New 2020 sulphur regulations for global shipping · containing more than 0.5% sulphur without...

Macro & FICC Research

IMO2020 Report March 2018

New 2020 sulphur regulations for global shipping

Crude and product markets to be shaken by the new maritime sulphur regulations in 2020

IMO’s 2020 sulphur deadline a done deal It is now impossible for the IMO to push the 2020 global 0.5% sulphur limit to a later date

without breaking its own rules. From January 2020 it will be illegal to run a ship using fuel

containing more than 0.5% sulphur without operating an exhaust cleaning gas system.

Fewer than 2000 ships will have a scrubber in 2020 Currently, some 18,000 bulk carriers, crude oil carriers and container ships account for 76% of

the world’s DWT capacity. Together, they likely consume close to 4 m bl/d HSFO. By 2020, we

expect less than 2000 ships to possess a scrubber. We therefore expect that present HSFO

demand will fall sharply from 4 m bl/d to as little as 0.3 – 0.4 m bl/d. Demand will instead switch to higher quality oil products such as ultra-low sulphur fuel oil (ULSFO 0.5%) or Gasoil.

Gasoil to HSFO spread likely to widen to over $450/ton As demand for HSFO almost evaporates in 2020 and instead shifts to ULSFO 0.5% or Gasoil, we

forecast global refinery upgrading capacity utilization will be stretched to its maximum. We

therefore expect the Gasoil to HSFO 2020 price spread to widen to more than $450/bl.

Bjarne Schieldrop

Chief analyst commodities

(47) 9248 9230 [email protected]

Historical Gasoil 0.1% to HSFO 3.5% product price spread - USD/ton

Source: SEB, Bloomberg

Macro research : IMO2020 Report Wednesday 21 March 2018 2

Contents

New 2020 sulphur regulations for global shipping ............................... 1

Executive summary ................................................................................... 3

The IMO 2020 Sulphur deadline is a done deal. ............................................... 3

Likely less than 2000 ships with scrubbers in 2020. ..................................... 3

2020 HSFO to Gasoil spread to rise above $450/ton .................................... 3

Paper scrubber, competitive hedge or plain bet .............................................. 3

Foreword ..................................................................................................... 4

Meeting with clients in Europe, Singapore and Hong Kong ........................... 4

Background ................................................................................................. 5

The graveyard of dirty oil........................................................................................ 5

IMO ending high sulphur emissions from global freight ................................. 5

Scrubbers? No thank you! We want fuel compliance! .......................... 6

Competitive concerns - What do others do? ........................................... 6

Risk-reward deemed far from good enough ..................................................... 6

IMO – will they or won’t they? .................................................................. 7

The IMO’s sulphur regulation is very different from the BWT regulation . 7

Focus shifts from IF to HOW ................................................................................... 7

IMO wants change, not havoc and disruption ................................................... 7

Who should pay? Shipowners, refineries or charterers? ...................... 8

Who should pay? Shipowners, refineries or charterers? ............................... 8

Catch 22 ....................................................................................................................... 8

Investing in a scrubber .............................................................................. 9

The need for switching fuel .................................................................... 10

3.2 m bl/d of out of today’s 4 m bl/d of HSFO to disappear to 2020 ...... 10

What can refineries do to 2020? ............................................................ 12

Surplus of bitumen, asphalt and sulphur .............................................. 13

Historical prices & spreads for HSFO 3.5%, Gasoil 0.1% and Brent . 13

Historical prices and spreads for ULSFO 0.5% and Gasoil 0.1% ....... 17

The HSFO to Gasoil Coker link ................................................................ 19

Compliant fuel to be Gasoil 0.1%, or ULSFO 0.5%?............................. 22

Recent price developments .................................................................... 23

Down the scrubber route unless they are forbidden .......................... 24

Summing up ............................................................................................... 27

The road ahead ......................................................................................... 28


Executive summary The IMO 2020 Sulphur deadline is a done deal.

Legally it is now impossible for the IMO to change its decision before January 2020. Nor,

since its decision in October 2016, have there been any requests from IMO member

states for any alteration.

Strong price signals in the form of a wider ULSFO 0.5% to HSFO or Gasoil product price spread are needed to drive the desired shift to lower sulphur emissions. The IMO will

likely favour a wider spread and support such an outcome. They will however also

probably ease the impact of worst possible scenarios, by softening transitional measures

to avoid unnecessary transitional havoc and disruption.

Likely less than 2000 ships with scrubbers in 2020.

We expect that fewer than 2000 ships will have a scrubber in 2020. Consequently,

demand for HSFO will decrease dramatically in 2020, likely to less than 0.8 m bl/d and

probably as low as 0.3 – 0.4 m bl/d, representing barely 10% of today’s marine HSFO consumption of 4 m bl/d. Demand will instead switch to compliant fuel with less than

0.5% sulphur content, i.e. either ULSFO 0.5% or Gasoil 0.5%.

This will push the global refining system’s upgrading capacity to the limit as 3-3.7 m bl/d

of HSFO suddenly need to be upgraded to ULSFO/Gasoil. Ripple effects of this development will likely be felt across the whole oil product sector and further impact

pricing of different crude slates. There is a real risk of a repetition of events in 2008

when strong Gasoil demand and limited and fully utilized refinery upgrading capacity led

to an upward spiralling price dynamic between higher and higher Gasoil prices and higher and higher light sweet crude oil prices. HSFO was then also priced at a deep

discount to crude.

2020 HSFO to Gasoil spread to rise above $450/ton

The 2020 HSFO to Gasoil price spread traded at only $220/ton on a forward basis in the

early autumn of 2017. Since then it has blown out to as much as $350/bl at the start of

2018 while currently trading at $320/ton. The spread is typically and historically

proportional to the Brent crude oil price. It averaged $308/ton between 2011 and 2014 when Brent crude averaged $108/bl, and $447/ton in 2008 when Brent crude averaged

$98/bl.

Compared to the current forward 2020 Brent crude oil price of $57/bl, the 2020 HSFO

to Gasoil price spread is today trading expensively certainly from an historical perspective, but is still more then $100/ton below an historical spread extreme of

$420/ton observed at a crude oil price of around $57/bl. In 2008 the spot spread blew

out to an extreme of $700/bl for a short period.

We expect worldwide refinery upgrading capacity utilization to be pushed to its limit in 2020 causing the Gasoil to HSFO price spread to widen to over $450/ton.

Paper scrubber, competitive hedge or plain bet

Our main view is that the HSFO to Gasoil price spread is likely to blow out to more than $450/ton. Buying the forward 2020 Gasoil to HSFO product spread can be utilized as a

virtual scrubber for shipping fleets without scrubbers. This will provide such shipowners

with an extra source of income proportional to the incremental income advantage (due

to a higher spread) for scrubber ships and as such offer a competitive hedge for non-scrubber ships compared to scrubber ships. A long Gasoil vs. short HSFO position for

2020 delivery may also be taken as a plain bet for a wider spread under the new

regulatory regime.

The IMO 2020 deadline is a done deal.

It may be softened peripherally by transitional measures but strong price

signals are needed and wanted by the

IMO to facilitate change.

Global shipowners do not want to

install scrubbers. They wish to be fuel

compliant. Demand for HSFO is likely

to drop from 4 m bl/d to as little as 0.3 – 0.4 m bl/d in 2020

We expect global refinery upgrading capacity utilization to be pushed to its

limit in 2020 and that the Gasoil to

HSFO price spread will in response

widen to more than $450/ton


Foreword This report reflects our involvement in the IMO 2020 sulphur emission

issue following meetings with more than 100 shipping clients and refineries over the past 12 months.

It summarises what we have learned over the past year and our views and reflections on

the situation. It is not an in-depth technical study trying to pin-point global refinery capacities vs. product needs in 2020.

A little more than a year ago the IMO decided that from January 2020 it will not be

allowed to run ships globally with HSFO fuel unless an exhaust scrubber has been

installed. Otherwise, a ship will have to use a fuel with maximum 0.5% sulphur content. Today’s HSFO typically has a 3.5% standard product specification. The actual volume

weighted sulphur content in the 4 m bl/d HSFO consumed for marine propulsion today

does however contain closer to 2.5% sulphur on average.

Two detailed studies have been made concerning the projected balance between marine fuel demand in 2020 under the new rules vs. global refinery product capacities.

The IMO’s Delft study concluded that there would be sufficient compliant fuel available

in 2020 to satisfy the new regulations. As a result, they decided in October 2016 that

the new regulations would take effect in January 2020. The Ensys Energy study however came to a completely opposite conclusion. It determined that the world’s

refinery system would be put under extreme stress to such an extent that it would send

shock waves through all product markets as well as crude oil prices and grades.

Meeting with clients in Europe, Singapore and Hong Kong

To understand more clearly how the IMO’s decision will impact fuel markets and the

shipping industry in 2020, we decided to meet with market participants to hear what

they thought and were planning to do. Over the past year, we have travelled throughout

both northern and southern Europe, to Singapore and Hong Kong, to meet more than 100 shipping companies, refineries and technical experts, to learn how shipowners,

charterers and the refining industry are preparing for the IMO 2020 deadline.

This report summarises what we have learned over the past year and our present

reflections and conclusions.

We are grateful to all those clients who have taken time to meet with us, who have

helped us understand the issues at stake. Our increasing expertise enabled us to

contribute more to these discussions as we progressed.


Background The graveyard of dirty oil

The global shipping fleet has been running on heavy fuel oil with high sulphur content

since the early 1970’s. Today this fuel is typically labelled HSFO or HSFO 3.5% (3.5%

sulphur). It is the bottom of the oil barrel, the residue of simple refining. It is the dirtiest

and heaviest product produced by refineries worldwide. Basically, it is a waste product with little use outside the shipping market except (and less and less in recent years) in

power production. For this reason, the world’s shipping fleet has been dubbed “the

graveyard of dirty oil”.

Generally, it is the old oil refineries in Europe, Africa and Latin America who produce HSFO. These are simple refineries with mostly straight through processing. Therefore,

crude oil used is basically just split into its different hydrocarbon components through

simple distillation and/or vacuum distillation. There is very little modification or after-

treatment of the molecules in the crude oil used. Conversely, the world’s most modern refineries today are highly complex, using many after treatment stages that modify

molecules at high temperatures and pressure. Consequently, they produce very little

heavy residuum [“residue”]. Instead, long, heavy molecules are cracked apart and

converted to much more valuable middle distillate products.

For the world’s old refineries, the residuum [“residue”?] (the heaviest products from

simple refining) is basically a waste product which is sold at a discount to Brent crude

and consumed by the global shipping fleet. This symbiosis, which has lasted since the

early 1970’s, is now set to change or end. Unless the global shipping fleet installs scrubbers, they will no longer be able to handle waste products from old refineries after

January 2020, at least not in its current form.

New refineries are in general built with after treatment modules so that they hardly

produce any heavy residue. It is mostly all cracked away and instead converted to higher value middle distillate products. Thus as today’s old refineries

IMO ending high sulphur emissions from global freight

In October 2016, the IMO decided that from January 1, 2020 ships will be forbidden to

use fuel with more than 0.5% sulphur worldwide unless they are equipped with a scrubber that cleans out the sulphur in the exhaust. However, the IMO did not announce

any other fuel guidelines, so generally fuel can be very dirty and of low quality provided

it contains no more than 0.5% sulphur.

The decision was long overdue and had been in the pipeline for since 2005. The end of HSFO (without scrubber) in global shipping had been decided a long time ago. As of

October 2016, the only thing left to decide was whether the deadline would be January

2020 or 2025. It was all down to the fuel availability study, the Delft study which the

IMO had ordered and had received in the autumn of 2016. This study concluded that to the best knowledge of various experts there would be sufficient fuel in required qualities

to implement the new regulations from January 2020. So, armed with the Delft report,

the IMO finally decided that the new regulations would be enforced from January 2020.

The Delft study has however been strongly contested by many who argue that the transition will not be easy at all. A comparable in-depth report prepared by Ensys Energy

concludes in total opposition to the Delft study that an abrupt and complete switchover

from one day to the next will place the global refining industry under extreme duress

with consequences rippling throughout both oil products and crude markets. Further that it will result in a large expansion in the Gasoil to HSFO product price spread as well as in

the price spread between high quality crude slates versus lower quality crude slates.

The Ensys study is not the only study or report arguing that this will be problematic.

Indeed, most reports we have studied agree with its authors to a greater or lesser extent. We also concur much more with the Ensys study than its Delft counterpart. As

such, we expect a large and significant impact on global fuel and crude markets in 2020.


Scrubbers? No thank you! We want

fuel compliance! One thing which became very clear to us as we travelled around the world was that hardly any shipowners we met really wanted or planned to install scrubbers on their

ships. The list of “why nots” was almost endless. The almost unanimous response was:

“We want to be fuel compliant. We don’t want to install scrubbers on our ships”.

The idea of installing scrubbers on board every ship in the world very clearly did not come from the shipowners. They for sure don’t want scrubbers. They want to be fuel

compliant.

The key reason for this view is that generally it is the charterer who indirectly pays for

the fuel as a pass through cost. It is much easier to pass on the specific fuel cost to charterers than to demand compensation for capex spending on scrubbers. For

shipowners a scrubber means capital expenditure, less free space on a ship, more

maintenance, greater crew competence, higher fuel consumption and uncertain sludge

disposal costs. It also means new legal obligations for exhaust pipe sulphur emissions. If shipowners run fuel compliant vessels without a scrubber, the fuel supplier is legally

obliged to ensure proper fuel quality and sulphur content. If a ship on the other hand runs

with a scrubber it is instead the shipowner who is legally responsible for the sulphur

content in the exhaust gases and thus that the scrubber works properly the ship-owner may be fined.

In other words, almost unanimously shipowners do not wish to use scrubbers.

Competitive concerns - What do others do? Also clear from our many meetings was that most shipowners were not very concerned

about higher fuel costs during the 2020 transition. What they really bothered about was

what other shipowners were doing. Fuel cost is mostly passed on to charterers, so long as everyone else is doing the same thing within the shipowner community they will all be

in the same boat - so to speak. Internal competition within the shipping market will be on

a level playing field with everyone just as well or badly off. What shipowners were and

still are concerned about is that a significant share of the global fleet is embarking on installing scrubbers, placing others at a considerable competitive disadvantage.

Risk-reward deemed far from good enough

Generally, shipowners we met thought the risk-reward for installing a scrubber was well short of justifying capex on them. Such devices are still regarded as technically

immature, still at the test stage. Shipowners expect scrubber costs will continue to

decrease over time. They were not confident about the firmness of IMO’s 2020 deadline.

They feared that they would not be able to pass the capex over to the charterers, that the Gasoil to HSFO price spread would not be wide enough to make the scrubber

installation profitable, that it could become very expensive to dispose of sludge from the

scrubber and that new environmental regulations governing CO2, PM and NOx in a few

years would mean that a scrubber installation today would be useless in a few years. All in all that it was better to wait and see has been and probably still is the general view

within shipping.

Shipowners do not want scrubbers.

They want to be fuel compliant.

Their greatest concern is sunk cost

capex on scrubbers which limits their

ability to pass on such expenses to charterers.

Following several tough trading years,

many shipowners have little cash to

spend on scrubbers.

No one needs to act so long as no one

acts. A level playing field remains

intact as most shipowners do not

install scrubbers. Charterers will bear most of the fuel costs.

Shipowners look at each other. What

matters is what other shipowners do.

Whether fuel costs are high or low is less important.


IMO – will they or won’t they? A year ago, there was huge uncertainty whether the 2020 deadline would be pushed

forward or not. The shipping industry’s experience with the ballast water treatment

system regulations made it easy to assume that there would be endless delays, and that sulphur regulation deadlines would also be repeatedly postponed. At that stage most

companies we met felt uncertain about the 2020 deadline. Clearly, this view changed in

the summer of 2017. Going forward, the discussion switched from “if” to “how”.

A key factor for the IMO concerning the 2020 deadline decision involved the fuel availability study. How the 2020 deadline would impact costs and fuel prices per se was

not at the heart of what was decided. Instead, the most important question was whether

physically there would be sufficient fuel available to enable the global shipping fleet to

operate from 2020. If it was to run solely on expensive Gasoil then that was probably fine in the eyes of the IMO provided there was physically enough Gasoil for the fleet to

run on. So, if it was shown there would not be physically enough compliant fuels in 2020

on which to run the global shipping fleet then the IMO might possibly have shifted the

deadline to 2025. This is however very difficult to prove and as such the 2020 deadline is today fixed.

By IMO’s own laws there is no longer any way that the January 2020 deadline can be

pushed back in time. To change that date will require an amendment to the MARPOL

Annex VI treaty. First, this would involve a proposal for such an amendment. Next, the proposal would have to circulate for six months before adoption. Afterwards, it could not

come into force before at the earliest 16 months after adoption, i.e. the amendment

could not take effect until 22 months had passed. No such proposal by the IMO’s

members has been received since the 2020 deadline decision was announced in October 2016.

The IMO’s sulphur regulation is very different from the BWT regulation

A key difference between the IMO’s sulphur regulation and the ballast water treatment

system regulations is that the sulphur regulations do not require any capex installations

onboard a ship. The IMO does not state that a scrubber is needed but that it can be used

if desired; otherwise compliant fuel should be utilized. The explicit need to install capex on ships to comply with the ballast water treatment regulations was one of several key

reasons for extensions. Unless lack of fuel availability can be proved such excuses are

hard to use in the case of sulphur regulations. As far as we can see, the 2020 sulphur

regulation deadline is near rock solid absent “proof of lack of fuel availability”.

Focus shifts from IF to HOW

As the market began to accept fully the 2020 sulphur deadline, its focus shifted from IF

to HOW. How is it going to play out? What will happen to fuel prices? What can refineries do and at what price? Will compliant ULSFO 0.5% be of acceptable quality and quantity

and will it be available worldwide? Will it be possible to buy HSFO globally for those few

ships that are running with scrubbers? Will there be a lot of cheating? How will the

regulations be monitored and how will they be enforced? Will there be waiver options unless there are no available fuels to be bought etc. Many such questions remain

unanswered today.

IMO wants change, not havoc and disruption

It is important to remember that the IMO’s decision is a regulatory decision on emissions. The IMO wants change. It wants it so strongly that it may be willing to accept some

disruption to get there. It has of course no desire for disruption if it can avoid it. As such

there is always the risk that the IMO looks kindly at softening measures which help to

avoid disruptions so long as they do not prevent changes. This could come in the form of different exceptions and waivers for 2020 if fuel is not available. The process of driving

change is sequenced as follows: 1) IMO’s 2020 decision, 2) Forward based price

reaction 3) Fuel spot price reaction once we get to 2020 and lastly 4) Market participant

reaction in terms of capex spending on either scrubbers or refinery upgrades. Neither shipping nor refineries are willing to make necessary investments before the market

sends the sufficient price signals. Today, these are beginning to emerge on a forward

basis.

IMO’s 2020 sulphur regulation deadline appears immoveable unless

someone can prove that the market

will run into insufficient fuel

availability in 2020.

Legally, it would take a minimum of 22 months to change the 2020

deadline. It is therefore too late to

alter the deadline now consistent with

IMO rules. So far, the IMO has not yet received proposals from any of its

members to change the deadline.

Effecting change

1) IMO’s 2020 deadline decision 2) Forward 2020 pricing reaction

3) Spot price reaction in 2020

4) Capex spending

Shipping/Refineries

Strong product price signals in terms

of a wide Gasoil to HSFO product

spread needed in order for capex

spending to be undertaken


Who should pay? Shipowners,

refineries or charterers? Who should pay? Shipowners, refineries or charterers?

It has been clear for several years that eventually the day would come when HSFO could

no longer be used without restriction in global seaborne transportation. Transport by sea will certainly become more expensive under the new regulations. The big question is -

who should pay for it? Shipowners, refineries or charterers? Clearly, in the long term,

shipowners will always have to pay higher environmental regulatory costs.

If the market solution for the global shipping market under the new regulations is fuel compliance, then charterers will almost directly and immediately pay for the new

regulations through higher fuel costs which normally are directly passed on to them. The

higher fuel costs for ULSFO or Gasoil will in time become a payment to the refineries for

key investments they need to convert HSFO into compliant fuels.

If the future solution mainly involves the use of scrubbers, then the world’s shipowners

will need to pay for the scrubbers and both their maintenance and operating

expenditure. In a retrofitting of today’s shipping fleet, it is unlikely shipowners would be

able to recover all capex on scrubbers. Over time however it is clear that charterers will implicitly have to accept a freight rate high enough to pay for the building of new ships

including a scrubber. Otherwise, new ships will not be built, at least not sensible,

economically viable vessels.

There are however significant skews in the two solutions. It takes many years for a refinery to upgrade their physical equipment by adding cokers or hydro-crackers.

Generally, it only takes a couple of weeks to retrofit a ship with a scrubber. Therefore, if

the market sends positive investment signals to both refineries and shipowners, the

latter have the capacity to react very quickly. Therefore, we think both action and reaction may be taken by shipowners rather than by refineries.

Catch 22

When the IMO opened up to allowing both fuel compliance and scrubbers it created a stale-mate situation. The refinery sector is unlikely to undertake multi-billion-dollar

investment decisions if it turns out that shipowners will end up installing scrubbers

across the fleet and therefore consume all HSFO anyhow. Then, there would be no need

for refineries to invest heavily to upgrade units. Amongst a myriad of issues, shipowners are reluctant to install scrubbers because there is a chance that the refinery sector may

be able to produce a compliant ULSFO 0.5% product at only a small mark-up to the HSFO

price making it unprofitable to install a scrubber. Consequently, both shipowners and

refineries are afraid that the other party will render their investments unprofitable and are therefore reluctant to undertake necessary investments for the upcoming transition.

If the market solution is a refinery and

fuel compliant solution, then

charterers will be handed the bill for higher costs for the new regulations

directly or indirectly through increased

fuel prices passed on to them.

If scrubbers are the market solution then shipowners are unlikely to be

able to recover all of their scrubber

capex. Over the longer term however

the charterers will of course have to pay sufficiently high freight rates to

incentivise the building of new ships

equipped with a scrubber.

Shipowners and refineries both fear

that the other part will invest so to render their own possible investment

unprofitable.


Investing in a scrubber The economics of a scrubber investment are straightforward: we assume an investment

of USD 3.5m for the scrubber and 200 days of sea time per year.

Payback in years for scrubber investment at various price spreads

Type -

Tonnes

Fuel spreads

Handysize

25

VLCC

50

VLCC

75

Container

100

Container

200

Container

300

25 28.0 14.0 9.3 7.0 3.5 2.3

50 14.0 7.0 4.7 3.5 1.8 1.2

75 9.3 4.7 3.1 2.3 1.2 0.8

100 7.0 3.5 2.3 1.8 0.9 0.6

125 5.6 2.8 1.9 1.4 0.7 0.5

150 4.7 2.3 1.6 1.2 0.6 0.4

175 4.0 2.0 1.3 1.0 0.5 0.3

200 3.5 1.8 1.2 0.9 0.4 0.3

225 3.1 1.6 1.0 0.8 0.4 0.3

250 2.8 1.4 0.9 0.7 0.4 0.2

275 2.5 1.3 0.8 0.6 0.3 0.2

300 2.3 1.2 0.8 0.6 0.3 0.2

325 2.2 1.1 0.7 0.5 0.3 0.2

350 2.0 1.0 0.7 0.5 0.3 0.2

375 1.9 0.9 0.6 0.5 0.2 0.2

400 1.8 0.9 0.6 0.4 0.2 0.1

425 1.6 0.8 0.5 0.4 0.2 0.1

450 1.6 0.8 0.5 0.4 0.2 0.1

700 1.0 0.6 0.4 0.4 0.2 0.1

Source: SEB

Our assumptions are probably unrealistically simple as the scrubber investment cost

probably scales with the size of the ship with fuel consumption ranging from 25-300 tonnes per day.

There are in addition a lot of other uncertain costs associated with a scrubber installation

like: higher fuel consumption, sludge disposal costs, more maintenance, loss of space,…

Installing scrubbers on the world’s shipping fleet. Many ships are not suited for a scrubber. The sum of crude tankers, Bulkers and Container ships is close to 18,000 and

accounts for 76% of the world’s DWT. So installing scrubbers on these 18,000 ships

would cover much of today’s consumption of HSFO. Possible feasible scrubber

installations could however amount to close to 40,000 ships

World Shipping Fleet

Category Number

of ships

mDWT Average DWT

per ship

Estimated need

for scrubber

Number of ships

suited for scrubber

Crude tankers 2,017 387.6 192167 100% 2,017

Product tankers 8,403 173.5 20647 70% 5,882

Chemical tankers 3,686 43.7 11856 50% 1,843

Other tankers 405 0.9 2222 100% 405

Bulkers 11,113 817.2 73535 70% 7,779

Combos 12 1.4 116667 100% 12

LPG carriers 1,452 24.3 16736 70% 1,016

LNG carriers 504 40 79365 0% 0

Containerships 5,164 252.8 48954 80% 4,131

Multi-purpose 3,183 29.3 9205 30% 955

General cargo 15,068 37.5 2489 30% 4,520

Ro-Ro 1,662 7.7 4633 100% 1,662

Car carriers 782 12.4 15857 100% 782

Reefers 1,458 4.8 3292 100% 1,458

Probable long term average with ref

Brent $50-80/bl

Synthetic ULSFO to HSFO

Historical average (ref Brent $50-80/bl)

Synthetic ULSFO to HSFO

2020 Synthetic ULSFO to HSFO

2020 Gasoil to HSFO spread

SEB 2020 forecast

2020 Gasoil to HSFO spread

The 2008 intra year high Gasoil to HSFO spread


Category Number

of ships

mDWT Average DWT

per ship

Estimated need

for scrubber

Number of ships

suited for scrubber

Offshore AHTS 4,680 9.6 2051 30% 1,404

World cargo fleet 59,589 1842.7 30923

Others 34,582 82 2371 15% 5,187

World Fleet 94,171 1,925 20,438 41% 39,054

Source: Clarksons

The need for switching fuel Global demand for HSFO in 2012 was estimated at 228 m ton/year. Since then the global

shipping fleet has grown significantly. However, it has also moved into slow steaming mode meaning ships consume 20% less fuel than when they were fast steaming.

Data on current global shipping fleet consumption of HSFO is hard to come by. This

makes it very difficult to project total demand for marine fuels in 2020. Consequently,

there is a very wide spread in projections for total marine fuel consumption and composition in 2020. Our best guestimate is that current marine consumption of HSFO

largely the same as in 2012 since the increased fleet size is countered by its slow

steaming.

We believe few ships will run with scrubbers on January 1, 2020. The base case in the IMO’s Delft Energy study was that by 2020 there would be 3,800 ships with scrubbers,

and that these would consume 36 m tons of HSFO per year or 0.62 m bl/d. We expect

there will be less than half that number, i.e. below 2,000 ships out of a global shipping

fleet of 94,000 ships. As such it looks more like demand for HSFO could fall to as low as 0.3 m bl/d in 2020.

If we consider the various forecasts by different companies such as BP and Shell as well

as projections made by agencies and independent research, we can deduce the

following: On average they expect HSFO demand of 0.8 m bl/d, Gasoil 0.5% demand of 1.4 m bl/d, and non-scrubber compliant ULSFO 0.5% demand of 2.8 m bl/d. There is

however a very wide projection for total marine fuel consumption in 2020. On average

the different forecasts projects a total marine fuel demand of 5 m bl/d.

Fuel demand projections for 2020 (m bl/d)

Source: SEB, Delft, Ensys, BP, PIRA, IEA, Shell, Robin Meech

3.2 m bl/d of out of today’s 4 m bl/d of HSFO to disappear to 2020

Today we estimate global marine consumption of HSFO at 228 m ton/year and marine

gasoil consumption of 64 m ton/year. This is equal to the IMO’s Delft study assumption for marine fuel demand in 2012 of 4 m bl/d of HSFO production and consumption and 1.3

m bl/d of MGO consumption. The average market forecast we have seen expects 3.2 m

bl/d of today’s 4.0 m bl/d HSFO demand to disappear overnight to 2020.

0.8

2.8

1.4

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

HFO LSFO/Blends Gas Oil

Mill

ion

bar

rels

per

Day

IMO 2012 CE Delft BP Shell PIRA IEA 2020 RobinMeech Average

Demand for HSFO in 2020 will

collapse to as low as 0.3 m bl/d vs.

today’s estimated demand of 4.0 m bl/d. Average forecasts project 2020

HSFO demand of 0.8 m bl/d. Demand

will switch to ULSFO 0.5% and Gasoil.


That is a massive hit to demand to a marine oil product which only constitutes 4% of

global oil products.

This means that in an already very small oil product market there will hardly be any demand left for the product in 2020. If it is possible to convert the projected 3.2 m bl/d

of surplus HSFO in 2020 then of course it would not be all that problematic. That is

however the thing, it is not all that easy to convert 3.2 m bl/d of HSFO to a non-scrubber

compliant ULSFO 0.5% fuel.

In order to better be able to compare the different 2020 forecasts we have normalized

them all to a total 2020 marine fuel consumption of 5.5 m bl/d.

Fuel demand projections 2020 normalized to 5.5 m bl/d

Source: Source: SEB, IEA, BP, Delft, PIRA, Robin Meech

In this normalized picture we have that the most extreme is Shell’s projection which projects demand of only 0.3 m bl/d of HSFO and only 1.7 m bl/d of ULSFO in 2020. I.e. it

projects that two out of four m bl/d of today’s HSFO demand will shift all over to Gasoil in

2020. In terms of demand for HSFO in 2020 Shell’s projection is consistent with the

assumption that less than 2,000 ships will have scrubbers by 2020 which equally implies HSFO demand of only 0.3 m bl/d.

SEB’s projection that less than 2000 ships will have a scrubber is actually consistent

with Shell’s very low projection of only 0.3 m bl/d HSFO demand in 2020.

What stands out very clearly is a general projection that there will be a large shift to non-scrubber compliant ULSFO 0.5% fuel. This fuel is still on a test-bed stage and very few

participants have been able to test it. The general view of the coming ULSFO 0.5% is that

it will be a hybrid, blended fuel and not a straight through refined product. As such it

cannot be easily mixed between different suppliers of the fuel and it is also assumed to be quite unstable so that it can be difficult to use for ships running tramp trading.

If there really will be demand for 3 m bl/d of ULSFO or if refineries really will be able to

supply 3 m bl/d of ULSFO we do not know. Both sides of the equation could be restrained.

What is clear is that there will not be a lot of HSFO demand in 2020 and that demand instead will shift to non-scrubber compliant ULSFO 0.5% or Gasoil 0.5% marine fuel.

4.0

0.3

1.0

0.9

0.8

0.6 1.

2

0.6

0

1.7

2.6

2.7

3.0

3.3

3.4

4.1

1.3

3.4

1.8

1.9 1.7 1.5

0.9 0.8

-

1.0

2.0

3.0

4.0

5.0

6.0

Delft 2012 Shell 2020 BP PIRA 2020 Average2020

IEA 2020 RobinMeech2020

Delft Base2020

Mill

ion

bar

rels

per

Day

HFO 3.5% ULSFO 0.5% (Blends) Gas Oil 0.5% or lower

Very little demand for HSFO in 2020

Demand shifting from HSFO 3.5% to

ULSFO 0.5%


What can refineries do to 2020? One of the major unknowns in the IMO maze is the question of what refineries really can

do by the 2020 crossover deadline. What can they do with their current refinery

equipment, and additional equipment to be installed between now and 2020? The refinery industry has been very tight-lipped about what it can or cannot do. Generally, it

has said that to install a new major installation such as a coker or deep conversion unit

needed to convert HSFO to middle distillates, it will take five years to progress from

planning to completion. So, what will be installed by 2020 will have very little to do with the IMO’s 2020 deadline decision in October 2016. New refinery upgrading capacity

from now to 2020 will basically be due to plans and investments taken ahead of the

IMO’s 2020 decision in October 2016.

One problem with the refining industry is that the huge refinery “machines” located worldwide are not especially homogenous. It is possible to create general refineries that

can do everything, but this is not economical. It is much better to tailor each refinery to

what it is specifically required to do, i.e. the crude oils it is required to convert and

products to make.

There are more than 300 different qualities of crude oil worldwide and a myriad of

different products and needs. Consequently, there is also a very wide range of different

refineries. This is also why there is little general literature on the global refinery system

because it is so difficult to generalize. Even refineries themselves find it hard to maintain a strong, clairvoyant view on their business outlook. What will refinery margins look like

one year from now? Based on communications with several refineries over the past 10

years, most, as far as we can see, do not hold especially strong views on forward cracks

and product spreads.

A clear message from one complex refinery we met with was that one good thing about

bout the IMO regulation was that it was solely a regulation on sulphur content and not on

the many other quality aspects of the marine fuel. In other words, compliant marine fuel

in 2020 can be quite dirty and heavy in many respects. What matters is that it does not contain more than 0.5% sulphur. If there had also been a regulation on the many other

quality aspects of the fuel itself and not just sulphur, then it surely would have presented

a serious challenge for the global refining industry. Then they would have had no choice

other than to convert 4 m bl/d of HSFO into cleaner middle distillates using deep conversion units like cokers.

However, the IMO has only set a new standard for sulphur content for shipping fuel and

not many other quality aspects of the fuel. According to refiners we have met with, this

confers considerable freedom on global refineries on how they can modify the HSFO to fuels that can be used under the new regulations. It is not so difficult to get down to

0.5% sulphur provided there are no guidelines and requirements governing the many

other aspects of fuel quality measures was the response we got from one complex

refinery. They had however no estimate of the aggregated global refinery capacity to produce ULSFO 0.5%.

A key problem with HSFO is that it is very difficult and expensive to de-sulphur the fuel

directly. Running the fuel through existing de-sulphuring units quickly clogs up the

catalysts and halt the process, partly due to the high level of impurities in the dirty fuel. It is however also attributable to sulphur molecules being tied much deeper into fuel

molecules in heavy fuel oil than they are in Gasoil making them harder to remove.

Therefore, existing de-sulphur units are unsuitable to de-sulphur HSFO. While it is

possible to build de-sulphur units to treat HSFO, they are however as expensive as deep conversion units. So, it is much better to build deep conversion units in order to convert

low-quality fuel oil to high quality middle distillates than to convert low-quality HSFO

3.5% to ULSFO 0.5%, which is still a low-quality fuel.

However, according to the complex refineries we spoke with, there are other routes to create ULSFO 0.5%. This involves different kinds of after-treatments and blending. One

issue highlighted was that if you “cut” the barrel differently in the vacuum distillation

stage so that the cut contains somewhat less of very heavy elements and somewhat

more of lighter elements, the cut may then be run through a normal desulphurisation unit to lower the sulphur content. What emerges is still a fairly heavy, dirty fuel but with

much less sulphur.

There is no time for the world’s refineries to install additional

upgrading units by 2020 in response

to the IMO’s 2020 decision, at least

not above what they have already planned to install.

The complexity of the world’s refinery

industry makes it very difficult to

estimate and predict what it is really able to do in 2020.

The IMO has only imposed a

requirement on sulphur content to be less than 0.5%. The many other

quality requirement aspects of the fuel

are unchanged. This gives refiners a

lot of freedom to make “dirty” ULSFO 0.5%. If IMO requirements had also

been imposed on other quality

aspects, they would have had to

upgrade HSFO to Gasoil instead.

Sulphur is tied much deeper in the molecular structure of HSFO

hydrocarbons. This reason, as well as

its possessing a range of impurities,

makes it difficult and expensive to remove sulphur from HSFO.

If you “cut” the barrel differently

during the vacuum distillation stage to

obtain slightly less sulphur and heavy molecules and impurities, then that cut

can be run through existing de-

sulphuring units. This helps to create

ULSFO 0.5%.


Subsequently, a significant amount of blending of different fuels takes place, to produce

an acceptable fuel lately dubbed ULSFO 0.5%. So far, there has not been a unified fuel

quality description of this new fuel, adding to market unease.

Another very unclear issue is the stability of new ULSFO 0.5% qualities. Since typically

they will be blended fuels rather than straight through processing products, they will

likely be more unstable. Arguably, these ULSFO 0.5% fuels will be better suited for fixed

routes link container liners. They can burn off the fuel continuously. They rarely risk sitting in one harbour for long with the possibility of fall-outs in blended fuels. Freight

activity on fixed routes like this will also be able to source a stable quality of ULSFO

0.5% from a few suppliers, as they typically only trade between two locations.

Container company Maersk has clearly stated they plan to target fuel compliance with ULSFO 0.5% and not with scrubbers. Their argument is very clear: Scrubbers occupy

space, add complexity requiring skilled on-board operatives, generate waste that must

be processed or disposed off at a cost, and give rise to higher fuel consumption.

Bulk carriers that run tramp trade could have issues with the new ULSFO 0.5% fuels. They will trade from location to location and are subject to the risk they may receive very

different qualities of the ULSFO 0.5% they need. We understand these cannot be mixed.

Therefore, fuel tanks will need to be cleaned before they can be re-filled with ULSFO

0.5% from a different supplier. Bulk carriers also typically risk being land-locked for periods with the risk of a fall-out in unstable ULSFO 0.5% fuel. How unstable the ULSFO

0.5% will turn out to be remains to be seen. It is hard to gauge at this stage with little of

these fuels on the market yet.

It is very unclear what volume of ULSFO 0.5% the world’s refineries can actually produce. Those we have spoken with have said they have no clear views on global

capacity and magnitude, emphasising once again the highly complex and variable nature

of the global refining business.

Surplus of bitumen, asphalt and sulphur The new maritime sulphur limit means that sulphur needs to be removed from HSFO

either before it is burned or after. Assume that sulphur must be removed from 3.2 m bl/d

of HSFO before it is burned, this is equal to a reduction of sulphur in 182 m ton of HSFO from average 2.5% sulphur to 0.5%. This is equivalent to sulphur production of 3.6

million ton of sulphur annually. To our understanding the global sulphur market is already

saturated. It may therefore be problematic for the world’s refineries to get rid of the

sulphur in 2020. The refineries may thus get a sulphur disposal problem in 2020.

Bitumen which is used in asphalt is basically a variant of the old refineries’ residue

production. i.e. it is part of the HSFO complex. Therefore, a 2020 market overflowing

with HSFO also means a surplus of bitumen. The European bitumen market is already in

surplus with prices heading downwards, partly due to the increasing tendency to build roads using concrete. The IMO 2020 event is likely going to lead to yet higher bitumen

surplus and thus even lower bitumen prices.

Historical prices & spreads for HSFO 3.5%, Gasoil 0.1% and Brent Much of the current market discussion is centred on the HSFO to ULSFO/Gasoil spread.

The value of a scrubber investment will be much lower if the spread is low rather than

high. This is one of many reasons why many ship-owners have held back in terms of investing in scrubbers because they are uncertain whether the spread will be wide or

narrow. They can see what it is today and what it has been in the past, but what will it

really be in the future? And, if the spread turns out to be wide in 2020 then how long will

it stay that way? One year, two years or longer?

So what is the correct spread to look at and to study? The HSFO to Gasoil spread or the

HSFO to ULSFO spread? In the previous section it is clear that the general market

expectation is that there will be a large shift from HSFO to ULSFO with ULSFO accounting

for 3 m bl/d of supply and demand in 2020. I.e. the expectation is that there will be a refinery fuel compliant solution and that this solution will primarily be ULSFO. As such the

ULSFO 0.5% is predicted to be fairly

unstable and best suited for steady freight activity between two ports

Maersk has stated that they plan to

run on fuel compliance, most likely by

operating on hybrid ULSFO 0.5% products.

There is very low visibility on how

much ULSFO 0.5% the world’s

refineries will in fact be able to produce in 2020.

Sulphur removal from HSFO by the

world’s refineries is likely to create the

need to dispose of 3.6 m ton of sulphur

A 2020 surplus of HSFO/residue also means a surplus in the

bitumen/asphalt market. The

European bitumen market is already in

surplus. We expect more downside pressure.

Shipowners holding back on scrubber

investments as they don’t know what

the fuel spreads will be in the future


most important thing would be to investigate the HSFO to ULSFO spread. However,

historically and also currently there is no such thing as a ULSFO product, price or

contract.

The lack of an historical ULSFO price is probably why most focus has centred on the

HSFO to Gasoil price spread instead. As an alternative we have created a synthetic

ULSFO 0.5% index constituted by 44% LSFO 1.0% + 56% Gasoil 0.1% which we will

get back to in the next section.

Gasoil typically has a larger multiplier relationship to Brent crude oil than HSFO 3.5%

HSFO 3.5% and Gasoil 0.1% prices versus Dated Brent crude oil


This of course naturally means that the historical relationship between the Dated Brent

crude oil price and the Gasoil 0.1% to HSFO 3.5% spread has a multiplier of 2.7 times the Brent crude oil price:

Gasoil 0.1% to HSFO 3.5% spread in USD/ton vs Dated Brent crude oil in USD/bl


More clearly sorted as averages for each 10-dollar price slot of Dated Brent crude oil

prices we have the following:

y = 5.6x - 33.5

y = 8.3x + 25.2

0

200

400

600

800

1000

1200

1400

10 30 50 70 90 110 130 150

Gas

oil

0.1%

an

d H

SF

O 3

.5%

in U

SD

/to

n

Brent crude oil in USD/bl

HSFO 3.5% Gasoil 0.1% Linear (HSFO 3.5%) Linear (Gasoil 0.1%)

y = 2.7x + 58.7

0

100

200

300

400

500

600

700

800

0 20 40 60 80 100 120 140 160

Gas

oil

0.1%

to

HS

FO

3.5

% s

pre

ad in

US

D/t

on

Dated Brent crude oil in USD/bl

Gasoil 0.1% to HSFO 3.5% spread in USD/ton Linear (Gasoil 0.1% to HSFO 3.5% spread in USD/ton)

Market looking at Gasoil to HSFO

spread as there are no historical index for ULSFO 0.5% prices


Gasoil 0.1% to HSFO 3.5% spread in USD/ton vs Dated Brent crude oil in USD/bl


What we see is that historically when the Brent crude oil price has traded in the range of

$50/bl to $80/bl then the Gasoil 0.1% to HSFO 3.5% has averaged $256/bl. However, what we see in the daily dots is that the price product price spread has traded all the

way up to $450/ton on individual days even when the Dated Brent crude oil price has

traded in the range of $60/bl.

If we instead sort average prices and spreads by year back to 2001 we get the following:

Yearly averages for Gasoil 0.1%, HSFO 3.5% and the spread in USD/ton


What we see is that the spread has rarely been much higher than about $310/ton for a

full year. This happened from 2011 to 2014 when Brent crude oil average $100-110/bl

and the spread was close to that as well also in 2006 and 2007. The real stand-out year was 2008 for which the spread averaged $447/ton. That was a year with strong middle

distillate demand and a very tight gasoil market. Gasoil prices and Brent crude oil prices

then spiraled higher and higher until Brent crude oil reached $148/bl.

In an historical perspective the current forward pricing of the 2020 Gasoil to HSFO spread at $314/ton is basically above all historical normal years. It is just trading lower

than the extreme year 2008. If we also take into consideration that forward crude oil

58 87

153

213 237

264 253 271

316 319 335

408

607 581

-

100

200

300

400

500

600

700

10 20 30 40 50 60 70 80 90 100 110 120 130 140

US

D/t

on

Dated Brent crude in USD/bl

Gasoil 0.1% to HSFO 3.5% spread in USD/ton

89

68

100

197

275

292

293

447

214

224

311

307

313

300

232

182

182 22

5 258 31

0

283

277

275

-

100

200

300

400

500

600

700

800

900

1,000

US

D/t

on

Gasoil - HSFO spread in USD/ton HSFO 3.5% in USD/ton Gasoil 0.1% In USD/ton

The Gasoil to HSFO 3.5% has historically averaged $256/ton when

Brent has been in the range of $50-

80/bl

The Gasoil to HSFO spread has rarely been above $300/ton for a full year

except in 2008 when it averaged

$447/ton


prices are only trading in the range of $56-57/bl for 2020 and 2021 it looks on the face

of it expensive.

Yearly average Gasoil mark-up to Brent and HSFO discount to Brent in USD/ton


Firstly however we think that 2020 is really going to be an extreme year in terms of the product spread in question. As such the relevant comparison in our view is the year

2008. We are not necessarily forecasting a Brent crude oil price spike towards $150/bl

even though that is very possible.

What we do feel confident about is that the global refinery’ upgrading capacity will be stretched to its limit. To all our understanding of the product price spread dynamics this

means a significant widening in the product price spread. Historically such events have

also implied a rippling effect into the pricing of the different crude oil slates. If the market

is in need for more middle distillates and refinery upgrading and and conversion units have been maxed out then the next solution is to use more light sweet crude oil. Thus the

spiraling price between Gasoil prices and Brent crude oil prices in such historical events.

What really stands out in the last graph is the mark-up in Gasoil prices over Brent crude

oil prices on a forward basis from 2020 to 2023. This mark-up is trading above all the historical yearly averages except for 2008. This forward mark-up for Gasoil over Brent

is signaling a real market concern that the Gasoil market will be tight for this period. And

this is exactly the recipe for a spike in the light sweet crude oil prices as well.

Thus implicitly the forward market prices are implying a fairly deep concern for a significantly tight Gasoil market in 2020 to 2023. This is also visible when we look at

Gasoil and HSFO prices in percentage terms versus Dated Brent crude oil prices:

23

11 31

60

94

86

85

172

92

67 84

95

85

82 94

58 73

77 94

112

114

115

118

-66 -57

-69

-136

-181

-206

-208

-275

-122

-158

-227

-213

-228

-218

-138

-124

-109

-149

-164

-198

-169

-162

-157

-300

-250

-200

-150

-100

-50

-

50

100

150

200

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

2020

2021

2022

2023

US

D/t

on

Gasoil mark-up over Dted Brent crude oil in USD/ton HSFO disscount to Dted Brent crude oil in USD/ton

Refinery upgrading capacities will be

stretched to their limits. Product price

spreads will widen out

The market is already pricing in an

unusually tight Gasoil market in 2020.

Historically such situations have led to

a spike in Brent crude oil prices


Gasoil 0.1% and HSFO 3.5% mark-up and discount to Dated Brent crude oil in percent


In this perspective we see that the forward market price for Gasoil for 2020 to 2023 in

percent versus Dated Brent crude oil prices is trading at levels above all historical years.

In addition to the IMO 2020 event there is also another reason to be concerned about the supply of middle distillates in 2020 onwards. On the face of it the current oil market

situation here and now looks fine. Global oil demand is growing strongly on the one hand

while US shale oil production is growing comparably strongly on the other hand. This

looks balanced and good. This may however not be the case. The reason is that crude slate produced by US shale oil contains hardly any middle distillates. It is ultra-light and

almost only contains light end products like gasoline and naphtha.

Thus we may get a situation towards 2020 and the following years where the high level

overall balance in the global hydrocarbon liquids market is balanced while there is actually could emerge a growing deficit in middle distillate products.

Historical prices and spreads for ULSFO 0.5% and Gasoil 0.1% Though not proven at all in terms of feasibility the average forecasts are projecting that

the lion’ share of today’s 4 m bl/d HSFO demand shifts to ULSFO 0.5%. No such product

exists today and no such historical benchmark exists either. As such it is a little bit

difficult to review and analyse. The general expectation is though that the ULSFO fuel will trade quite tightly towards Gasoil 0.5% prices in 2020 as it will be priced relative to

the alternative compliant fuel.

From historical LSFO 1.0% prices and Gasoil 0.1% prices we have created a synthetic

ULSFO 0.5% index price given as a mix of 44% LSFO 1.0% and 56% Gasoil 0.1%. The historical price picture for this ULSFO index may give some indication of where the future

ULSFO 0.5% price will trade in the longer term while it may be far away from the prices

we’ll see in the first years from 2020 onwards.

-37%

-30%

-32%

-47% -4

4% -42% -3

8%

-38%

-26%

-26%

-27% -2

5%

-28%

-29%

-35%

-37%

-27%

-30%

-36%

-45%

-40% -38% -37%

13%

6%

14%

21% 23

%

18%

16%

23%

20%

11%

10%

11%

10%

11%

24%

18%

18%

15% 21

% 26%

27%

27%

28%

-60%

-50%

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

2020

2021

2022

2023

Per

cen

t d

issc

ou

nt

and

mar

k-u

p v

ersu

s D

ated

Bre

nt

cru

de

HSFO 3.5% disscount in % to Dtd Brent crude Gasoil 0.1% mark-up in % to Dtd Brent crude

There is very little middle distillate

content in new ultra-light US shale oil.

A tight Gasoil market could be the result

There are no historical prices for

ULSFO 0.5%

A synthetic ULSFO 0.5% given by 44% LSFO 1.0% + 56% Gasoil 0.1%


Average Gasoil to HSFO and synthetic ULSFO 0.5% to HSFO spreads in USD/ton


What we see is that when Brent crude oil prices have ranged from $50/bl to $80/bl the synthetic ULSFO 0.5% mark-up over HSFO 3.5% prices has averaged $150/ton. In

comparison the comparable spread between Gasoil 0.1% and HSFO 3.5% averaged

$256/ton for the same Brent crude oil prices.

So in a historical perspective the synthetic ULSFO 0.5% index has been $150/ton more expensive than HSFO 3.5% while Gasoil 0.1% has been $256/ton more expensive when

Brent crude oil prices have averaged $50/bl to $80/bl.

Assume that the product market and refinery system is not stressed in 2020 onwards

and that product price spreads trade according to normal historical patterns and that a freight market segment is set by non-scrubber ships running on ULSFO. Then the few

scrubber-ships running on HSFO would only fetch a freight premium equal to $150/ton

times the number of tonnes per day of fuel consumption.

On a forward basis the current market pricing is for Gasoil to average $289/ton above HSFO from 2020 to 2023 while the our synthetic forward ULSFO 0.5% is priced

$216/ton above the HSFO prices. It looks like this:

Yearly averages for synthetic ULSFO 0.5%, HSFO 3.5% and the spread in USD/ton


58 86

153

213 237

263 253 271

316 319 335

408

607 581

33 50

92 126

141 152 147 159 185 190 202

251

369 365

-

100

200

300

400

500

600

700

10 20 30 40 50 60 70 80 90 100 110 120 130 140

Pro

du

ct s

pre

ads

in U

SD

/to

n

Average Brent crude oil in USD/bl

Gasoil to HSFO 3.5% spread in USD/ton ULSFO 0.5% to HSFO 3.5% spread in USD/ton

52

42

65 118 16

9

173

174

281

131

141 19

9

202

196

190

137

116

119

136 17

1 223

204

201

200

-

100

200

300

400

500

600

700

800

900

US

D/t

on

Synthetic ULSFO 0.5% mark-up over HSFO 3.5% in USD/ton

HSFO 3.5% in USD/ton

Synthetic ULSFO 0.5% USD/ton

The synthetic ULSFO 0.5% has

averaged $150/ton above HSFO in a

Brent crude reference of $50-80/bl

A synthetic ULSFO is now priced at

more than $200/ton above HSFO for

2020 delivery and beyond


The HSFO to Gasoil Coker link There is a very strong and fundamental link between HSFO or refinery residue on the one

hand and Gasoil (middle distillates) on the other hand. The link goes through refinery

upgrading units like cokers and crackers. These are often labelled deep conversion units as they go deep into the molecular structure of the long and heavy residue molecules

and break them apart at high temperature and pressure into smaller and lighter

molecules.

Cokers are very expensive and costs approximately one billion USD for a unit able to convert 40,000 bl/d of residue to middle distillates. Thus to upgrade 4 m bl/d of HSFO

one would need to spend $100 bn in capex. To our understanding such a unit typically

has a Short Run Marginal Cost (SRMC) or opex of $29/ton residue converted and

$86/ton all in cost (opex + capex) or Long Term Marginal Cost (LTMC).

If that was all there was too it then the typical spread between HSFO and Gasoil should

typically have been around $86/ton. The historical average price spread between the

two products from 2001 to the start of 2018 was however $237/ton.

The key reason is that when HSFO is converted to middle distillates in a coker then 30% of the feedstock is lost in the conversion process and instead falls out as Pet Coke which

typically only fetches a price of $60/ton. For each ton of HSFO converted to middle

distillates there is thus an added cost on top of the all-in opex + capex cost for the coker

operation stemming from conversion losses. For each ton of HSFO converted there is thus an additional cost due to the conversion loss equal to:

Eq1: Feedstock Coker conversion loss: 0.3*(HSFO price – Pet Coke price)

However, since one ton of HSFO is only converted to 0.7 ton of Gasoil or middle

distillates one needs to convert 1/0.7 = 1.43 tons of HSFO in order to get one ton of Gasoil. Thus one needs to calculate the conversion cost of converting 1.43 tons of HSFO:

Total conversion cost in order to convert 1.43 ton HSFO to 1 ton Gasoil with Pet Coke

=$60/ton:

Eq2: 1.43 * [0.3 * (HSFO price – Pet Coke price) + 86] = 0.43*HSFO + 97

Putting in the historical average HSFO price of $340/ton and a Pet Coke price of $60/ton

we get that Eq2 is equal to $243/ton. That is very close to the historical average HSFO to

Gasoil spread of $237/ton over the given historical period.

If we look at the Gasoil price as a function of the HSFO price we get that Gasoil = HSFO plus conversion cost in Eq2, or: Gasoil = HSFO + 0.43* HSFO + 97 = 1.43* HSFO + 97

If we define the Short Run Marginal Cost (SRMC) of conversion as conversion losses +

opex and Long Run Marginal Cost (LRMC) of conversion as conversion losses + opex +

capex we get the following equations where the gasoil price is written as a function of the HSFO price:

SRMC:

Eq3: Gasoil(HSFO) = (1/0.7)* [HSFO + 29 – 0.3*60] = 1.43*HSFO + 15

LRMC: Eq4: Gasoil(HSFO) = (1/0.7)* [HSFO + 86 – 0.3*60] = 1.43*HSFO + 97

What is clear both when one looks upon this from the mathematical point of view as well

as the historical price spread point of view is that the Gasoil – HSFO price spread is proportional to the price level of the HSFO. The higher the HSFO price is the higher is the

conversion loss and the higher is the price spread between Gasoil and HSFO.

When we graph the theoretical SRMC and LTMC as given by Eq3 and Eq4 on the basis of

the historical HSFO prices and also graph the actual HSFO and Gasoil prices we get:

The opex of a typical Coker conversion

unit has been given $29/ton while the

opex + capex cost is

The cost of converting HSFO to Gasoil

in a coker unit is proportional to the

HSFO price since 30% of the volume is lost to Pet Coke in the process.

The Gasoil to HSFO is proportional to

the HSFO price. Higher HSFO price

means a wider spread


Gasoil 0.1% vs HSFO prices and SRMC and LRMC Coker conversion costs - USD/ton

Source: SEB, 37th IAEE International conference 2014

What is apparent is that the historical price points not at all are glued neither to the

SRMC nor to the LTMC, though very few price points are below the SRMC line which of

course makes a lot of sense.

The driving force for where the price spread settles is given by the need for conversion of HSFO from day to day since 2001. When the need is very low the utilization rate of the

global coker conversion units is very low. This again means that market is cleared on the

SRMC which is the lower blue line in the graph.

If the conversion need is high so that all coker conversion units in the global refinery system are maxed out then the marginal price setting goes above the LTMC line of

conversion which is the green line in the graph. There are other marginal conversion units

than cokers which are less economic and less optimal for the treating and conversion of

HSFO. These have much higher treatment costs.

In extreme cases when the global conversion capacity is totally maxed out but the

market is still asking for more the price spread can go exponential. This is typically what

happened in 2008 when the Gasoil to HSFO price spread widened to $700/ton.

In the next graph we show the historical relationship between HSFO price on the x-axis versus the Gasoil 0.1% to HSFO price spread on the y-axis. We have also drawn the

theoretical SRMC and LRMC conversion cost lines as given in Eq3 and Eq4 using $29/ton

and $86/ton respectively as the constants within the equation.

The dots which lay above the light green line are again typically situations where upgrading needs have exceeded coker capacity making it necessary to move to more

expensive and uneconomical conversion units, driving up the conversion cost and

therefore the Gasoil to HSFO price spread.

0

200

400

600

800

1000

1200

1400

- 100.0 200.0 300.0 400.0 500.0 600.0 700.0 800.0

Gas

oil

0.1%

in U

SD

/to

n

Fueloil 3.5% in USD/ton

Historical Gasoil 0.1% prices in USD/ton Theoretical SRMC Cocker cost Theoretical LT Cocker cost

The price spread between HSFO and

Gasoil becomes exponential when

conversion needs exceed installed

conversion capacity. It did so in 2008.


HSFO prices vs Gasoil to HSFO spreads, SRMC, LRMC Coker conversion costs - USD/ton

Source: SEB, 37th IAEE International conference 2014

In the above graph we have also pinpointed the market prices for forward Gasoil to Fuel oil price spreads for the coming years to 2021. What we see is that only the balance of

the year for 2018 is trading below the LTMC of conversion with respect to the market

price of HSFO. The other years from 2019 to 2021 are trading above. This shows that

the market has started to price in a wider spread as well as a lower HSFO price.

What we have experienced historically is that the highest price spreads have occurred

when the HSFO price has been high. This is of course obvious from the equations above

which shows that the spread is proportional to the HSFO price. The most extreme price

points are from 2008 when the Brent crude oil price traded up to $148/bl. It was very strong demand for Gasoil and middle distillates and the Brent crude oil price spiralled

upwards hand in hand with higher Gasoil prices. As the global refinery upgrading

capacity was maxed out the Gasoil to HSFO price spread expanded to $700/ton at the

most.

What is important to remember from the 2008 incident is that it was still allowed to use

HSFO, it was just not so much need for it. Also, the real need in the market was on the

Gasoil side which again led to the need for maximum upgrading of HSFO to Gasoil.

What will be different in 2020 and 2021 is that it will no longer be allowed to use HSFO in marine freight without a scrubber. Thus rather than moving from the lower left hand

side corner in the graph to the upper right hand side we think that the 2020 price points

should head to the upper left hand side corner of the graph. The IMO 2020 event should

give us a very low HSFO price of about $120/ton, and a fairly high Gasoil price and a high spread.

It will basically be impossible to store a significant running surplus of HSFO over some

time in 2020. Therefore, if demand is insufficient and there are not enough conversion

capacities in the refining industry action will need to be taken. In our opinion, the last such option is to burn the surplus HSFO in on-shore power plants instead of coal. There

are probably sufficient such power plants available equipped with on-shore sulphur

scrubbers where the HSFO can be burned. There has been discussion whether refineries

would in fact have to pay to get rid of their surplus HSFO or residue.

We do not think it will be necessary for refineries to pay to dispose of their surplus

residue or HSFO. However, to burn the surplus HSFO in a power station, the HSFO price

will have to fall further so it becomes competitive vs. today’s much cheaper coal prices.

HSFO typically contains some 40% more energy per ton than normal thermal power station coal. With a coal price currently at $85/ton it means that the HSFO price will need

to fall to around $120/ton to be competitive with coal and therefore be burned in a coal-

fired power station.

At the time of writing, the price of HSFO delivered 2020 is about $220/ton. If the power station option needs to be utilized in order to handle a running surplus of HSFO in 2020, it

-

100

200

300

400

500

600

700

0 50 100 150 200 250 300 350 400 450 500 550 600 650 700 750 800

Gas

oil

0.1%

to

FO

3.5

% s

pre

ad in

US

D/t

on

Fueloil 3.5% in USD/ton

Historical Gasoil to HSFO spread in USD/ton Short term conversion cost Long term conversion cost Forward spreads

2018

2019

2020

2021

The Gasoil to HSFO price spread is already trading high vs. theoretical

long term coker conversion costs. This

is a sign that the utilization rate of the

world’s refinery system is expected to be significantly stressed in 2020 and

2021.

However, the Gasoil to HSFO price

spread for 2020 and 2021 is still

priced within a reasonable historical range. It is nowhere nearly priced

alongside the severely stressed event

of 2008 which saw the spread move

up to $600-700/ton.

The price of HSFO may need to fall

towards the comparable price of coal to burn surplus HSFO in power stations

instead of coal in 2020 and 2021.

With thermal coal today trading at

$85/ton and with 40% more energy content in HSFO per ton, this implies a

potential decrease in HSFO towards

$120/ton. At the time of writing the

2020 HSFO price in the ARA region is $220/ton.


means that the 2020 HSFO price has potentially $100/ton further downside before it

finds solid support at the coal cost level.

If it really turns out that the market will need to burn HSFO in power stations in order to get rid of the surplus, then it also means that the total liquids supply in the global oil

market is shrinking by a comparable amount. It signifies an overall tighter global oil

market with higher oil prices. This again pushes up the Gasoil to HSFO price spread based

on the relationship described earlier.

We assume that HSFO consumption is 4 m bl/d. If demand for HSFO is only 0.8 m bl/d in

2020, 3.2 m bl/d will need to be converted to either ULSFO or Gasoil. If cokers were to

upgrade these 3.2 m bl/d of HSFO to middle distillates or more specifically Gasoil, 1.2 m

bl/d of this would be lost to Pet Coke during the process. This means a comparable tightening in the overall supply of liquids in the oil market, increased crude oil prices, and

again a higher price spread between Gasoil and HSFO.

Compliant fuel to be Gasoil 0.1%, or ULSFO 0.5%? One thing is that product price spreads are likely to blow out in 2020 and for some years

following that as the global refinery system’ upgrading capacity is stretched to its limit.

Over time however the product price spreads are likely going to revert to the spreads we

have witnessed historically for different levels of Brent crude oil prices.

The following is a table of historical average product prices for different price levels of

Brent crude oil. We assume that these historical price spreads reflects refinery

upgrading economics over time. Thus as the global refining system adjusts over time one

should comparable spreads to emerge again.

Historical prices for Brent crude and products and spreads in USD/bl and USD/ton


Assume that a “normal” oil price is to be in the range of $50-80/bl in the years to come.

Then ships using Gasoil 0.1% as compliant fuel should expect to pay a mark-up in fuel

price over HSFO in the ball-park of $250/ton. Ships which instead run on a blended mix between LSFO 1.0% and Gasoil 0.1% (44% & 56%) should expect to pay a fuel

premium of $150/ton over HSFO.

Complex refineries are however stating that they can do more than just blend LSFO and

Gasoil. They claim that they can do different kinds of upgrades of HSFO as well as partial desulphurization by “cutting” the barrel differently in the vacuum distillation process.

Some have also claimed that they have come up with desulphurization methods for HSFO

directly (Rigby Refining LLC) though we have no details of this process in terms of

quality, cost or possible volume of magnitude.

However, it seems clear that the complex refineries can do more than just plain blending

of LSFO and Gasoil. As a consequence the price of ULSFO 0.5% products should end up

being cheaper than our synthetic ULSFO 0.5% index extrapolated from LSFO and Gasoil

composition. This means that the spread between the future ULSFO 0.5% product and HSFO should be less than $150/ton in the Brent crude oil price slot of $50-80/bl range. A

wild guess would be that it ends up somewhere between a $50-100/ton mark-up above

the HSFO with Brent ref $50-80/bl.

If cokers are used to convert a 3.2 m

bl/d HSFO surplus in 2020 to Gasoil then 1.2 m bl/d of this will be lost to

Pet Coke in the process. This results in

a comparable tightening of the overall

oil market.

Product price spreads should revert to historical norms as markets eventually

normalizes. Probably not before 2025

In the longer term beyond 2025 the

ULSFO 0.5% grade should probably trade only $50-100/ton above HSFO


Recent price developments Mostly, markets are not very good at pricing upcoming events especially not digital

occurrences such as the IMO 2020 decision. When the IMO made its 2020 decision in

October 2016, it led to a rapid appreciation in the forward 2020 and 2021 Gasoil to HSFO spreads. However, there was insufficient momentum, a lack of participants, driving

this move. There was too much disbelief and distrust in the shipping community

concerning the IMO decision for the price hike to stick, especially after the ballast water

treatment issue which has dragged on for many years. As the HSFO market accounts for only 4% of global oil demand, it is a highly specialized market where most of the

participants are from within the shipping or refining industry. There is thus very little

appetite for position taking within this segment by financial, speculative participants.

Forward Gasoil to HSFO price spreads - USD/ton


Also, as the calendar 2017 spread rolled off in January 2017, calendar 2018 forward

contract became the front year spread contract. As such it became the forward contract of focus. As a consequence of being the front year spread contract it also became

increasingly associated to what happened in the spot spread developments. The spot

spread traded down to a low point in mid-2017 alongside a drop in the Brent crude oil

price. OPEC & Co’ cuts in primarily heavy sour crudes also helped to tighten up the heavy cracks which also helped to tighten up the spot spread. The forward spread for 2018

then traded down along with the declining spot spread. And lastly the forward spreads

for the years 2019, 2020 and 2021 traded as time spreads to each other and to 2018,

they were all dragged down along with the lower spot spread and the lower 2018 spread.

As the spot spread recovered strongly in H2-2017 driven by a rally in crude oil prices,

the Cal-2018 forward spread followed upwards as well and so did the forward spreads

for 2019, 2020 and 2021 etc. However, the market did fundamentally change in H2-2017 as well. In early 2017, skepticism was high. Our clients focused especially on

whether the IMO would stick to the 2020 deadline or not. This attitude changed

completely over summer 2017. Then it was no longer a question whether or not IMO

would stick to its 2020 deadline. It became instead a question of how it would play out in 2020. The 2020 deadline was largely accepted. This led to more pricing in of the IMO

event in the forward spreads.

Even if the market now has much more confidence in the 2020 deadline, we still believe

forward spreads are likely to be highly sensitive to changes in the spot spread. So, if the current fairly strong spot spread was to fall back either due to changes in spot cracks or

because of a lower Brent crude oil spot price, we think it highly likely pull-backs in the

forward spreads for calendar 2019 and 2020 onwards will also occur.

120

140

160

180

200

220

240

260

280

300

320

340N

ov-1

5

Dec

-15

Jan-

16

Feb

-16

Mar

-16

Apr

-16

May

-16

Jun-

16

Jul-1

6

Aug

-16

Sep

-16

Oct

-16

Nov

-16

Dec

-16

Jan-

17

Feb

-17

Mar

-17

Apr

-17

May

-17

Jun-

17

Jul-1

7

Aug

-17

Sep

-17

Oct

-17

Nov

-17

Dec

-17

Jan-

18

Feb

-18

Mar

-18

US

D/t

Gasoil 0.1% minus HSFO 3.5% (Barges FOB Rotterdam in USD/ton)

Y2018 Y2019 Y2020 Y2021 Spot product spread Gasoil 0.1 to HFO 3.5 in USD/t

Generally, markets are not good at pricing future events. In October, the

IMO decision led to a temporary price

jump in 2020 Gasoil to fuel oil spreads

which faded away again.

Higher Brent crude oil spot prices in H2-17 helped lift the Gasoil to fuel oil

spot price spread, which again rippled

down to affect product spread prices

for 2018, 2019 and 2020 onwards.

Forward 2020 Gasoil to fuel oil spreads are likely to remain sensitive

to spot spreads. A pull-back in Brent

crude and the spot spread is likely to

pull down forward spreads as well


Typically, the shipping sector has a two-year horizon for forward fuel hedging. With less

than two years to 2020, its hedging activity will start to impact pricing of products in

2020. Normally the shipping sector would have begun to purchase forward 2020 HSFO contracts by now. Instead they will buy Gasoil 0.1% on a 2020 forward 2020 hedging

basis or nothing at all. This will make the refineries product books more and more

skewed with no offset for their projected production of HSFO in 2020. Consequently, the

forward spread will widen to counter and reflect their skewed books.

Forward Gasoil, HSFO and spread prices - USD/ton


However, forward pricing of the event is in our view likely to be muted compared to the

actual 2020 spot event. So, partial pricing of the event on a forward basis will take place

until mid-2019. From mid-2019, the 2020 deadline will increasingly start to be reflected

in the spot spread as tanks are emptied and cleaned with ships starting the transition. As the event starts to be reflected in the spot spread it will immediately be comparably

reflected in forward spreads as well.

Since there is likely to be a huge surplus of HSFO in 2020, storage facilities for such fuel

must be emptied as much as possible to make room for the surplus set to hit the market in 2020. Therefore, HSFO needs to be sold cheaply in H2-19 to draw down HSFO stocks

as much as they can be to create space for the 2020 surplus. Another way to look at it is

that the Gasoil to HSFO spread needs to widen out in order to facilitate maximum

conversion of HSFO to Gasoil ahead of the 2020 date line which will help to draw down HSFO stocks.

As the HSFO surplus hits the market in 2020, stocks of the fuel are likely to rise strongly

which should result in a deep contango pricing of HSFO in 2020.

As we write, HSFO 3.5% is priced at $230/ton for 2020 delivery. In our view it seems plausible and likely that the market will run a significant surplus of HSFO in 2020 as

demand drops from around 4 m bl/d to less than 1 m bl/d and maybe as low as 0.3 m bl/d

during the same year. We do not expect many scrubbers on the global shipping fleet in

2020. There will be insufficient capacity to convert it to compliant fuel. As it is impossible to store a large and growing surplus of HSFO, the remaining option is probably to burn it

in power stations instead of coal. In our view, this exit would require the HSFO price to

fall towards $120/ton.

Down the scrubber route unless they are forbidden We believe that unless scrubbers are forbidden there is a considerable risk that the

global shipping fleet will gradually or rapidly install scrubbers from 2020. This is not because it is an optimal long-term solution but because it will be too tempting to let it

pass. In our view, come 2020 the HSFO to ULSFO 0.5% (or Gasoil 0.5%) price spread

341

293

240 25

9

263

557

551

550

542

540

216

257

310

283

277

0

100

200

300

400

500

600

2018 2019 2020 2021 2022

US

D/t

on

HSFO3.5% Barges FOB Rot Gasoil 0.1% Barges FOB Rot Gasoil 0.1% minus HSFO 3.5% in USD/ton

The HSFO market is dominated by industry participants from shipping

and refining with little pure financial

speculative activity. The market is too

small and illiquid for most financial participants.

Pricing of the event is likely to be a

two-step process. Forward pricing ahead of the event, which will likely be

muted. Then as we get to H2-2017

the event will start to unfold in the

spot spread. This will then immediately be reflected in the

forward spreads for 2020 onwards.

That is likely to be the most explosive

part of the price event.

A significant surplus of HSFO is likely

in 2020, resulting in deep contango

and most likely a drop in the HSFO price from currently $230/ton to

$120/ton enabling the surplus HSFO

to compete with coal and be burned

off in power stations with on-shore scrubbers.

It will be too profitable and too tempting not to install a scrubber in

2020


will widen out considerably. Charterers looking to choose between two ships will

naturally select the one that incurs the lowest cost fuel. Ships using low cost HSFO and a

scrubber should be able to negotiate a higher freight rate than no-scrubber ships.

The added freight premium for ships running scrubbers should be close to the difference

in compliant 0.5% sulphur fuel and HSFO. Whether that will be the difference between

ULSFO 0.5% and HSFO or Gasoil 0.5% to HSFO will depend on which compliant fuel is

dominant in each shipping segment.

If we assume that a shipping segment is predominantly run without scrubbers with a

clearing freight rate of $10,000/day (fuel not included). Further that fuel consumption is

50 ton/day, low cost HSFO is $235/ton, and higher cost ULSFO is $445/ton. Then the

scrubber ship should be able to obtain a freight rate $20,500/ton vs. the non-scrubber ship, which only receives $10,000/day. The difference is given by: 50*(445-235). Thus

scrubber-ships should ideally be able to negotiate a freight premium of $10,500/day on

top of the $10,000/day due to its lower fuel cost. It would look like this:

Non Scrubber ship at the margin. Large premium for scrubber ship with low cost fuel

Source: SEB

In this situation we think that it will be far too tempting to install a scrubber for those

ships which can do so. It is likely going to be a slippery slope that includes a gradual

increase in the number of scrubbers within the shipping segment.

However, the moment the dominant share of the shipping market in a given shipping segment is set by scrubber ships then the going freight cost will be set by scrubber + low

cost HSFO. The ships that then still run without a scrubber will then be at a clear

disadvantage.

Assume the the cleared freight rate is still $10,000/day (fuel not included) when scrubber ships are clearing the market. The non-scrubber ship running on expensive

HSFO/Gasoil would then have to accept a freight price reduction equal to high cost to low

cost fuel price times 50 tons per day.

If we assume that the price picture is a little different when the scrubber solution is setting the price with HSFO at $330/ton and ULSFO 0.5% at $480/ton then we get that

the non-scrubber-ship will have to accept a rebate of 50*(480 – 330) = $7,500/day

versus the clearing freight rate of $10,000/day. It would thus only be left with a freight

income per day of $2,500/day which of course would be totally unsustainable. It would look like this:

10,000

20,500

22,250

11,750

-

5,000

10,000

15,000

20,000

25,000

30,000

35,000

Total Charter cost with Hybrid fuel in 2020 (USD/d) Total Charter cost with HSFO 3.5% in 2020 (USD/d)

Tota

l Ch

arte

r co

st in

US

D/D

ay

VLCC freight rate in USD/Day Fuel cost for 50 ton/Day

Freight premium of running with a

scrubber should be proportional to the fuel price spread between the

dominant non-scrubber fuel used in a

shipping segment and the HSFO price

Scrubber premium shifts to non-

scrubber pain when/if scrubbers are

the dominant solution in a freight

segment

Non-scrubber ships will hardly be able

to operate in within a segment

dominated by scrubber ships


Scrubber ship trades at the margin. Large penalty for non-scrubber ship

Source: SEB

So, in the first couple of years between 2020 and 2023, it is likely going to be very

profitable to install a scrubber as long as the overall freight cost and rate are set by non-scrubber ships with high cost fuel. That will likely encourage one ship-owner after

another to install scrubbers. It will be too economically tempting. Those who do install

scrubbers during this period are likely going to be able to pay down their scrubber capex

costs within a couple of years.

Those who instead wait until scrubbers are dominant with low cost fuels setting the

overall freight cost in the market will have to install a scrubber out of necessity since

they no longer can compete in the market without a scrubber. Ship owners installing

scrubbers at a late stage right before their segment competitively shifts over to clear on scrubber-ships + HSFO will likely face total sunk costs for their scrubber installations.

The time period where they can charge above normal freight rates due to scrubber and

low cost fuel usage on their ships would be very short.

The speed at which the current global shipping fleet is retrofitted with scrubbers will matter considerably to shipowners. Let’s assume that retrofitting for the whole fleet

happened overnight to 2020. Then the total market would immediately progress to a

stage where scrubber-ships clear the market with low cost HSFO. In this extreme case

the world’s shipowners would have to foot a total scrubber installation bill of $100-300bn. It would all be sunk cost with no pass-through to charterers.

If we assume instead that it takes 10 years to reach 80% penetration for scrubbers. In

that case, the market will not tip over into scrubber-clearing before 2030. This will allow

10 years for scrubber-ships to fetch an above market freight rate and so cover their scrubber installation costs. One then would assume that a lot of ships would have been

able to install a scrubber and fetch above market freight rates long enough to pay them

down.

The global freight market market is however highly fragmented. As such the uptake of scrubbers by the individual segments is what matters. There are for example only about

2000 large crude carriers. Thus one would probably only need to install some 1500

scrubbers before this segment tipped over to scrubber-ships setting the price.

2,500

10,000

24,000

16,500

-

5,000

10,000

15,000

20,000

25,000

30,000

35,000

Total Charter cost with Hybrid fuel from 2024 (USD/d) Total Charter cost with HSFO 3.5% from 2024(USD/d)

Tota

l ch

arte

r co

st in

US

D/D

ay

VLCC freight rate in USD/Day Fuel cost for 50 ton/Day

All non-scrubber ships should be fine in the first couple of years from 2020

If scrubbers are the market solution

then a long transition is the best for the

global fleet. But for the individual

shipowners a fast implementation is the best


Summing up The IMO 2020 deadline is firm. We expect that less than 2000 ships will be equipped

with scrubbers by 2020 and as a consequence that most of today’s 4 m bl/d of HSFO

marine consumption will have to shift to ULSFO 0.5% or Gasoil 0.1%.

We expect the world’ global refinery upgrading capacity to be pushed to its limit and as a

consequence the price spreads between light and heavy products will widen

significantly. We expect the Gasoil 0.1% to HSFO 3.5% spread to widen to more than

$450/bl as we get to spot price delivery in H2-2019 and 2020.

A strained refinery upgrading capacity with the market craving for more middle

distillates will lead to stronger demand for light sweet crudes like Brent crude which

typically are rich on middle distillates components. There is clearly a potential to a larger

or lesser degree for a 2008 like repetition where strong middle distillate demand led to an upwards price spiral between Brent crude and gasoil with Brent peaking at $148/bl

by mid-2008.

We expect refinery upgrading capacities to be maxed out and as such not be able to

convert all that is needed of HSFO to legally compliant fuels in 2020. There should thus be a significant surplus of HSFO (or refinery residue) in 2020 and we thus expects the

price of this product to collapse down towards $120/ton (coal price energy equivalent)

in order for surplus HSFO to be burned off in power stations with onshore scrubbers.

A significant widening in the light to heavy product spreads is needed in order to drive a change to lower sulphur emissions through capex spending by either refineries or the

shipping community. The IMO will likely look kindly at such a product price development.

A disruption is however not at all what the IMO is looking for. Transitional measures are

thus likely to emerge from the IMO in order to reduce the risk for the most sever possible outcomes of product price spread blow outs and Brent crude oil price spike.

Ships equipped with scrubbers should be able to earn a significant extra premium in

2020 and the first years following that. The premium is likely to be equal to the fuel price

spread between HSFO and whatever is the dominant compliant fuel in each shipping segment. If the compliant fuel in a given shipping segment is Gasoil 0.1% then the

premium is likely to be equal to the Gasoil to HSFO spread times tons of consumption per

day. If however the dominant compliant fuel is the cheaper ULSFO 0.5% then the

premium is going to be proportional to the ULSFO 0.5% to HSFO 3.5% price spread instead.

Installing a scrubber on a ship only takes a few weeks. Building a new refinery upgrading

unit instead typically takes up to five years. This clear asymmetry between capex

spending between the two sectors leads us to the conclusion that when product price spreads blows out in 2020 and sends strong investment signals to the two sectors then

the primary capex move will take place within the shipping segment and scrubbers will

be installed. It will be too tempting to install a scrubber. It will be too lucrative.

We expect scrubber ships running on HSFO to earn a significant freight premium as long as they are in minority within their segment. However, as soon as scrubbers and low cost

fuel (HSFO) becomes the dominant solution within a segment there will no longer be any

premium for having a scrubber. There will only be a penalty and a pain if you don’t have

it.

The coming ULSFO 0.5% fuel grade will likely trade close to Gasoil 0.1% at the start in

2020 as supply is likely to be on the short side and it will be priced according to its

alternative. Over time, as capex is spent on both scrubbers and refinery upgrading

capacity, the light to heavy price spreads should revert to their historical norms with respect to different Brent crude oil price levels. Over time we expect ULSFO 0.5% to

trade at a premium of $50-100/ton above HSFO (maximum $150/ton above) with a

Brent crude oil reference level of $50-80/bl.

Ships running with scrubbers from the start of 2020 may face some problems of HSFO availability in all ports. Demand will be very low and all ports may not bother supplying

the fuel. The main ports are however highly likely to supply HSFO in 2020. Refineries do

need to get rid of their residue production. So if someone will buy it then the refineries

will sell it.

Few scrubbers in 2020

We expect the Gasoil to HSFO spread

to widen to above $450/ton in 2020

Brent crude oil is likely to be affected

by the 2020 transition and move higher

The HSFO price needs to move down

to energy price parity with coal in

2020

IMO wants change but no disruption

Transitional measures in 2020 likely

High scrubber investment return in 2020 and the following 2-3 years

Scrubber investments will be too tempting to resist in 2020

Late scrubber investments may be

sunk cost

ULSFO 0.5% to trade close to Gasoil in

2020 as an alternative cost/price.

Availability of HSFO may be an issue

for scrubber ships in 2020


The road ahead Going forward we expect increasing clarity with respect to the quality and availability of

compliant non-scrubber fuel being ULSFO 0.5%. It will be in the interest of the refineries

to produce as much as possible of the ULSFO 0.5% in order to get rid of their heavy residue. Selling Gasoil will not solve their problem since they will not have enough

upgrading capacity to convert 4 m bl/d of HSFO to Gasoil (or middle distillates).

It is very difficult for markets to price in future events which deviate from historical

norms. As such we do not expect the forward market to price in a $450/ton or higher Gasoil to HSFO spread until we get to mid-2019 when we expect to see the new

regulations increasingly being reflected fundamentally and physically in a much wider

spot spread. Until then the forward pricing of the 2020 spread is likely to shift around

along with higher or lower Brent crude oil prices and the spot Gasoil to HSFO spread as well as varying regulatory IMO signals.

If refineries can make a large amount of ULSFO 0.5% with adequate quality by 2020

then most shipping segments which today runs on HSFO will in 2020 instead run on

ULSFO 0.5%. In that case the total added cost to freight in 2020 will be proportional to the ULSFO to HSFO spread rather than the Gasoil to HSFO spread. The profitability of a

scrubber will likewise be proportional to the ULSFO to HSFO spread. If refineries cannot

make a lot of ULSFO 0.5% then the Gasoil to HSFO spread will instead be what matters

and will thus be the measuring yardstick for scrubber profitability with Gasoil or a Gasoil like fuel to be the marginal fuel in most shipping segments. Our view is tilted towards the

latter scenario with Gasoil predominantly being on the freight cost margin in 2020.

Developments in the global crude oil market will be important for the spot and forward

spreads. Lower crude oil prices means lower Gasoil to HSFO spreads which again means lower 2020 forward Gasoil to HSFO spreads. Likewise a strong crude oil market will

drive spot spreads and 2020 forward spreads higher. There is clearly a risk that a

significant shift by the global shipping fleet towards Gasoil in 2020 could lead to a 2008-

like situation in 2020 where Gasoil prices and light sweet crude oil prices chase each other in an upwards spiral.

With current clarity that there will be few ships with scrubbers and thus that almost all

prior HSFO shipping segments will be either cleared by ULSFO 0.5% or Gasoil in 2020

and that IMO’ 2020 decision is firm it may suddenly make sense to be an early scrubber adopter. An early adopter will now be able to take advantage of wide product spreads in

2020 and the few years after that. More precisely a scrubber-ship will be able to take

advantage of a freight market where total freight costs are cleared on a high cost fuel

while a scrubber ship will run on low cost HSFO. This will help to pay down the scrubber investment quickly and before the penetration of scrubbers in a given shipping segment

drives the whole segment over to clear on low cost HSFO. We are thus likely going to see

more interest in installing scrubbers going forward. Especially in smaller, narrower

shipping segments which can more quickly tip over to clear on low cost HSFO if enough ships in the segment are equipped with a scrubber. The risk for such a strategy is the

longer term outlook for the availability for HSFO.

The longer term outlook for marine fuel supply is however foggy. Will there be a HSFO

market in the longer term or will it be too small to sustain as the larger share of ships moves to ULSFO 0.5%? Already today the marine HSFO 3.5% market is very small as it

only accounts for a mere 4% of global demand. If demand shrinks to only 1 m bl/d it will

only constitute 1% of global demand. It will however be the dirtiest of the lot. If there are

enough ships with scrubbers to consume 1 m bl/d then they will definitely be consuming the bottom of the bottom of the barrel. As such they may be an important solution for the

world’s refineries in terms of the disposal of their residue and thus a market which they

then will want to maintain and keep alive. Also, the world’s refineries will always have a

choice between feeding their residue through an upgrader or selling it as HSFO. If the demand and price for HSFO is good enough they’ll rather sell their residue as HSFO.

Over time as we have well passed the 2020 time line plus a few years we expect

product spreads gradually to revert back to their historical norms with respect to

relative Brent crude oil price levels as depicted in the table on page 22 since these historical spreads in our view typically reflects fundamental refinery economics of

conversions and upgrading. Howe quickly is again a huge uncertainty with respect to a

potential scrubber investment or investments in refinery upgrading units.

Refineries are likely to try to make as much ULSFO 0.5% as possible in order

to get rid of their surplus residue.

Market will not price the event

properly before the event hits the

Gasoil to HSFO spot spread

Will most shipping segments clear on Gasoil or ULSFO 0.5%? It will for sure

not clear on HSFO 3.5% in 2020 as

hardly any ships will have a scrubber

Tight or loose crude oil market with

high or low crude oil prices will impact

spot spreads and forward pricing

ahead of the 2020 date line

Early scrubber adoption may now be a winning strategy as the 2020

deadline now is a done deal and there

will clearly be very few scrubber-ships

in the market in 2020 making freight markets clear on either Gasoil or

ULSFO 0.5%

The longer term fuel availability

outlook for HSFO is however foggy and

is likely going to hold back scrubber

investments.

Oil product spreads to revert back to historical averages over time

reflecting the underlying refining

economics


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Commodity Research

Bjarne Schieldrop, Chief Commodity Analyst

[email protected]

+47 9248 9230

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