IMO 2020 Impacts To Shipping
Overview: What is "IMO 2020?"
Shipping investors have rallied around "IMO 2020" as a positive factor for the past few quarters with the broad viewpoint that disruptions surrounding the preparation and implementation of this regulation would lead to spikes in rates from mid-2019 throughout the majority of 2020.
The IMO is the International Maritime Organization, an agency of the United Nations tasked with regulating shipping and reducing pollution. IMO 2020 specifically is a major regulatory move aimed at sharply reducing the pollution of sulfur oxide. See below for a quick video overview of the regulation:
This regulation is relevant for nearly every shipping stock on the market besides LNG carriers which are fueled by their own cargo boil-off.
These firms include, but are not limited to, Ardmore Shipping (ASC), Diana Shipping (DSX), Genco Shipping (GNK), Golden Ocean (GOGL), Eagle Bulk (EGLE), Safe Bulkers (SB), Star Bulk Carriers (SBLK), Frontline (FRO), Navios Maritime Holdings (NM), Navios Maritime Partners (NMM), Navios Maritime Acquisition (NNA), Costamare (CMRE), DHT Holdings (DHT), International Seaways (INSW), Scorpio Tankers (STNG), Scorpio Bulkers (SALT), Teekay Tankers (TNK), Nordic American Tankers (NAT), Tsakos Energy Navigation (TNP), Dorian LPG (LPG), Diamond S Shipping (DSSI), Danaos Corp (DAC), Global Ship Lease (GSL), Capital Product Partners (CPLP), and Seaspan (SSW).
Why Does IMO 2020 Matter?
Beyond simply improving health quality for global citizens, why is IMO 2020 so significant for shipping investors?
IMO 2020 requires all ship-owners to either switch to far more expensive Very-Low Sulfur Fuel Oil "VLSFO" or Marine Gasoil "MGO" or to install expensive scrubber equipment to remove the sulfur emissions from the dirtier legacy High-Sulfur Fuel Oil "HSFO." This regulation drastically drives up the cost to operate ships across the world. Wait! Isn't that a bad thing for investors? Yes, if you own predominantly older tonnage and can't afford to install scrubbers, it's a terrible thing for investment prospects.
I expect IMO 2020 will drive an unprecedented number of older vessels to the scrapyards between 2020-2025. IMO 2020 is the largest, most disruptive regulation, to impact global shipping in modern history.
The closest regulatory parallel is the switch from single-hull to double-hull tankers in the 1990s, which was accelerated in the early-2000s. That was a major shake-up of tonnage (similarly driving out the old), but it was only geared towards the tanker sector, whereas IMO 2020 applies to every ocean-going vessel.
IMO 2020 Long-Term Market Benefit's
- IMO 2020 Poised to Force Out Old Ships = Future Supply Down
Furthermore, while IMO 2020 is poised to push out those older vessels, the current orderbook is at near all-time lows for nearly every segment of shipping except for LNG. IMO 2020 lays the general groundwork and enforcement mechanisms for potential future expansion into other ancillary areas including carbon emissions.
This risk of future expansionary regulation makes ordering a vessel today a fairly scary proposition because it's uncertain which sort of propulsion should be considered and how long the true lifespan will be. I covered the beginning chatter and prioritization of Environmental-Social-Governmental ("ESG") investing in a mid-November update.
- IMO 2020 the Basis for Future Regulations = Future Supply Down
Those are the two long-term benefits of IMO 2020 and are the crux of the bullish thesis and why I was personally bullish on many shipping sectors into 2020 (and remain bullish today). The crux of the longer-term bullish thesis (2020-2025 impacts) relies on the elimination of older tonnage during any period of prolonged weakness.
IMO 2020 in this regard is a "safety valve" for global supply/demand levels.
Depending on fuel-spreads, overall oil pricing levels, and vessel sizes a combination of eco-design vessels and scrubbers could outperform an older scrubber-free vessels by as much as £20k-£30k/day. In certain markets, such as VLCC tankers, it would be possible for modern ships from an entity like DHT Holdings (DHT) or Frontline (FRO) to be earning solid rates like £30,000/day even during heavy downturns while weaker peers barely achieved £10,000/day and would be forced to scrap or go bankrupt.
- Higher Fuel Costs Drives Slow Steaming = Future Supply Down
Another longer-term benefit of IMO 2020 is that global average fuel costs will increase for shippers. This will likely lead to increased 'slow steaming' to attempt to reduce vessel fuel consumption rates.
Slow steaming is always a balance between fuel costs and charter-rates, so this is only something that occurs when fuel costs are enormous or when market rates are terrible. It is moreso a balancing tool and adds to the aforementioned benefits. Slow steaming won't lead to gigantic market rates as vessels would then simply speed up since fuel costs would be less of a relative factor.
IMO 2020 offers the potential for massive market stabilization and both stronger upcycles and lesser downcycles throughout the next 5 years, but it's not some 'magic effect' that would make all markets amazing into 2020.
Yes, there are some shorter-term benefits, but a lot of those have been misunderstood by investors.
IMO 2020 Short-Term Benefits vs. Misconceptions
In addition to the longer-term benefit of supply rationalization, IMO 2020 was expected to cause significant disruption in fuel markets and in available vessel supply via four facets:
- Scrubber Installation Offhire
- Compliant VLSFO & Legacy HSFO Storage Spikes
- Increased Trading Demand for Blends & Components
- Potential Offhire Due to Contaminated Fuels
Scrubber Installation Offhire = Current and Near-Term Supply Down
If a shipowner wants to burn the cheaper fuels, they need to install scrubbers which range from £3-£5M on average in this market. This is an expensive proposition for an older ship and the fuel savings are less on a modern eco-design vessel, so the primary candidates are typically middleaged tonnage.
These scrubber installations were projected to take about 30 days, but delays ended up stretching installation periods to up to 50-60 days.
As an additional near-term wrinkle, the Coronavirus impacts might further delay these still ongoing retrofits. This offhire is primarily a 2H-2019 through 1H-2021 benefit and the latter levels of scrubber installations will depend on fuel spreads.
Scrubber installation offhire has exceeded our expectations due to delays, but the super strong tanker rates actually caused a lot of owners to defer their scrubber installations, netting the catalyst out to a 'push.' The upside is that this means more scrubber installations are expected during 2020.
Storage Requirement Spikes = Current and Near-Term Demand Up
In order to properly prepare for a surge in demand for compliant VLSFO, an unprecedented amount of fuel storage was required. Since VLSFO still contains sulfur it is still considered a 'dirty' fuel and therefore is stored on convention crude oil tankers as opposed to 'clean' product tankers.
We saw significant spikes in storage requirements in mid-2019, which began to taper down towards the end of the year.
A lot of this storage was simply to meet surging demand requirements since refinery outputs weren't properly geared for steady-state production runs, but some of the storage was particularly designed to fuel hedge, such as that done by Euronav (EURN) as discussed in our exclusive October 2019 interview.
As we push further into 2020, the VLSFO storage is likely to decline, but we should see a pick-up in HSFO storage while production outpaced near-term demand. As a larger percentage of the global fleet finalizes their scrubber installations, we will then expect to see drawdowns from this storage.
This is primarily a 2H-2019 through late-2020 catalyst and not a long-term benefit, but has thus far been playing out according to expectations.
Increased Blend Trading = Near-Term Product Tanker Demand Up
Another expected near-term catalyst is the increased trading in blending components for compliant fuels. There are two primary ways to supply VLSFO to the market, straight-run refinery production and after-market blends from fuel components.
Since the majority of the blending components would be 'clean' products, this shift from initial first-run production to post-market blending is expected to significantly increase the near-term and medium-term demand for product tankers, lifting demand in 2020-2021.
We haven't seen a significant lift in these trades yet except for a few spikes in late-2019, so of all the IMO 2020 impacts, this is closest to a 'flop,' but we're just five weeks into what is expected to be a multi-year transition so it's pretty early to call this one.
Contaminated Fuel Issues = Near-Term Supply Down
A potential impact of the IMO 2020 transition was the likelihood for lots of fuel contamination, which could cause vessel delays due to fuel cleaning requirements or even outright engine failure. In the perverse world of shipping investing, a massive bout of engine failures is actually an extremely bullish catalyst as it takes supply off the market. We're seeing lots of reports of sediment issues, but it hasn't been enough to cause disruptions yet.
This was primarily a potential 'bonus' catalyst for 2020 and although it's too early to call for sure, it looks like overall fuel quality is higher than expected, leading this potential catalyst to be mostly a 'miss.'
Additional Ancillary Findings
Our lead macro analyst at Value Investor's Edge, James Catlin, has recently provided a clear update on some of the IMO 2020 implementation nuances, so rather than re-state most of those, I highly recommend reviewing his latest public update along with his entire series on the regulation, some of which I've linked here (these are in chronological order, starting in October 2016):
Readers can see that we've been well ahead of this regulatory curve and this led to strong success in 2019.
Unfortunately some of the latest 'hot money' traders, particularly in tankers, bit off on some misconceptions instead of focusing on the catalysts I've described above (both long-term supply regulators and short-term disruption boosts).
There are lots of misconceptions floating around, but I'll try to address some of the primary ones below:
- IMO 2020 Will Eliminate Seasonality
- IMO 2020 Will Kick-Off a Massive Supercycle Starting in 2020
- IMO 2020 Will Lead to Massive Oil Sector Chaos: £100+/bbl
Misconception #1: Seasonality Eliminated
This is one of the more extreme viewpoints I've seen floating around, but during our IMO 2020 & Tanker Forum we held during early-January, there were a lot of investors and traders who acted shocked when tanker rates started falling. This was actually a fairly popular (albeit unfounded) sentiment among traders. I've posted a clip from our chat boards below as an example.
There were dozens of such sentiments boiling down to:
"IMO 2020 will cause such a disruption that seasonality will be gone!"
We've had heavy seasonality in tanker markets for 20 of the past 20 years, and of course, in the 21st year, we once again have seasonality. This was prior to the Coronavirus demand-shock, which is further reducing immediate and front-quarter demand. Seasonal curves and temporary demand shocks have nothing to do with whether IMO 2020 is a 'flop' or not.
According to data provided by Clarksons Shipping Intelligence, we can see that average tanker earnings have been exceedingly volatile over the past two decades. Additionally, the higher the peaks, the more steep the falls. During the last super-cycle (2003-2008), there were at least 6 massive crashes and subsequent recoveries in rates, all on seasonality.
Source: Clarksons Shipping Intelligence Network, 16 January 2020
If we go back even further to 1991 and study nearly three decades worth of tanker market data, we see the massive seasonality trends going month-to-month over time.
Note how rates typically stabilize month 8 (August) to month 9 (September) before starting a massive run October-December. Rates then take heavy hits in January, February, and April. Keep in mind that these rate declines are actually distorted by weak years where supply is overhanging hard so the spike never happens, therefore the declines are much less.
Source: Clarksons SIN, Chart by Value Investor's Edge, 27 Jan 2020
As striking as that chart already is, keep in mind that it is for all tankers and over all types of years.
If we focus on VLCC only and look at the top 5-6 years on record, every single year shows enormous plummets into February. Just scroll up two charts and look at 2005's plunge versus 2018's, and remember again that is for all tankers, VLCCs can be even more volatile.
Misconception #2: IMO Kicks Off Massive Supercycle
Another misconception is that IMO 2020 would automatically kick off a massive supercycle in shipping rates. First, we should remind ourselves that seasonality is totally different than a supercycle as we've already demonstrated that 2003-2008 has massive seasonality.
Second, keep in mind that IMO 2020 is a supply-regulator with expected effects from January 2020 through the mid-2020s. Finally, keep in mind that the immediate impacts were expected to be higher fuel costs, which all-else-equal leads to lower earnings at first as the market reacts. Just look at the plunge in the Baltic Dry Index, which has fallen from 976 to 453 over the past month:
Source: Bloomberg, Baltic Dry Index Quote, 4 February 2020
Part of this decline is the seasonality of dry bulkers (they always collapse into February to correspond with Chinese New Year), but another major part is the rising fuel costs as the BDI has now switched over to the more expensive VLSFO blends when adjusting for estimated earnings.
If anything IMO 2020 would initially produce lower rates for the benchmarks, which are primarily designed for the older non-eco non-scrubber tonnage that we are avoiding!
Whether or not we end up getting some sort of super-cycle equivalent due to supply regulation/suppression combined with demand surprises remains to be seen (I've fleshed out my bullish tanker sector thesis in other areas including in a live presentation in Summer 2019), but the idea that it would magically kickoff on 1 January 2020 is not factually grounded, nor has it been touted by myself or any analysts I associate with.
Misconception #3: Mega Oil Crisis, Oil £100-£200+
There was some ridiculous stuff floating around the internet about how IMO 2020 could cause some massive level of global oil contagion and lead to surging oil prices. Some reports even quoted £100+ or even £200+ pricing.
These propositions were so absurd that I didn't even address them in my previous public writing. I didn't think anyone took them seriously.
Obviously refineries would be able to eventually produce fuel to meet the new standards. Could there be temporary huge spikes in VLSFO prices? Absolutely.
Might there be issues with fuel quality? Sure. Might we possibly see some knock-on effects in diesel fuel prices if MGO consumption soared and crowded out convention diesel?
Maybe (although futures were flat, suggesting not). Nobody credible in the shipping space was looking for these sorts of impacts.
Conclusion: IMO 2020 Impacts Mixed & Developing
We're just about five weeks into 2020 and facing a significant temporary black swan demand disruption at the same time as we are hitting some of the weakest parts of seasonality (weakest point for dry bulk and LNG, second weakest for tankers). It is far too early to gauge the full impact of the IMO 2020 regulations for shipping investments, but we can clear up misconceptions and focus on the true importance of the regulation, which is the likely impact of medium and long-term supply rationalization.
I welcome investors to join the discussion below by posting in the comments section as well as in other related coverage posts.
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Disclosure: I am/we are long DHT, EURN, STNG. 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.