Streetwise Professor

September 26, 2018

We’re From the International Maritime Organization, and We’re Here to Help You: The Perverse Economics of New Maritime Fuel Standards

Filed under: Climate Change,Commodities,Economics,Energy,Politics,Regulation — cpirrong @ 6:26 pm

This Bloomberg piece from last month claims that the International Maritime Organization’s looming 2020 caps on sulfur emissions from ships “could lift crude prices by $4 a barrel when the measures come into effect in 2020.”

Not so fast.  It depends on what you mean by “crude.”  According to the International Oil Handbook, there are 195 different streams of crude oil.  Crucially, the sulfur content of these crudes varies from basically zero to 5.9 percent.  There is no such thing the price of “crude,” in other words.

The IMO regulation will have different impacts on different crudes.  It will no doubt cause the spread between sweet and sour crudes to widen.  This happened in 2008, when European regulation mandating low sulfur diesel kicked in: this regulation contributed to the spike in benchmark Brent and WTI prices, and wide spreads in crude prices.  During this time, (if memory serves) 10 VLCCs full of Iranian crude were swinging at anchor while WTI and Brent prices were screaming higher and sweet crude inventories were plunging precisely due to the fact that the regulation increased the demand for sweet crude and depressed demand for heavier, more sour varieties.

The IMO regulation will definitely reduce the demand for crude oil overall.   The demand for crude is derived from the demand for fuels, notably transportation fuels.  The regulation increases the cost of some transportation fuels, which decreases the (derived) demand for crude.  This change will not be distributed evenly, with demand for light, sweet crudes actually increasing, but demand for sour crudes falling, with the fall being bigger, the more sour the crude.

The regulation will hit ship operators hard, and they will pass on the higher cost to shippers.  In the short run, carriers will eat some of the cost–perhaps the bulk of it.  But the long run supply elasticity of shipping is large (arguably close to perfectly elastic), meaning after fleet size adjusts shippers will bear the brunt.

The burden will fall heaviest on commodities, for which shipping cost is large relative to value.  Therefore, farmers and miners will receive lower prices, and consumers will pay higher prices for commodity-intensive goods.  Further, this regulatory tax will be highly regressive, falling on relatively low income individuals, who pay a higher share of their income on such goods.

This seems to be a case of almost all pain, little gain.  The ostensible purpose of the regulation is to reduce pollution from sulfur emissions.  Yes, ships will produce less such emissions, but due to the joint product nature of refined petroleum, overall sulfur emissions will fall far less.

Many ships currently use “bottom of the barrel” fuel oil that tend to be higher in sulfur.  Many will achieve compliance by shifting to middle distillates.  But the bottom of the barrel won’t go away.  Over the medium to longer term, refineries will make investments that allow them to squeeze more middle distillates out of a barrel of crude, or to remove some sulfur, but inevitably refineries will produce some low-quality, high sulfur products: the sulfur has to go somewhere.  This is inherent in the joint nature of fuel production.

And yes, there will be some adjustments on the crude supply side, with the differential between sweet and sour crude favoring production of the former over the latter.   But sour crudes will be produced, and new discoveries of sour crude will be developed.

Meaning that although consumption of high sulfur fuels by ships will go down, since (a) in equilibrium consumption equals production, and (b) due to the joint nature of production the output of high sulfur fuels will go down less than its consumption by ships does, someone will consume most of the fuel oil that ships no longer used.  And since someone is consuming it, they will emit the sulfur.

The most likely (near term) use of fuel oil is for power generation.  The Saudis are planning to ramp up the use of 3.5 percent sulfur fuel oil to generate power for AC and desalinization.  Other relatively poor countries (e.g., Bangladesh, Pakistan) are also likely to have an appetite for cheap high sulfur fuel oil to generate electricity.

The ultimate result will be a regulation that basically shifts who produces the sulfur emissions, with a far smaller impact on the total amount of emissions.

This represents a tragic–and classic–example of a regulation imposed on a segment of a larger market.  The pernicious effects of such a narrow regulation are particularly acute in oil, due to the joint nature of production.

Given the efficiency and distributive effects of the IMO, it is almost certainly not a second best policy.  Indeed, it is more likely to be a second worst policy.  Or maybe a first worst policy: doing nothing at all is arguably better.


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  1. Craig – the issue of scrubber retrofits on existing ships that use heavy fuel oil also needs to be part of the discussion. Clearly this is an alternative solution that does not require a change to more expensive distillate or lower sulphur fuel oil. The main issue with scrubbers seems to be a perceived lack of supply. Lots of inputs to this issue that have lots of arguments on both sides of the pricing equation.
    An additional recent topic that continues to be discussed is the lack, or not, of enforcement authority by the IMO.
    Do they have authoritative regulatory oversight on this issue?

    Comment by Joe Raia — September 26, 2018 @ 7:40 pm

  2. don’t be ridiculous, the additional cost is about 3 cents / pair of shoes.
    see the CMA CGM price increase of 160 USD / TEU.

    Comment by lbc — September 27, 2018 @ 4:42 am

  3. The issue surely is not just the cost but the feasibility. Either the fuel oil is burnt anyway as-is by someone else, as you conjecture; or we start desulfurising fuel oil (which AFAIK has never made economic sense).

    Desulfurising usually entails putting the product – heat, diesel, whatever – through your refinery’s catalytic hydrodesulfurisation plant (or CHD), inside which you react hydrogen with the oil to make sour gas, aka hydrogen sulfide. You get the sulfur out of the sour gas via one or more of several possible processes (direct oxidation, Claus, etc). Typically it’s then pelletized into briquettes, bagged, and sold to chemical companies. They use it to make fertilizer because sulfur is actually helpful to plant growth up to a point. It’s really good for oilseed rape, which is grown mainly to make low sulfur diesel, and which used to benefit from slightly sulfurous rain but now needs sulfur driven to it and sprayed on it in fields. I find that funny for some reason. Greens – you couldn’t really make their shit up, could you?

    Anyway the magic word in the above is “hydrogen”, and the technical issue is the adequacy of hydrogen supply within refineries. If the refinery doesn’t have enough H2 to desulfurise fuel oil – as well as diesel, heating oil and gasoline – then the cheapest of those will, as you say, just get burnt elsewhere as high sulfur fuel oil. A number of refineries looked marginal on hydrogen supply when low sulfur diesel came in so GOK what adding fuel oil does.

    There is a technical fix, which is to boost your hydrogen by adding a syngas supply. The three problems with this are finding the capex, finding and booking in the EP&C (there aren’t *that* many firms in that business), and comparative economics. What sort of syngas source – wood, coal, natural gas? Would you be better off building a different secondary unit altogether? What if none pays for itself? It feels to me like this will close some number of marginal refineries.

    You’d like to think someone at the IMO had thought about any of this. I bet nobody did. What do you think?

    Comment by Green as Grass — September 28, 2018 @ 3:00 am

  4. @Green–Very informative. Thanks.

    And I agree–I bet nobody thought about it. This would require systemic thinking, and people in charge of a piece of a system are almost constitutionally incapable of doing so, because of limited information and lack of incentive.

    Who outside of the maritime community? ever heard of the IMO before this? Who appoints it members? To whom is it accountable?

    Well, a little digging reveals that it is one of the tentacles of the UN. Meaning that it is not accountable to anyone, and that it is highly vulnerable to being hijacked by those with an agenda, and a green (no insult intended!) agenda in particular.

    Read their pathetic FAQ page (which looks like it was created by a teenager in 1998). It betrays not one whit of understanding of refining, or even the principle of conservation of matter. It goes no deeper than to mention the blending of fuel oil with gasoil to achieve compliance, but apparently it has never dawned on them to consider what happens to the sulfur in crude oil if it doesn’t go into ship bunkers, or what will happen to the gallons of fuel oil that are not consumed by ships because it has been displaced by gasoil.

    I imagine that they went to refiners and asked how could compliance be achieved. The refiners said: “Blend.” The IMO apparatchiks said “‘K. Problem solved!” and went on their merry way. No doubt the more efficient refiners, whom would have likely been the ones the IMO approached, had no incentive to enlighten the IMO, because said refiners will likely do very well from the healthy cracks which will be driven by the marginal–i.e., least efficient–producers of distillates. This is a bootleggers-and-baptists alliance.

    The theory of regulation shows how this kind of perverse regulation can go into effect. The costs are spread among billions of people. Yes, @lbc, it will add a small amount to any individual purchase, or even the aggregate purchases by any individual–which is exactly why it will not generate any political opposition. Bad regulations (i.e., those where costs greatly exceed benefits) arise when the costs are diffuse and the benefits are concentrated. Here the costs are extremely diffuse–far more so even than monstrosities like the US sugar program, which is the poster child for bad regulation driven by diffuse costs/concentrated benefits. Some benefits are extremely concentrated among influential firms–namely, operators of complex refineries. Producers of sour crude are harmed, but producers of sweet crude benefit, and on net the upstream industry probably doesn’t have a huge interest either way.

    Bad regulations are produced in large quantity even in systems with a modicum of accountability, e.g., the US where voters can impose some checks on Congress and the executive, and procedural protections and the possibility of court challenges can impede regulatory agencies. As weak as these checks are, they are mighty in comparison to what a virtually unknown piece of the UN bureaucracy has to contend with.

    Trump gave the globalists vapors in his attack on international organizations during his UN speech this week. The IMO demonstrates exactly the kind of thing he criticized, though he’s probably never heard if it either. Which in a way, is exactly the point. Organizations most people know nothing about can run amok when given great power.

    Comment by cpirrong — September 28, 2018 @ 9:33 pm

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