Coming to the effective date of IMO 2020, most of shipping players, including container players, believe that customers will understand with the increased bunker costs. However, the process may prove to be more complicated
The new global mandate on using marine fuels with 0.5% sulfur, from the current 3.5% sulfur grade, would take into force from January 1. The new sulfur cap of 0.5% on marine fuels promises to displace more than 3 million b/d of high sulfur fuel, shaking up the oil industry and giving all other commodity markets with exposure to seaborne freight, according to S&P Global Platts analysis.
However, it is the shipping sector that has the eye of the upcoming storm fixed upon it. And none of the three major shipping markets covered by Platts – tankers, dry bulk and containers – look to be fully prepared for the rough weather heading their way.
Shipping is still an old-school business with limited capacity to easily digest big changes. It is also a club of optimists and bulls, who more often than not tend to expect the best outcome from the worst circumstances.
These are dangerous blind spots to have when you are facing a game-changing scenario like IMO 2020. The catch, of course, is in the money. Fuels compliant with the 0.5% limit are more expensive than the traditional high-sulfur bunkers,” said S&P Global Platts.
The extra costs for ship owners will depend on the adoption of various compliance options and spreads between fuel type prices and are certainly hard to predict. However, even moderate projections indicate hefty bills, running to tens of billions of dollars extra a year for the sector.
Can the shipping sector absorb these extra costs itself? “The straightforward answer is – no. Like any business, it will have to try and slide the bill across the table to its customers. The trick here is simple in essence. Just charge your clients sufficient premiums in freight rates to cover your new expenses,” it said.
Even now, only months before the January 1, 2020 deadline, there are a surprising number of shipping players who believe that getting customers to pay up will be a smooth operation. The optimists have a few staple arguments: customers will have no choice but to pay, bunker cost recovery tools will help, and the market is improving.
As usual, the reality may prove to be a bit more complicated. Customers may not have to pick up the full bill if they have the negotiating power to pay less. Bunker cost recovery mechanisms are imperfect and tend to fail in times of volatility. The market recovery is threatened by too many wild cards and may not come as quickly as some anticipate.
The tankers, dry bulk and container freight markets will each face unique challenges in recovering the extra bunker costs brought by IMO 2020. The critical question is: will they pass through the storm unscathed, or will there be wreckage on the shore when the morning comes?
Container Shipping Mechanism
The container shipping industry is huge, handling over 60% of the world’s seaborne trade by value. With such market contribution, the container shipping will get more effects from the new regulation, compared to tanker and dry bulk.
Further, container shipping is unique. Unique challenges include the limitations of the Bunker Adjustment Factor fuel cost recovery system, the importance of annual freight and bunker charge contracts, and persistent overcapacity.
For the container market, bunker costs in most freight deals are handled using a mechanism commonly referred to as the BAF, or Bunker Adjustment Factor. In theory, it allows carriers to recoup the fuel expenses they incur when transporting containers.
The biggest problem with BAFs, especially with the upcoming global sulfur cap, is an almost a complete lack of standardization and transparency in the underlying formulas. For example, even for the two big partners of the 2M alliance, Maersk and Mediterranean Shipping Company (MSC), bunker surcharges on the same trade lanes are different.
Shippers therefore face a confusing excess of indications and formulas, with quotes for the same routes sometimes being vastly different.
The fuels used as a reference, the ports chosen, the length of review period for bunker prices, capacity utilization and other elements may vary significantly. For 2019-2020 carriers have also come up with various new names for their BAFs, creating a series of new abbreviations for shippers to get to grips with. Maersk renamed its Standard Bunker Factor (SBF) back to BAF, Hapag Lloyd rebranded its BFF (Bunker Fuel factor) and BUC (Bunker Charge) to Marine Fuel Recovery (MFR), while MSC got rid of its multiple fuel charges FAD, EFS and BUC, replacing them with a single Bunker Recovery Charge (BRC).
To make things even more interesting, carriers often have additional emergency and low-sulfur surcharges (EFS) in addition to the BAFs. All of that is on top of the general freight element. There is also the question of splitting bunker charges from the freight or including all charges together to produce all-inclusive FAK (Freight All Kinds) rates to be included in the contracts. Carriers and shippers often have opposing views on how this should be handled.
To top it all off, the freight contracts for 2019-2020 also tend to include hardship clauses, which allow further review of bunker charge mechanisms in Q3 and Q4 of 2019, when adoption of new 0.5% fuels is expected to pick up.
Naturally, the big shippers and NVOCCs responded with BAFs of their own, pushing for their adoption in contracts.
Impact to Freight Rate
As a result of all these factors, negotiations have been frustrating, often leading to strained relationships and some counterparties ending up with a contract which includes bunker charges they do not quite understand or agree with.
Volatility in oil prices during 2018 served as a warning to the container industry that BAF may be the wrong vessel for navigating through stormy market conditions. As bunker prices followed crude oil on a rollercoaster, both carriers and shippers were exposed to the adverse changes in bunker costs.
The problem is that FAK rates that include bunker charges do not follow changes in bunker expenses closely enough. First of all, the quarterly review periods of BAFs do not allow for much agility. Secondly, just like in other shipping markets, the overall freight levels will depend on the negotiating power of the counterparties.
And despite their consolidated position, carriers still have the issue of severe overcapacity on their hands, which restricts their clout when negotiating both spot and annual rates. As a result, there have regularly been misalignments between the overall freight and bunker charges. And every time that has happened, counterparties have been losing money.
The rigidity of BAFs and the lack of standardization led to some frustrating moments in freight negotiations and P&L management in 2018 – for everyone involved. This has been the case to an even greater extent this year as players have had to start coming to terms with the wild cards thrown up by IMO 2020, like the inclusion of compliant fuels into BAF formulas and the greater uncertainty in bunker prices over the next few years.
The mounting displeasure towards the current BAF system has encouraged market participants to look for new ways of handling bunker charges in freight contracts. There has been an increasing shift towards “floating bunker charge pricing,” which would keep bunker charges separate from the freight element in contracts.
The natural evolution here would be an adoption of independent bunker charge indexes that would standardize BAFs to a single number on a respective trade route. Such an approach would allow a much leaner and more transparent freight trading environment, leveling the playing field for all players and removing strains in the process for all sides. There is a need for some sort of clear guideline the market can rely on.
The issue of volatility in bunker prices is not new. It was not born with the IMO 2020 regulation and it will not go away once the switchover happens. However, the current troubles should serve as a wakeup call for the industry that the BAF wheel is broken and needs to be replaced.
This article was published in ISG Print Magazine January 2020 Edition.
