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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Headline crude prices for the week beginning 23 March 2020 – Brent: US$27/b; WTI: US$23/b
Headlines of the week
Crude oil prices have fallen significantly since the beginning of 2020, largely driven by the economic contraction caused by the 2019 novel coronavirus disease (COVID19) and a sudden increase in crude oil supply following the suspension of agreed production cuts among the Organization of the Petroleum Exporting Countries (OPEC) and partner countries. With falling demand and increasing supply, the front-month price of the U.S. benchmark crude oil West Texas Intermediate (WTI) fell from a year-to-date high closing price of $63.27 per barrel (b) on January 6 to a year-to-date low of $20.37/b on March 18 (Figure 1), the lowest nominal crude oil price since February 2002.
WTI crude oil prices have also fallen significantly along the futures curve, which charts monthly price settlements for WTI crude oil delivery over the next several years. For example, the WTI price for December 2020 delivery declined from $56.90/b on January 2, 2020, to $32.21/b as of March 24. In addition to the sharp price decline, the shape of the futures curve has shifted from backwardation—when near-term futures prices are higher than longer-dated ones—to contango, when near-term futures prices are lower than longer-dated ones. The WTI 1st-13th spread (the difference between the WTI price in the nearest month and the price for WTI 13 months away) settled at -$10.34/b on March 18, the lowest since February 2016, exhibiting high contango. The shift from backwardation to contango reflects the significant increase in petroleum inventories. In its March 2020 Short-Term Energy Outlook (STEO), released on March 11, 2020, the U.S. Energy Information Administration (EIA) forecast that Organization for Economic Cooperation and Development (OECD) commercial petroleum inventories will rise to 2.9 billion barrels in March, an increase of 20 million barrels over the previous month and 68 million barrels over March 2019 (Figure 2). Since the release of the March STEO, changes in various oil market and macroeconomic indicators suggest that inventory builds are likely to be even greater than EIA’s March forecast.
Significant price volatility has accompanied both price declines and price increases. Since 1999, 69% of the time, daily WTI crude oil prices increased or decreased by less than 2% relative to the previous trading day. Daily oil price changes during March 2020 have exceeded 2% 13 times (76% of the month’s traded days) as of March 24. For example, the 10.1% decline on March 6 after the OPEC meeting was larger than 99.8% of the daily percentage price decreases since 1999. The 24.6% decline on March 9 and the 24.4% decline on March 18 were the largest and second largest percent declines, respectively, since at least 1999 (Figure 3).
On March 10, a series of government announcements indicated that emergency fiscal and monetary policy were likely to be forthcoming in various countries, which contributed to a 10.4% increase in the WTI price, the 12th-largest daily increase since 1999. During other highly volatile time periods, such as the 2008 financial crisis, both large price increases and decreases occurred in quick succession. During the 2008 financial crisis, the largest single-day increase—a 17.8% rise on September 22, 2008—was followed the next day by the largest single-day decrease, a 12.0% fall on September 23, 2008.
Market price volatility during the first quarter of 2020 has not been limited to oil markets (Figure 4). The recent volatility in oil markets has also coincided with increased volatility in equity markets because the products refined from crude oil are used in many parts of the economy and because the COVID-19-related economic slowdown affects a broad array of economic activities. This can be measured through implied volatility—an estimate of a security’s expected range of near-term price changes—which can be calculated using price movements of financial options and measured by the VIX index for the Standard and Poor’s (S&P) 500 index and the OVX index for WTI prices. Implied volatility for both the S&P 500 index and WTI are higher than the levels seen during the 2008 financial crisis, which peaked on November 20, 2008, at 80.9 and on December 11, 2008, at 100.4, respectively, compared with 61.7 for the VIX and 170.9 for the OVX as of March 24.
Comparing implied volatility for the S&P 500 index with WTI’s suggests that although recent volatility is not limited to oil markets, oil markets are likely more volatile than equity markets at this point. The oil market’s relative volatility is not, however, in and of itself unusual. Oil markets are almost always more volatile than equity markets because crude oil demand is price inelastic—whereby price changes have relatively little effect on the quantity of crude oil demanded—and because of the relative diversity of the companies constituting the S&P 500 index. But recent oil market volatility is still historically high, even in comparison to the volatility of the larger equity market. As denoted by the red line in the bottom of Figure 4, the difference between the OVX and VIX reached an all-time high of 124.1 on March 23, compared with an average difference of 16.8 between May 2007 (the date the OVX was launched) and March 24, 2020.
Markets currently appear to expect continued and increasing market volatility, and, by extension, increasing uncertainty in the pricing of crude oil. Oil’s current level of implied volatility—a forward-looking measure for the next 30 days—is also high relative to its historical, or realized, volatility. Historical volatility can influence the market’s expectations for future price uncertainty, which contributes to higher implied volatility. Some of this difference is a structural part of the market, and implied volatility typically exceeds historical volatility as sellers of options demand a volatility risk premium to compensate them for the risk of holding a volatile security. But as the yellow line in Figure 4 shows, the current implied volatility of WTI prices is still higher than normal. The difference between implied and historical volatility reached an all-time high of 44.7 on March 20, compared with an average difference of 2.3 between 2007 and March 2020. This trend could suggest that options (prices for which increase with volatility) are relatively expensive and, by extension, that demand for financial instruments to limit oil price exposure are relatively elevated.
Increased price correlation among several asset classes also suggests that similar economic factors are driving prices in a variety of markets. For example, both the correlation between changes in the price of WTI and changes in the S&P 500 and the correlation between WTI and other non-energy commodities (as measured by the S&P Commodity Index (GSCI)) increased significantly in March. Typically, when correlations between WTI and other asset classes increase, it suggests that expectations of future economic growth—rather than issues specific to crude oil markets— tend to be the primary drivers of price formation. In this case, price declines for oil, equities, and non-energy commodities all indicate that concerns over global economic growth are likely the primary force driving price formation (Figure 5).
U.S. average regular gasoline and diesel prices fall
The U.S. average regular gasoline retail price fell nearly 13 cents from the previous week to $2.12 per gallon on March 23, 50 cents lower than a year ago. The Midwest price fell more than 16 cents to $1.87 per gallon, the West Coast price fell nearly 15 cents to $2.88 per gallon, the East Coast and Gulf Coast prices each fell nearly 11 cents to $2.08 per gallon and $1.86 per gallon, respectively, and the Rocky Mountain price declined more than 8 cents to $2.24 per gallon.
The U.S. average diesel fuel price fell more than 7 cents from the previous week to $2.66 per gallon on March 23, 42 cents lower than a year ago. The Midwest price fell more than 9 cents to $2.50 per gallon, the West Coast price fell more than 7 cents to $3.25 per gallon, the East Coast and Gulf Coast prices each fell nearly 7 cents to $2.72 per gallon and $2.44 per gallon, respectively, and the Rocky Mountain price fell more than 6 cents to $2.68 per gallon.
Propane/propylene inventories decline
U.S. propane/propylene stocks decreased by 1.8 million barrels last week to 64.9 million barrels as of March 20, 2020, 15.5 million barrels (31.3%) greater than the five-year (2015-19) average inventory levels for this same time of year. Gulf Coast inventories decreased by 1.3 million barrels, East Coast inventories decreased by 0.3 million barrels, and Rocky Mountain/West Coast inventories decrease by 0.2 million barrels. Midwest inventories increased by 0.1 million barrels. Propylene non-fuel-use inventories represented 8.5% of total propane/propylene inventories.
Residential heating fuel prices decrease
As of March 23, 2020, residential heating oil prices averaged $2.45 per gallon, almost 15 cents per gallon below last week’s price and nearly 77 cents per gallon lower than last year’s price at this time. Wholesale heating oil prices averaged more than $1.11 per gallon, almost 14 cents per gallon below last week’s price and 98 cents per gallon lower than a year ago.
Residential propane prices averaged more than $1.91 per gallon, nearly 2 cents per gallon below last week’s price and almost 49 cents per gallon below last year’s price. Wholesale propane prices averaged more than $0.42 per gallon, more than 7 cents per gallon lower than last week’s price and almost 36 cents per gallon below last year’s price.
Headline crude prices for the week beginning 16 March 2020 – Brent: US$30/b; WTI: US$28/b
Headlines of the week