf/d) in 2021. The fall in production will reverse in 2022, when EIA estimates that natural gas production will rise by 2% to 97.6 Bcf/d.
Source: U.S. Energy Information Administration, Short-Term Energy Outlook (STEO)
EIA’s forecast for crude oil production is separated into three regions: the Lower 48 states excluding the Federal Gulf of Mexico (GOM) (81% of 2019 crude oil production), the GOM (15%), and Alaska (4%). EIA expects crude oil production in the U.S. Lower 48 states to decline through the first quarter of 2021 and then increase through the rest of the forecast period. As more new wells come online later in 2021, new well production will exceed the decline in legacy wells, driving the increase in overall crude oil production after the first quarter of 2021.
Associated natural gas production from oil-directed wells in the Permian Basin will fall because of lower West Texas Intermediate crude oil prices and reduced drilling activity in the first quarter of 2021. Natural gas production from dry regions such as Appalachia depends on the Henry Hub price. EIA forecasts the Henry Hub price will increase from $2.00 per million British thermal units (MMBtu) in 2020 to $3.01/MMBtu in 2021 and to $3.27/MMBtu in 2022, which will likely prompt an increase in Appalachia's natural gas production. However, natural gas production in Appalachia may be limited by pipeline constraints in 2021 if the Mountain Valley Pipeline (MVP) is delayed. The MVP is scheduled to enter service in late 2021, delivering natural gas from producing regions in northwestern West Virginia to southern Virginia. Natural gas takeaway capacity in the region is quickly filling up since the Atlantic Coast Pipeline was canceled in mid-2020.
Just when it seems that the drama of early December, when the nations of the OPEC+ club squabbled over how to implement and ease their collective supply quotas in 2021, would be repeated, a concession came from the most unlikely quarter of all. Saudi Arabia. OPEC’s swing producer and, especially in recent times, vocal judge, announced that it would voluntarily slash 1 million barrels per day of supply. The move took the oil markets by surprise, sending crude prices soaring but was also very unusual in that it was not even necessary at all.
After a day’s extension to the negotiations, the OPEC+ club had actually already agreed on the path forward for their supply deal through the remainder of Q1 2021. The nations of OPEC+ agreed to ease their overall supply quotas by 75,000 b/d in February and 120,000 b/d in March, bringing the total easing over three months to 695,000 b/d after the UAE spearheaded a revised increase of 500,000 b/d for January. The increases are actually very narrow ones; there were no adjustments for quotas for all OPEC+ members with the exception of Russia and Kazakshtan, who will be able to pump 195,000 additional barrels per day between them. That the increases for February and March were not higher or wider is a reflection of reality: despite Covid-19 vaccinations being rolled out globally, a new and more infectious variant of the coronavirus has started spreading across the world. In fact, there may even be at least of these mutations currently spreading, throwing into question the efficacy of vaccines and triggering new lockdowns. The original schedule of the April 2020 supply deal would have seen OPEC+ adding 2 million b/d of production from January 2021 onwards; the new tranches are far more measured and cognisant of the challenging market.
Then Saudi Arabia decides to shock the market by declaring that the Kingdom would slash an additional million barrels of crude supply above its current quota over February and March post-OPEC+ announcement. Which means that while countries such as Russia, the UAE and Nigeria are working to incrementally increase output, Saudi Arabia is actually subsidising those planned increases by making a massive additional voluntary cut. For a member that threw its weight around last year by unleashing taps to trigger a crude price war with Russia and has been emphasising the need for strict compliant by all members before allowing any collective increases to take place, this is uncharacteristic. Saudi Arabia may be OPEC’s swing producer, but it is certainly not that benevolent. Not least because it is expected to record a massive US$79 billion budget deficit for 2020 as low crude prices eat into the Kingdom’s finances.
So, why is Saudi Arabia doing this?
The last time the Saudis did this was in July 2020, when the severity of the Covid-19 pandemic was at devastating levels and crude prices needed some additional propping up. It succeeded. In January 2021, however, global crude prices are already at the US$50/b level and the market had already cheered the resolution of OPEC+’s positions for the next two months. There was no real urgent need to make voluntary cuts, especially since no other OPEC member would suit especially not the UAE with whom there has been a falling out.
The likeliest reason is leadership. Having failed to convince the rest of the OPEC+ gang to avoid any easing of quotas, Saudi Arabia could be wanting to prove its position by providing a measure of supply security at a time of major price sensitivity due to the Covid-19 resurgence. It will also provide some political ammunition for future negotiations when the group meets in March to decide plans for Q2 2021, turning this magnanimous move into an implicit threat. It could also be the case that Saudi Arabia is planning to pair its voluntary cut with field maintenance works, which would be a nice parallel to the usual refinery maintenance season in Asia where crude demand typically falls by 10-20% as units shut for routine inspections.
It could also be a projection of soft power. After isolating Qatar physically and economically since 2017 over accusations of terrorism support and proximity to Iran, four Middle Eastern states – Saudi Arabia, Bahrain, the UAE and Egypt – have agreed to restore and normalise ties with the peninsula. While acknowledging that a ‘trust deficit’ still remained, the accord avoids the awkward workarounds put in place to deal with the boycott and provides for road for cooperation ahead of a change on guard in the White House. Perhaps Qatar is even thinking of re-joining OPEC? As Saudi Arabia flexes its geopolitical muscle, it does need to pick its battles and re-assert its position. Showcasing political leadership as the world’s crude swing producer is as good a way of demonstrating that as any, even if it is planning to claim dues in the future.
It worked. It has successfully changed the market narrative from inter-OPEC+ squabbling to a more stabilised crude market. Saudi Arabia’s patience in prolonging this benevolent role is unknown, but for now, it has achieved what it wanted to achieve: return visibility to the Kingdom as the global oil leader, and having crude oil prices rise by nearly 10%.
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