Note: This report was originally published on January 20th on Value Investor’s Edge, a Seeking Alpha subscription service.
What Is IMO 2020?
The decision to implement a global sulfur cap of 0.50% m/m (mass/mass) in 2020, revising the current 3.5% cap, was announced by the International Maritime Organization, or IMO, the United Nations regulatory authority for international shipping on October 27, 2016.
This will affect as many as 70,000 ships and went into effect on January 1 of 2020.
The IMO provided guidance on how the maritime industry might comply:
Ships can meet the requirement by using low-sulphur compliant fuel oil. An increasing number of ships are also using gas as a fuel as when ignited it leads to negligible sulphur oxide emissions. This has been recognised in the development by IMO of the International Code for Ships using Gases and other Low Flashpoint Fuels (the IGF Code), which was adopted in 2015. Another alternative fuel is methanol which is being used on some short sea services.
Ships may also meet the SOx emission requirements by using approved equivalent methods, such as exhaust gas cleaning systems or “scrubbers,” which “clean” the emissions before they are released into the atmosphere. In this case, the equivalent arrangement must be approved by the ship’s administration (the flag state).
Since the announcement of IMO 2020, I have spilled quite a bit of virtual ink as we attempted to divine what the market would do upon implementation.
With no historic guidance on how a shift of this magnitude would impact the shipping industry, crude oil prices, refiners, available vessel supply, and even the global marketplace at large, there were quite a few moving parts to cover.
While IMO 2020 was touched on several times in numerous reports I published, here are the main reports dealing specifically with IMO 2020 in chronological order.
Following these reports, my position had pretty much been publicly declared. I have repeated it several times that the market will solve the issue and therefore:
“The degree of retirements and/or slow steaming induced by this mandate will be directly related to the cost of bunker fuel and older vessel maintenance balanced against any rise (or fall) in charter rates.”
Since 2017, we have maintained that there will only be regional shortages of bunker fuel which will be solved quickly through astute arbitrage players. Bunker prices will not spike to the stratosphere and, therefore, slow steaming, based on economics, will be very limited. You can see the report “Shipping’s 2020 Sulfur Cap: A Popular Question Is Answered” for that specific academic study showing negligible speed adjustments unless we see very significant bunker price movements (which were not forecast).
Any retirements induced by this mandate will be carried out in more of an ebb and flow manner rather than a collective knee-jerk reaction. A knee-jerk reaction in demos would create an equal knee-jerk reaction in pulling back potential retirements as charter rates would rise based on this sudden supply side shift, and owners would hold on to older vessels.
We projected that there will be no mass scrapping leading up to or at the start of the year as market expectations at large continue to improve. Higher rates would mitigate/negate increasing on the water operating costs which could, therefore, actually serve to keep older tonnage on the water.
This was our stance: higher but not outrageous MGO prices with short-term regional shortages. Minimal speed adjustments. Much lower than expected scrapping as higher rates serve to negate increased voyage expenses across many classes, with dry bulk looking the most vulnerable based on the 2019 supply outlook. Finally, scrubbers would prove to be an economically sound investment for at least the medium term after implementation.
Our forecast: Published in January of 2018, in a report entitled “Shipping’s 2020 Sulfur Cap: A Popular Question Is Answered”, I tackled the issue of slow steaming. I concluded that it would be minimal unless we saw compliant fuel prices spike well beyond levels I anticipated. Back in August of 2019 when pressed again on the potential for slow steaming I answered, “I think speed adjustments will be relatively small compared to past shifts, and that’s because collectively the fleet is already close to optimal efficient speed.”
Looking at average speeds from all of January 2019 compared to average speeds as of January 16, 2020, provided by VesselsValue, we can see the magnitude of the speed shift, if any.
Bulkers are showing a decline from 11.22 knots to 11.11 knots. This is a negligible difference and won’t lead to any sort of meaningful supply side tightening.
Capesize vessels, specifically, are relatively unchanged moving from 11.17 to 11.18 knots.
The very solid rates in VLCCs have inspired a movement from 12.17 to 12.68 knots, possibly illustrating that the market sensitivity to high rates is surpassing concerns about increased bunker costs.
MR2 tankers are seeing a strengthening market, and possibly more urgent cargo demand from bunker hubs, which is leading to higher speeds, moving from 11.72 to 11.78 knots.
LPG has moved from 12.53 to 12.68 knots and LNG has moved from 15.05 to 15.45 knots. Both very negligible and unlikely to impact the market in a noticeable manner.
Finally, while containers show signs of improving rates in the mid-sized classes especially, average speeds have remained relatively unchanged, edging from 14.36 to 14.35 knots. The container segment is the one I gave the greatest chance for speed reduction based on their greater fuel loads, poor market for the larger ships, and relatively high vessel speeds prior to 2020. However, that has failed to materialize.
One reason could be that increasing ‘blanked sailings’ used to support the larger vessel market is contributing to greater urgency for those vessels that do sail.
In fact, the ULCV class specifically has seen rise in vessel speeds compared to 2019, moving from 16.26 to 16.34 knots.
Average Ultra Large Container Vessel Speeds – Courtesy of Vessels Value
Also noteworthy is the dip prior to 2020 and the sharp recovery as the shift to compliant fuel was being made at large.
Overall, I will concede that the one area (the ULCV class) I expected to see a bit of slowing in never came to be. But, for the most part, I feel pretty good about the call I made starting in January of 2018 that slow steaming would be limited unless we see a significant spike in bunker costs, which was never anticipated to a meaningful degree. So, how did that call on compliant fuel costs go?
Compliant Fuel Costs
Our forecast: Higher but not outrageous MGO prices at the onset. Short-term regional shortages which will be solved quickly through astute arbitrage players. Bunker prices will not spike to the stratosphere and calls by some analysts of MGO prices quadrupling were, and are more than ever, irresponsible.
This wasn’t a hard call to make. Capacity was going to be there for the most part in 2020 given the latest refinery additions and expected reconfigurations. Refiners are notorious for chasing margins, and calls for MGO prices quadrupling would be too much to resist, making it very likely that we’d see existing complexes reconfigure in order to capitalize on an immediately open, then slowly closing, window of opportunity.
Slowing global demand for crude and products in 2019, courtesy of a slowing global economy, also helped to ensure adequate supply leading into 2020.
So, how have compliant fuel prices fared?
Source: Ship & Bunker
MGO would be the traditional source of compliant fuel, but, due to the magnitude of the shift in bunker demand, other solutions had to be found.
Source: Ship & Bunker
VLSFO is largely a middle distillate blend that offers compliance and while there have been some isolated cases of fouling and such, for the most part, the introduction has been quite successful. Time will likely improve the product.
Looking at the Global 20 Ports Average MGO prices and their historic correlation with crude oil prices, it’s safe to say that $650/ton was a pre-IMO shift starting point. Since that time, it has spiked up to an average of $722/ton – that’s just over a 10% rise. It has since settled back down to $683/ton, representing just a 5% difference.
Now, how much of that is actually due to the latest crude spike?
Source: Ship & Bunker
Notice the correlation between MGO and crude prices. Would the spike in MGO and VLSFO have been even less pronounced if we hadn’t been facing all this geopolitical turmoil amid renewed OPEC+ resolve? Likely, yes.
In short, there were some logistical and infrastructure issues that seemed to prove the most difficult at the onset. But for all the “crazy doomsday prophecies” surrounding this particular aspect of IMO 2020, from economic collapses, astronomical oil prices, a complete breakdown in the supply chain due to a lack of compliant fuel, etc. – this particular area proved completely and utterly boring, which is exactly what we predicted.
Will the demo market be more exciting?
Briefly, 2019 demos were muted compared to previous years almost entirely across the board. While this call seemed easy for us to make, as we expected improving rates in 2019 and heading into 2020, many analysts didn’t seem to recognize the most fundamental of market relationships.
For example, an analyst had suggested that all VLCCs 15 years and older would become nonviable and would be scrapped. But they failed to realize that a shift in the supply side would also shift rates making for a new base case of viability with each passing demolition.
Rates respond to supply and demand. Not only were we expecting higher rates in 2020, but we also took into account the dynamic nature of the market as it responds to improving rates with every supply side shift. This is why we called for an ebb and flow demo market to materialize instead of a knee-jerk reaction.
So, yes, 2019 demos were waning as the market improved, even in the face of IMO 2020, as on the water cost increases were dwarfed by market improvements and future expectations.
Remember, bunkers are only a part of overall costs, so if charter rates move up X amount, bunker costs would have to move a magnitude greater in order to offset that X amount.
Next, let’s move on to something far more interesting; a key idea going forward in our macro forecasting for many segments.
The number of demolition candidates is growing, even though we don’t see them hitting the beaches yet.
Demolitions are a function of the overall shipping market, specifically with regard to rates. A strong market defers demolitions and a weak market promotes them.
Right now, solid rates in product tankers, crude tankers, mid/small containers, LPG, and LNG are mostly overriding any increased on the water costs from bunkers or growing maintenance costs for older vessels. Dry bulk could have been in that group right up until recently, but seasonality and a thick orderbook started taking its expected toll. Expectations here are also not great.
This isn’t a new phenomenon. Shipping has many economic sub patterns. Being the cyclical industry that it is, with records spanning hundreds of years, these sub patterns are well established for various parts of the cycle.
You can see my report, Shipping’s Bullish Setup – How Will It Unfold?, for a more detailed explanation on these trends during an upturn.
So, as older vessels are being kept on the water this creates a supply side reaction that smooths out the business cycle.
For example, if demolitions would proceed at a normal pace in a tightening market then the supply side removals would further amplify the strength of the market. However, keeping vessels on the water helps smooth out the bullish upturn.
This ensures three things, reactionary owners (along with the market) are kept in check to a greater degree than they otherwise would be. Again, if you are unsure as to what I mean when I say reactionary owners please read the aforementioned report.
Second, a relief valve is being built up in the market, in terms of removable tonnage, for when rates finally do turn in this cyclical industry. The longer, and stronger, a bull market becomes the greater this relief valve.
Third, and unique here, older vessels will be deemed uneconomic much more quickly post-2020 as on the water costs increase courtesy of higher bunker prices. This greater burden will induce retirements earlier on in a market downturn than it previously would have. Owners with scrubbers can indeed look at this as another market support mechanism as those without scrubbers will be economically challenged first and therefore forced to be the primary movers.
However, that relief valve will be needed as these reactionary owners will likely do their part in eventually responding to this bull market in a magnitude leading to a similarly strong bear market down the road.
The supply side removals/additions are a classic market response mechanism at work and are therefore foreseeable to a degree if we have market clarity.
We can see this at work right now in the capesize class.
In the last half of 2019, as owners were basking in a strong spring and summer, we saw the impact on the demo market as just seven capesize vessels were retired.
However, in the first couple weeks of January we have already seen five capesized vessels sold for scrap. This compares to a total of seven vessels scrapped in all of January and February of 2019 when we similar seasonality unfold along with the second largest decline in the BDI on record.
Please forgive the crudeness of the next chart, but I thought an illustration would help demonstrate this inverse correlation.
Source: Data Courtesy of VesselsValue – Chart By VIE
Above we see the total number of demolitions per month put over the BDI index. Notice that as the market strengthens, we see retirements wane and vice versa.
We saw this in crude tankers during the 2016-2018 downturn where demolitions were amplified and are now scarce as a recovery is taking shape.
In fact, for more on this please see my report, Trading And Investing In Shipping Part II: Focus On Supply Side, which discusses all these trends in depth with historic examples and much better charts.
The biggest call in a generation for shipping produced a great number of diverse opinions, analysis, and forecasts. Many, many got it wrong.
Over at VIE I believe we did a very good job navigating this unprecedented mandate which held the potential for a vast number of outcomes.
Our economics background and knowledge of the shipping markets laid the foundation for this seemingly simple formula: “The degree of retirements and/or slow steaming induced by this mandate will be directly related to the cost of bunker fuel and older vessel maintenance balanced against any rise (or fall) in charter rates.”
The knowledge of market cyclicality coupled with our macro forecasts, which tend to have a very high degree of reliability, led us to our views regarding the outcome of IMO 2020. Using the formula above we simply filled in the blanks with our own macro forecasts. They turned out to be largely correct.
The shock of IMO 2020 started late in 2019 as owners bunkered for 2020’s compliant voyages, and has now largely run its course. Only fine tuning is left and that will take place with much less fanfare.
So, what will the IMO target next? Carbon? Particulate matter? Emission free shipping by 2050? Whatever it is you can count on the market to dictate the outcome, and over at VIE, I think we’ve proven now that we offer the most accurate shipping market and economic forecasting.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.