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IMO 2020: The Coming Storm

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IMO 2020: The Coming Storm

On Jan. 1, 2020, the International Maritime Organization (IMO) is set to enact regulations on the shipping industry that will limit emissions of a pollutant that will have broad implications for the oil and gas and shipping industry. The IMO, a United Nations agency composed of most seafaring countries, regulates international shipping with a focus on safety, pollution prevention, and emission reduction. The rules, initially drawn up in 2008 and ratified in October 2016, will cap the sulfur content of marine ship fuels from its current 3.5% to 0.5%. The rules were approved by 91 countries accounting for almost 100% of marine freight volume. Sulfur emissions have been linked to acid rain that can damage wildlife habitats and vegetation, and are blamed for causing respiratory ailments. According to the IMO, ships account for about 13% of global sulfur-dioxide emissions. This regulation, which will impact approximately 4% of total oil demand, has the potential to be one of the most disruptive changes to ever affect the shipping and refining industries.

Upon implementation, shippers that have not installed scrubbers to remove sulfur from exhaust gas, can meet the lower sulfur requirements by replacing residual, high sulfur fuel oils (HSFO) with cleaner alternatives such as diesel and marine gas oil (MGO) or various low sulfur blends of gasoil/residuals. This does not require major alterations to ship engines nor capital expenditures to meet compliance standards, but will require more-expensive fuel.

When the IMO ruling was initially enacted, there were uncertainties about the deadline including:

  • Global compliance;
  • How will the price for crude oil and refinery/product margins respond; and
  • How will IMO member states set penalties and fines that are consistent and fair and who can enforce penalties, since the IMO does not have the authority to do so.

It posed serious conflicts of interest and offered little incentive for port or member states to enforce noncompliance, as they continue to reap the benefits of being a destination port. Then, in early 2018, the IMO proposed a ban on noncompliant bunkers in the tanks of ships not fitted with scrubbers to address this problem. This effectively requires enforcement at the bunkering port and will go into effect March 1, 2020.

Rhetoric from various international governments to delay or postpone the deadline reignited the uncertainty and, along with significant capital investment required by refineries, were partly responsible for a delay in investment from the shippers and refineries. However, as we get closer to the deadline, S&P Global Ratings is seeing signs of increased investments in scrubber installations and refinery modifications.

Before we drill further into the implications of IMO 2020 for the refining and shipping industries, it's important to understand the uses of HSFO in the context of the refining process.

What Is HSFO?

Residual fuel oil, or HSFO, is the product remaining after higher-value products such as diesel, naphtha, kerosene, and liquefied petroleum gas (LPG) are distilled away in the early stage of the refinery operations. Many refiners who lacked the capacity to subsequently refine and upgrade residual fuel oil into a lower-sulfur product, such as gasoline, jet fuel, and distillate, have sold the HFSO into the marine fuel or bunker fuel market, to be blended with distillates to create various grades of bunker fuel. According to the U.S. Energy Information Agency (EIA), total residual fuel oil represents between 8%-9% of demand of oil end–products, or about 7 million-8 million barrels per day (mmb/d). Of that amount, McKinsey & Co. estimates that global HSFO ship bunker demand in 2018 reached 3.5 mmb/d.

Chart 1

image

The Refinery Process Simplified

First the crude is heated to remove corrosive salts and, depending on temperature, is separated into various products in the distillation unit called "fractions," like kerosene, jet fuel, naphtha, and butane, which serves as a feedstock for other units.

Chart 2

image

The next step is called vacuum "resid" processing, where heavier gas oils that resides at the bottom of the distillation unit (the "resid") are stripped out and transformed into higher value added products, through "cracking" or "hydrotreatment." This step includes crackers (which take heavy-molecule gasoil and "crack" it into various distillates and gasoline) and coking (upgrades residue from the vacuum and atmospheric distillation units into higher value products) units. Some products can be treated further to remove sulfur through de-sulfurization units. Complex refineries--those with coking, catalytic, and hydrocracking processing capabilities--are able to process the bottom of the barrel and convert it into higher-value products such as gasoline, distillate, and jet fuels. Lower complexity refineries--those that lack these upgrading facilities--have higher yields of secondary, lower-margin products, like residual fuel oils, pet coke, and asphalt.

Refineries: Winners And Losers

Refiners that are considered complex will be the most profitable given their flexibility to optimize their crude slate to the most price-advantaged crudes (heavy, sour crudes) and process it into higher value added products. The Nelson Complexity Index (NCI) is a measurement of refining complexity and is based on the refinery construction costs for various crude and upgrading capacity. The NCI assigns a factor of 1 to the distillation unit. All other units are rated in terms of their cost relative to this unit. The higher the index, generally, the more sophisticated the refinery.

Chart 3

image

Refiners located in Africa, South America, Russia, and some European and Asian countries that have limited coking or hydrocracking ability and yield more low-value fuel oil will most likely have to do some switching to lighter/sweeter (but more expensive) crude slates such as Brent, LLS, etc. Less complex refiners will likely feel the effects of the crude slate re-pricing most acutely since they lack the cokers, crackers, and hydrotreaters necessary to convert cheaper heavy sour crude into higher-value-added products. Refining margins will likely be volatile as the shift in demand to cleaner marine fuels like LSFO or MGO from HFSO occurs. Some refineries in Europe will be in a less advantageous position given low coking capacity that results in higher fuel oil yields. Refiners with high complexity generally have higher ratings and a stronger business risk profiles than those that don't.

The regulation will be a significant tailwind for most U.S. refiners that we rate. The U.S. refining industry spent a significant amount from 2004-2008 to upgrade their refineries. As a result, the U.S. refining industry is the most complex in the world.

Also, based on EIA data, the U.S. is among the least exposed to the HSFO market with residual fuel oil making a small portion (about 2%) of total refined product demand. We believe given the high complexity of most U.S. refineries, especially around the Gulf of Mexico, and the low demand for residual fuel in the U.S., the U.S refineries are in a better position relative to global peers to benefit from the ramifications of IMO 2020. That said, how long the impact of IMO 2020 will last and how refiners deploy increased cash flows will go a long way in determining the impact on their credit profiles.

The U.S Gulf Coast refiners are best positioned to take advantage of lower priced heavy/sour oils. Gulf Coast refineries such as Exxon Mobil Corp., Phillips 66, Valero Energy Corp., and Marathon Petroleum Corp. all see themselves as well-positioned for IMO 2020 because their facilities can break down heavy, sour crudes and residual fuel oil into low-sulfur distillates and other high-value products. We expect these companies to tweak their crude slates rather than dedicate large amounts of capital to upgrade their assets. PBF Energy is taking a different approach, by entering into a long-term lease agreement with a third party that by the fourth quarter of 2019 will build and operate a new hydrogen plant near PBF's 190,000 barrel per day (b/d) refinery in Delaware City. The hydrogen will enable PBF's Delaware City complex to run even heavier, more sour crudes, which will also presumably be cheaper and produce more low-sulfur distillate.

Chart 4

image

What's A Refinery To Do?

Refiners, depending on complexity, will have several options to deal with IMO 2020:

  • Alter production yields and add incremental runs. Complex refiners will source cheaper heavy/sour crudes and produce less HSFO while maximizing distillate and low-sulfur fuel oil production through the distillation tower or conversion capacity (i.e., catalytic cracker or hydrocracker), resulting in lower production and a knock-on effect of higher prices for gasoline, kerosene, and jet fuel (LSFO can also be produced by de-sulfurising HSFO, although it's expensive and very little capacity exists globally).
  • Change to a sweeter/lighter crude slate. Less complex refiners will find this is their only choice to produce more LSFO, potentially driving up demand and prices for light sweet crudes.
  • Blend more distillates with HFSO to create compliant fuel oils.
  • Less complex refiners can sell excess HSFO as a coker feedstock to more complex refiners, enabling them to reduce purchases of heavy/sour crudes .
  • Use HSFO to produce other lower-value products such as asphalt or pet coke.
  • Alter refining capacity to add residual fuel oil destruction (very expensive and highly unlikely to occur).
  • Install cokers and hydrocrackers (not likely given the enormous capital requirements).
Just because a refinery produces HSFO doesn't mean it will be shut down.

There will continue to be demand for HSFO, and the margins for a less complex refinery's other products could still increase sufficiently to make it profitable for those refiners to operate. Also, one outlet for HSFO may be another, more-advanced refinery, which could use the cheap residual fuel as a coker feedstock rather than running heavy sour crude. Moreover, HSFO prices could decline to a point that it will begin to compete against fuel oil for power generation or pet coke for industrial use. As residual fuel markets come under pressure, refiners globally will likely tweak output to generate more pet coke and asphalt at the expense of residual fuel oil. Unfortunately for less complex refiners, they will suffer further margin compression because they tend to produce more bottom resid, and since both the asphalt and the pet coke markets are fairly price-inelastic, incremental supplies will only push down prices.

Another consequence of IMO 2020 could be higher gasoline, jet fuel, and kerosene prices. Refineries will most likely switch production to higher crack distillates resulting in a reduced volumes and inventory levels.

Another option--although a very expensive, time consuming, and highly unlikely option--would be to build a coker and the processing units to go along with it. Most refining companies have held off on this since they view the margin improvement as temporary.

What Will Be The Impact On Refinery Product Pricing?

Depending on shippers' compliance and the pace of scrubber installations, the required specification changes will require the 3.0-3.5 million barrels/day of HSFO to be replaced most likely through lower sulfur bunker options like marine gasoil (MGO) or low sulfur blends of gasoil and residual fuel oil with vacuum gas oil and distillates. Some LSFO will be produced directly from refineries but the rest will have to be met with a distillate-HSFO fuel oil blend, which will increase the demand and price for higher-valued distillates.

Chart 5

image

Probably the best near-term solution for low sulfur fuel will come from MGO, a diesel-like middle distillate that is one of the most preferred clean fuel/gasoils used on ships, produced with varying degrees of sulfur content but a maximum permissible value of 1.5%. This is a known quantity among shippers and will alleviate some of the uncertainties of compatibility, viscosity, and stability concerns with other types of fuel oil.

Distillate refining margins will be robust in late 2019 and 2020, not just from shipper demand for pure distillate or diesel but from bunker suppliers looking to blend with HSFO. Blending residual fuels with more distillate to improve compliance will likely further increase demand and the price for distillates. Prices and cracks for LSFO and distillates are expected to rise sharply. As previously stated, gasoline margins should increase as well due to the shift in utilization of distillate production and thus reduced production of gasoline.

On the flip side of the coin, no doubt falling demand for HSFO will cause its price to decline, widening the spread between traditional high-sulfur bunker fuel and marine gasoil. In fact, the market is already pricing this in:

Chart 6

image

Upstream Winners And Losers

Initially, it is likely that IMO 2020 will cause a broad increase in oil prices, all else equal. Despite the decline in HSFO demand, widening diesel and distillate crack spreads and the higher demand for gasoil will force refineries to increase crude runs, putting upward price pressure on global crude prices. Street estimates have put this range at $4-$5/bbl.

Chart 7

image

One thing that is certain is that for the many crude grades that vary in sulfur and viscosity, IMO 2020 will most definitely have an impact on prices. Heavier crudes tend to have a higher sulfur content and yield a higher proportion of HSFO through the refining process. Some of the highest sulfur-content crudes (like those from Canadian producers that produce the heavy bitumen Western Canadian Select (WCS), and Mexico's Maya, as well as most Middle Eastern producing nations) will see some of the widest discounts given their high sulfur content and heavy gravity.

Chart 8

image

Discounted HSFO cracks will lead to lower demand for heavy/sour crudes. Demand for Algerian, Libyan, Nigerian, Indonesian, Malaysian, and Caspian Blends will increase. North Sea and U.S. exporters of WTI will benefit as well. All in all, we do not see the price increases as long lasting or sufficient to warrant wholescale ratings improvements for U.S. based shale oil producers. Alternatively, the decline in heavy crude realizations, while more meaningful, should not be long lasting enough to warrant wholesale negative rating actions.

Heavier crudes should come to the U.S. where there is the capacity to process it into light products while lighter shale oil should be sent to Asia where there is no such capacity. It is unclear, however, whether this crude re-shuffling will be possible or economical due to transportation logistics and costs.

Implications For U.S. Refinery Ratings

Table 1

Implications For U.S. Refinery Ratings
Issuer Corporate Credit Rating Business Risk Financial Risk

Deer Park Refining L.P. (1)

BBB+/Stable/A-2 Fair Intermediate

Phillips 66

BBB+/Stable/A-2 Satisfactory Intermediate

Marathon Petroleum Corp.

BBB/Stable/A-2 Strong Significant

Motiva Enterprises LLC (1)

BBB/Stable/A-2 Fair Significant

Valero Energy Corp.

BBB/Stable/-- Satisfactory Intermediate

HollyFrontier Corp.

BBB-/Stable/-- Fair Intermediate

Delek US Holdings Inc.

BB/Stable/-- Fair Intermediate

PBF Holding Co. LLC

BB/Stable/-- Fair Significant

CVR Refining L.P.

BB-/Stable/-- Weak Intermediate

Par Petroleum LLC

B+/Positive/-- Weak Aggressive

CITGO Holding Inc. (2)

B-/Stable/-- Fair Significant

CITGO Petroleum Corp. (2)

B-/Stable/-- Fair Significant
(1) Ratings uplift from strategic link to parent. Deer Park (SACP of 'bb+'; linked to Royal Dutch Shell (AA-/Stable/A-1+), Motiva ('bb'; linked to Saudi Arabia A-/Stable/A-2). (2) Ratings constrained (SACP of 'bb') due to link with Petroleos de Venezuela S.A. (PDVSA) rated 'SD'.

While we believe the IMO 2020 will be credit positive for the refiners we rate, we do not think the implementation of these new regulations will definitively lead to higher ratings for the following reasons:

  • The possible spike in refining margins will be temporary and does not change our ratings approach for refining companies. Most likely, prices will revert as ships add scrubbing technology and refineries make necessary conversion investments. We continue to base our forward-looking analysis on a mid-cycle margin specific to each refining company we rate, much like we did during the robust margin environment from 2012-2015.
  • We believe most refining companies view the coming boost in margins as a short-term benefit and have based their capital structure on EBITDA that at a minimum will maintain existing ratings. We therefore do not expect companies to use excess cash flow for debt reduction, unless they intend to repay debt at the refining company level while debt increases at the faster-growing midstream subsidiary, so as to maintain similar credit measures when viewed on a consolidated basis.
  • Refining companies have increased rewards to shareholders in recent years, through higher dividend payments and multi-billion dollar share repurchases, which in our opinion is likely to continue. We believe any excess cash flow generated from higher margins as a result of IMO 2020 will go to shareholders before organic growth or strengthening the balance sheet.

What About The Shipping Industry?

The IMO 2020 low-sulfur regulations will shake the global shipping industry. Most shipping companies will meet the stricter requirements predominantly by using low-sulfur-compliant bunker oil or cleaner alternative fuels, likely to start in the last months of 2019--in preparation for January 2020 to ensure no glitches (e.g., engine failures while using unknown fuel blends). However, with prices for these compliant fuels expected to rise, earnings stability and ultimately survival, particularly for smaller, more vulnerable players, will depend on their ability to effectively pass through increased fuel costs to customers. Shipping companies can also choose to reduce vessel speed and thereby fuel consumption to help reduce costs (by 20%-40% as per Platts).

Although higher vessel capital and operating costs are likely to translate into higher freight rates over time, shipping is a competitive, cyclical, and often thin-margin business (notably for container liners) that may have to bear some of the cost on its own, particularly in the short-term. Passing on increased bunker fuel prices could be harder or take longer than expected (our base-case assumption is about three months). The negotiating power in any freight market comes down to simple fundamentals of supply and demand, and frequent oversupply in the industry remains an enduring issue. Shipping companies' exposure to this risk varies, depending on the nature of their contracts with customers and other factors. Financial capacity to handle higher costs and capital spending likewise differs significantly among individual shipping companies. Over the long-term, some stronger companies may benefit if regulatory demands drive some ships and shipping companies out of the market, thereby reducing capacity and allowing for higher freight rates. Over the next few quarters, refineries will likely ramp up low-sulfur fuel production. As production and supply steps up, fuel prices will likely fall, relieving some pressure on the ship operators' operating costs.

Various Options To Meet The New Regulations

Ship owners can also meet the IMO requirement by investing in approved equivalent methods, such as exhaust gas cleaning systems, commonly known as scrubbers. However, these are costly (between $2 million and $6 million as per Platts) and if stricter regulation comes there is no guarantee that they will continue to meet regulatory requirements. Furthermore, there are potential technical issues, such as corrosion of discharge pipes, and potential breakdowns. Also the supply fundamentals of high-sulfur oil over the longer term are uncertain. Some argue that a lot of high-sulfur oil will still be produced after 2020, but will be sold at a heavy discount (these fuels are residual, naturally derived from the refining process). We understand that only about 4,000 ships are expected to have scrubbers by the end of 2020 out of 60,000 commercial ships (less than 10% of the global maritime fleet).

Another option shipping companies can choose is to use liquefied natural gas (LNG) to run ships. According to ExxonMobil, LNG can reduce sulfur oxide emissions by at least 90% as compared to heavy fuel oil. It's also cheaper than heavy fuel oil under normal circumstances, while its significantly lower emissions create a cushion against any future tightening of environmental guidelines. However, there are impediments that make LNG not particularly attractive at this stage. First, vessels must be capable of carrying high-volume LNG tanks. Second, it is very expensive to retrofit ship engines to LNG. Third, shipping companies have no guarantee of uninterrupted access to a reliable and cost-effective LNG supply network because the LNG bunkering (supply of fuel) infrastructure appears to be still underdeveloped.

Of course some ship owners may choose to not comply with the new regulations if they perceive low penalty risks. As a United Nations agency, IMO has no authority itself to enforce these regulations. We understand that flag states (i.e., the jurisdiction under whose laws the vessel is registered) will oversee compliance with regulations, and port states will have no enforcement authority but can notify the appropriate flag state of noncompliance.

Regulatory Costs Could Weigh On Ratings

Dry bulker, tanker, and gas carrier owners that we rate are typically sheltered from rising fuel costs if they lease out their vessels under non-cancellable bareboat (a purely financial lease) or time-charter contracts (which cover the vessel and crew costs) on fixed terms, whereby the charterer normally pays the bunker fuel bill. However, if more owners start installing scrubbers in the medium term, it will become increasingly difficult to charter out a vessel without a scrubber, likely resulting in a need for other companies to catch up.

Spot operators and container liners typically bear the highest fuel risk. We believe the larger industry players, such as A.P. Moller - Maersk A/S, CMA CGM S.A., and Hapag-Lloyd AG, will have the most success passing these costs on, due to better bargaining power with customers and protective pricing mechanisms in their contracts. Indeed, we expect bunker fuel adjustment factors in contracts to largely cover the fuel cost increase, albeit with a typical time lag of about three months and, as such, liquidity profiles must be strong enough to cover this extra working capital need. Smaller players are likely to struggle if they lack the bargaining power or contract mechanisms to adjust prices adequately and may find it difficult to continue to operate.

Apart from environmental and health benefits, there are other potential benefits of the IMO regulations to bear in mind. The tanker segment could actually gain from increased demand if fuel prices become more volatile because of arbitrage opportunities. Furthermore, low-sulfur compliant fuel oil will need to be transported and demand for floating storage may also increase. The new regulation could also boost the rate of vessel scrapping. We anticipate that owners of older ships might view the necessary extra investment as economically unviable and send the aging tonnage to the scrapyard through 2020, which would help to limit net fleet growth.

We rate 15 shipping companies globally in sectors ranging from LNG shipping and passenger ferry, which we assess as the least risky, to container liner and dry bulk shipping, which we assess as the most risky. Given that over two-thirds of the shipping companies we rate globally are currently in a single 'B' category or lower, any material added costs or capital spending that cannot be recovered could potentially move rating outlooks to negative or lower ratings. However, we believe industry-wide freight rate increases will be inevitable in the short-term as ship owners and operators seek to rebalance with a structurally higher operating cost base from January 2020 to avoid losses. The entire industry is similarly adversely affected by the new emission limits, and it will be in all players' interest to recover cost inflation, so we think we are likely to see either higher shipping rates or deals with customers to share the capital investments.

Table 2

Global Shipping Companies Rated By S&P Global Ratings
As of Oct. 1, 2019
Company Shipping segment Rating*

Nakilat Inc.

Liquefied natural gas (LNG) A+/Stable/--

MISC Bhd.

Oil and gas BBB+/Stable/--

PAO Sovcomflot

Crude oil, oil products, and LNG BB+/Stable/--

Wan Hai Lines Ltd.

Container liner BB+/Stable/--

Bahia de las Isletas, S.L.

Ferries (pax and cargo) B+/Positive/--

CMA CGM S.A.

Container liner B+/Stable/--

Hapag-Lloyd AG

Container liner B+/Stable/--

Navios Maritime Partners L.P.

Dry bulk and containers B+/Stable/--

Global Ship Lease Inc.

Containers B/Stable/--

Navios Maritime Holdings Inc.

Dry bulk and logistics B/Stable/--

Navios Maritime Acquisition Corp.

Crude oil and oil products B-/Stable/--

Navios Maritime Midstream Partners L.P.

Crude oil B-/Stable/--

International Seaways Inc.

Crude oil and oil products B-/Negative/--

Moby SpA

Ferries (passengers and cargo) CCC-/Negative/--

Eletson Holdings Inc.

Crude oil and oil products SD/--/--

This report does not constitute a rating action.

Primary Oil & Gas Analyst:Thomas A Watters, New York (1) 212-438-7818;
thomas.watters@spglobal.com
Primary Refining Analyst:Michael V Grande, New York (1) 212-438-2242;
michael.grande@spglobal.com
Primary Shipping Analysts:Philip A Baggaley, CFA, New York (1) 212-438-7683;
philip.baggaley@spglobal.com
Rachel J Gerrish, CA, London (44) 20-7176-6680;
rachel.gerrish@spglobal.com
Izabela Listowska, Frankfurt (49) 69-33-999-127;
izabela.listowska@spglobal.com

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