IMO 2020: Holiday Gift Guide, No SOx

So if we continue to operate under that premise, maybe it's a draw. Okay, fine, that works. What are you looking forward to about the change of the decade in the new year. Well, clearly it's going to be I m O when new regulations come into force for the global shipping industry. Clearly joining us today in the studio is Richard Chatterton, who is our lead oil analysts, and Richard's actually based out of our Singapore office. Mark and I had a business trip to Singapore last year around

the New Year. And Mark, what do you remember most about Singapore chili crab? Yeah, it was really tasty. Apparently it doesn't come from Singapore though, Um, I don't know. Maybe maybe a thin from Singapore. They can correct me on that, but yeah, tall buildings, I don't know. In the Merlin, don't forget the half Mermaid, half Lion. Well, the thing I remember most of all about Singapore is when you look outside the window and you're flying in,

you see ships in that bay. More ships and maybe I've ever seen anywhere, and I actually grew up in northern California. I've seen quite a few ships in San Francisco Bay. But Singapore, You've got more ships in one bay than I even thought was possible. So it is perfect that we have Richard Chatterin joining us today to talk about shipping. UH and I am ow we actually

write a monthly report about im. If you would like to read it, you can find it on the Bloomberg terminal at b NF, go on bn F dot com, or on the b NF mobile app. And if you're already turning this podcast off thinking it's about shipping it's not for me, well you'll find out pretty quickly that this really applies to pretty much every sector. So have a listen, stay tuned, and UH, let's jump in with Richard.

As a reminder, biennyf does not provide investment or strategy advice, and you can hear a full disclaimer at the end of the show. Now let's jump in with Richard. Hi, rich thank you for joining us today. Thank you for having me. I am O is a phrase that I was not familiar with until this year, but is pretty much well anybody can talk about in the shipping industry at the moment. Can you please tell us what it is? Well? Being an oil analyst, it's pretty much the only thing

that I've worked on for the past twelve months. Um, i'm is the most important regulatory changed to impacts or reported markets for decades. It's is creating significant disruption and complications for the shipping industry, but it's also a big deal for the refining sector. So from the first of Jan the sulfur fuel content specification as regulated by the International Maritime Organization will fall from three point five per

cent SUL for contents to zero point content. Now, that is a really really big shift to put into context. Sulfur has been regulated out of pretty much every other sector where oil is used. Why because it's a very undesirable pollutant that causes localized devolution in an urban setting. If you look at the regulations which which have come into force over the past decades to to to reduce the sulfur content of road fuels, which were quite significant.

Um if we go back to the seventies, eighties and early nineties, they were causing acid rain. It's it's it's really something that's undesirable. So regulators acted to to to push down the sulfur content of of road fuels and other phosphors which are used in built up areas. What this then resulted in Thore is that refiners are faced with the problem when you when you look at what's in a barrel of oil hydrocarbons, and there's impurity. Is

one of the key impurities of sulfur um. If you push sulfur out of the u of the of the barrel, across across diesel, across gasoline, across kerosene um, it ends up in the bottom of the barrel, the residual, so to speak, which is the main source of supply for the for the bunker market for shipping fuels. So what you've ended up with is this concentration of sulfur emissions

from oil essentially accumulating in shipping fuel. Interesting statistic is the fifteen of the largest ships actually admit more sulfur than all of the world's cars now because the regulation around road fuels is so stringent and the and the absence of regulation for shipping fuels means that suff emissions

in the in the ship industry un constraint. So this is the first time, from the first chance with the first time that sulfur content will be regulated to a meaningful degree, and that is causing causing some big challenges. But it's been a step change coming for some time, hasn't it. It has, but this is the first time

that it is creating a pain point. This is the first time that shipping companies are having to install equipment to to comply with with more stringent regulations, and it's the first time that the refining system is having to significantly reconfigure and having to significantly react to a new standard, which which will require a wholesale re engineering of the marine fuel supply infrastructure. Um So there are different ways

that you can comply. From the beginning of the year, you can either just buy low sulfur fuels, but you can also install a few if you're a vessel operator, instead of buying low so for fuel, which may be more expensive, you can install a piece of kit on your ship to scrub the sulfur emissions from the flu gasses. These are these exhaust gas cleaning systems or scrubbers for shorts,

which costs money. Like maybe it can be it can be several million dollars to install one of these things, and the challenges that there are only a few companies that have the capacity to to install scrubbers. These scrubbers have been pretty common placed in the power sector for some years now. Are the same companies that installed them? There are the same ones that install them on chips um.

It's a good question. I think that a lot of the technology is the same, but the main companies are marine technology companies or mean engineering companies, your Apple vowls, your what Sillers, your Yarra marine. But there's no doubt that they also in a sell into the supply chain that that provides similar equipment of stationary stationary application. So if I'm a stationary provider, should I see this as

an opportunity? Well, a lot of people saw this as an opportunity for UM, the for the marine engineering companies. And we did see sort of in the run up to IM or in the run up to the discussions maybe last year and early part of you saw significant increases in the share prices of some of these companies. But the expectations for scrub adoption have actually fallen off

some what and I'll tell you why. What what you've had is is this sort of face off between the refining system and the shipping industry as to who acts first.

It's kind of a bit of a first movie disadvantage, right, if you're absolutely if you if if you're if you're one of the big vessel operators or shipping companies, if you install scrubbers on all your vessels in the expectation that UM, you're gonna you're gonna make more money by complying that way, I should probably explain the rationale to install a scrub on your vessel is because you would assume that the high soul for fuel which you will

then be able to continue burning. Because remember you're scrubbing the solfa on your ship. You're so you're still in compliance. You're reducing your sulf emissions, but you can still buy the high sulfur fuel, which should trade at a discount to the compliant fuel which has had to go through more extensive refining processes. Um, the gamble that you're making is that the multimillion dollar investments to restore the scrubb but will be paid off over time by the lower

fuel costs. All right, So you you're essentially taking a bet on the outlook for fuel prices. However, if the refining system does one of two things, if they increase the supply of compliant fuel to such an extent that there isn't really a price spread between high sulf and low suff for fuels, then it might not be worth it all the scrubbers. But then, on the other hand, it just might not be possible to buy high sulfur fuel over a period of time. If you think about it.

You know, in the revual sector, was the last time you ever saw leaded petrol for so it gets regulated out of the market. Suppliers will you know, will will will respond if the market diminishes to certain extent, and if they have infrastructure constraints or they only have one barge that they can use to rebunk of vessels in

a particular location. They might just not offer high sulfur fuel oil in a particular place, which means it doesn't matter if you have your scrubble or not, you're still gonna have to pay for the for the compliant fuel. So as a result, you've had a kind of very slow decision making process from the shipping industry as to how many scrubbers were going to install, and we've got

closer from collection close to the deadline. Earlier this year, there were some big estimates that were put out there by by other by other analysts, five six thousand scrubbers by numbers always been around about three three and a half thousands. We think by the end of the year of the number will be about three thousands. So that means about one in ten large ships will have one intent. Ships not the largest ships will one intent. Of the

marine fleet will have have a scrubber installed. That means that there's the st equilibrium that we've got to write where companies are sort of hedging their bets. They're installing a few scrubbers here, and they're they're gonna they're gonna they're gonna buy compliant fuel for the rest of their fleet, and what they're um, well, they're What they're essentially going to do is wait and see see what happens to

the price breads. So if you're a Lavello, what Silla and you were making, people were making big bets on the number of scrubbers that you were going to sell over this period of time, you're you've probably been disappointed by how this has turned out. But the scrubbers do have some advantages, don't they In terms of timelines for

the actual ships. Scribbers have a number of disadvantages. I would say they probably, I think, I think in terms of in terms of operational um in terms of operational flexibility, scrubbers provide ships with less risks in terms of bunkering operations. Because you could argue that in certain places from January one, it won't be possible to get a hold of piint fuel. We can go into this amite, but I actually don't think that's going to be the case. In most major

bring reports that is going to be availability. But if you were worried about that, you could say it installing the scrubber means it's less likely that I'll have any issues with getting hold of the pliant fuel. But the downside is there are operational challenges with having scrub on board. It's a complex piece of kit which usually need to have. You need to have a certain degree of expertise and

training for the crew to operate. There are inputs that you need to You need to you need to feed these things with with re agents, with soda ash lime. You also have an issue with wash water and this is going to become a bigger issue I think over the coming years. There are two types of well, the three types of scrubber. There's an open loop scrubber, there's

a close loop scrubber, and there's a hybrid scrubber. The names sort of sort of our self explanatory and openly scruber, but it does as it pushes water in through an inflow through the flu gasses, dissolves the sult of content in the in the exhaust gases, and then it just chucks the water out into the sea. A closed loop scrubber it's the same process, but you have as a self contained closed loop where you have storage tank on board and there is no there is no discharge and

the hybrid allows you to switch between the two. Difficult thing about having closed scruber is that aim more expensive and be the second more space on the vessel. The problem with an open loop scrubber is that it's not very nice. It sounds like there's any scrubber eventually, Rightly, what you actually want to push towards is compliant fuel,

right absolutely. I mean, if you're an environmental advocate, well, I think I think in terms of the way that the regulation has been structured, it's it's been a bit of a compromise, because that in prinsible, it should just be we're moving to a lower um sour fur specification for fuels, let's let's get it done. But the argument was we have to give the industry a pathway to adapt, a pathway to be able to to to transition to that lower spec over time, and scrubbers allow you to

do that. I think that in terms of the impact of our mo we don't want to we don't focus too much on scrubbers because they are they are kind of a only only only only part of the equation. What you have with the economics of scrubbers is really a temporary trend. One of these things, like I said, costs a few million books, and you're you're betting on there being a spread between the price of the high sulfur and low sulfur fuels. That spread is now really

really significant. It's two hundred and fifty per ton. We calculated that at a hundred and seventy five to two hundred dollars, you can pay back one of these things, and under two years two you're you're you're pushing closer towards eighteen month payback. So really, you know that that's that's that's that's going to probably pay off the three thousands that that that are that are that are going

to be stored by the end of the year. We think around about three thousand, seven hundred thousand, eight hundred are going to be installed in total over the next Over the next year or so, it also just seems like more time to allow for compliance fuel supply to

build up. Yeah, well this is the thing, like after that, you know, year eighteen months is up and those those investments have been paid off, you're probably not gonna write I want to install the scouple because you're not gonna able to get hold of the three point five fuel, are not gonna able to get hold of the dirty stuff, so you might as well, you might as well, um, look beyond this, this this transition technology and think think

longer term about how you comply with with tightening regulations. There's also a risk and this is this is going beyond the current market question. But what's going to happen post I Naturally there's going to be a push toward even more stringent targets, perhaps constructs on carbon emissions as well as sulfur content of fuels, which is causing a lot of shiping companies to lose sleep Can we talk about that for a second, Like regulations and center of

mass or where things are going? Who is enforcing these rules? Right? So is it just kind of consensus or did they ratify something the shipping companies or what are the loosing sleepover? If they say just forget it, I'm just not gonna comply, who's going to say anything. There's there's two sectors which sort of fall outside of the full stool cracks you say, of the global climate policy debate. When you look at

the Paris Agreement, it's structured around country level targets. So each country adopts a golfer its long term carbon low carbon pathway. International aviation and international shipping are the two sectors which fall outside of that framework, because which country we're talking about, which country is responsible for those for for those missions and for that, for that, for that

fuel consumption. So what you have is a is a sort of delegation of the of the of the of the climate policy framework to the multilateral institutions which are most well aligned and most well positioned to be able to carry the the issue um into some form of regulatory framework. So for aviation you have i k OH it's the International Civil Aviation Organization, and for shipping you have the IMO. And the IMO operates in very much the same way as as the UN Framework Commational Climate Change.

It's a multilateral organization. They have they have periodic meetings, they have working groups, they have a number of leading voices have they have different UM country groupings and and coalitions which which which take on opposing positions and that and that drive the debate. So enforcement of this is driven through the IMO framework. To answer the question directly,

enforcements is based at the flag state level. So in theory, if if if a ship is noncompliant, for a ship is in some way breaking the rules, the procedure is to report that ship to the flag states, and the flag state is then obligated onto the IMO framework to act.

The problem is that most flag states don't have the institutional capacity to do so because most ships are actually flout in quite random parts of the world Mauritius, Liberia, Panama, major flag states, and it's mainly because of various tax reasons. But but as a result it's it's it's kind of an ineffective compliance framework for anything which is going to create a meaningful, meaningful disruption or require meaningful levels of policing.

So there is a discussion underwear them many about what to do about this. Do you shift the burden of compliance onto the ports state? Which is one way of thinking about it. So if you dock your vessel in Singapore, if you dot your vessel in Rotterdam, if you dot your vessel in the UK, would the authorities in that jurisdiction have the have have the ability under the IMO framework to impost sanctions or or to to impound vessels to to to do what's necessary to enforce compliance. That

is an unresolved discussion at this time. Is that way their industries or other people, investors, companies are interested in this because if it transitions to the port country, right, and my goods are being held up in port or outside of port, then that affects me. My deliveries are not being shipped, right. So is that why non shippers are worried about I M O or is there something else?

I think that the main reason why people people paying attention to this is because it is likely to and already is increasing the cost structure of the shipping industry, so increasing the cost of shipping my stuff wherever. Yeah, the compliance issue is a bit of a red heron

because most people are going to comply. The reason why most people are going to comply is because the companies involved here are major companies, especially on the container sides, on the tankering side, They're just not gonna They're not gonna risk the reputational damage that non compliance would would entail. If if we're talking about small merchant vessels that are that are that are moving between ports in the region, that they are probably going to get away with it,

then yeah, there's going to be non compliance. But we're talking in terms of tons of fuel. We're talking we're talking small numbers that the major components of demand in the international shipping segment are contain a line as tankers which are going between major ports, and therefore we're gonna we're gonna likely see high high compliance rates across across

the volumes that matter. The cost structure question is really interesting one because the global shipping industry, I'll take a step back, there has been a really surprising coalition of support for the IS and I followed I've followed through my career the climate negotiations and regulatory um discussions at the international level for many years, and and and and has never ever been a situation that I've seen where governments and business and civil society all agree on the

approach that's being taken and wanted to be implemented as intended. If you look at at the aviation discussion in comparison, there's there's a huge disconnect between the principles that the regulators want to work toward and what the aviation industry want because there is no credible pathway the for the aviation to reduce CEO two emissions, which is the discussion

under the IK framework at the moment. For though, the reason why the shipping industry are on board is because there's a big surplus of capacity in the market, and it's been there pretty much the financial crisis. For all the vance crisis is very high increase in the rate of ship building. That overhang is still really really depressing shipping rates globally across almost all segments, but particularly in the tank, in the in the in the bulk carrier segment.

So if you're MASK or CMA, CGM or Happy gloydal one of the other big container container liners, or if your costco um or one of the other big book carriers, what you what you want is to you want to flush out the smaller players. You want to try and get rid of that over capacity. So what this what this is, What this does is it increases the cost structure of the industry. The people who are less equipped to deal with that increase in costs are smaller players.

They you're going to get out of business first. You might have a little bit of pain if you're one of the one of the bigger players, but it's going to be to your benefit ultimately because because hopefully the whole market can be brought back into balance. So um So, I think that in terms of cost the too dynamics of play one is the fuel costs going to go up, But we're not talking a huge amount here. We're talking for a container to be shipped Fromrottenham Singapore's approximately an

increase of fifty And I live in Singapore. When I moved out of there, moving my stuff costs thousands of dollars in containers, So you know, we're talking about um a couple of percentage points in terms of in terms of the cost of transporting goods. However, the real shift or potential shift in the cost of shipping is not

going to come from increased fuel prices. It's going to become from come from a tightening of capacity in the shipping market, which I'm is not in itself going to bring about, but it's definitely going to It's definitely going to work in that direction. What are you watching for on January one? What are you going to know on

January one that you don't know now? The first thing I'm going to do when I open up my blooming terminal on the first day, first first trading day of the year is to look at the price bread between high sulfur and low sulfur fuel oil, because that is the key indication of the extent of the dislocation in the market that this is causing. It reflects the balance

of availability of complying fuel with noncomplying fuel. It also gives you an indication of how how refiners are going to respond and what refiners are essentially faced with in

terms of the pricing environment. So what happens from the first of January will define how the dynamics of the down stream economics will look for a period of time, and and the question will then be how big is that dislocation and how likely is that dis location to persist, Because that's gonna that's going to create trading opportunities, it's gonna it's going to create interesting unusual movements of crude and products around the world. Potentially, there's also the potential

for this to actually impact diesel prices quite consistantly. One of the big question marks that's been hanging over the market all year is will in increased diesel prices? Overall we've had this question from a number of clients that don't really have any interest in shipping. They just want to make sure that the cost of diesel doesn't go up. The expectation has been that it would. The expectation has been that there will be an increase in middle distillate demand.

Middle distillance is the casual term for diesel, for kerosene, for gas oil, for that middle cut of the barrel. And there has been this expectation that that because of I'm more of the little distilate supply will have to be pushed into into the into the marine sector. So far, that doesn't look like it's the case so far. What

we're actually seeing as the opposite. There's weak demand fundamentals for diesel because of the China US trade war, because of weak economic growth fundamentals, because there's been particular softening of de bands for diesel in India over the last few months. That's actually having a much more of an impact on on refining margins and middle of su prices than I am owas at the moment, whether or not come first of Johnny that that switches will make boos.

Thank you so much for joining us today, and I think we look forward in actually having you back after the first of Jan and this has actually all had some time for the dusk to settle, or maybe the sulfur to settle, if you will, Um, Thank you so much for joining us today. Rich thanks for having Bloomberg an app is a service provided by Bloomberg Finance LP

and its affiliates. This recording does not constitute north would be construed as investment advice, investment recommendations, or a recommendation as to an investment or other strategy. Bloomberginny F should not be considered as information sufficient upon which to base

an investment decision. Neither Bloomberg Finance LP nor any of its affiliates makes any representation or warranty as to the accuracy or completeness of the information contained in this recording, and any liability as a result of this recording is expressly disclaimed.