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$10 Gas? The Obscure Maritime Rule That Could Make it a Reality

U.S. News & World Report logo U.S. News & World Report 7/31/2018 Alan Neuhauser
A ship spewing heavy smoke is pictured on the Bosphorus on April 21, 2009 off the coast of Istanbul.: The global shipping industry is a major source of pollution, recent analyses have found.© Bulent Kilic/AFP/Getty Images The global shipping industry is a major source of pollution, recent analyses have found.

A little-noticed rule requiring large ships to soon slash the air pollution they produce threatens to drive benchmark oil prices as high as $200 a barrel, send prices at the pump soaring to $6 or even $10 a gallon and crash the global economy just 17 months from now.

The doomsday scenario was described in a paper last week by Philip Verleger, an economist who advised two presidents and correctly forecast in 2007 that oil prices would sharply rise to levels that could trigger a financial crisis – a development experts say contributed to the Great Recession. And in his latest prediction, he's not alone.

Goldman Sachs , Morgan Stanley and other industry experts have issued similar warnings about significant increases in oil prices to come.

The reason is the near-unanimous decision by the International Maritime Organization, a United Nations agency that oversees the shipping industry, to cut the amount of sulfur in the maritime fuel used by large ships from 3.5 percent to 0.5 percent.

Experts, including Verleger, broadly agree that the rule, first announced in 2008, is a necessary and even overdue corrective to decades of pollution by the maritime sector: A single cruise ship in one day generates as much particulate matter as 1 million cars, and 15 of the world's biggest ships emit more sulfur and nitrogen oxides than all the cars on the planet, Goldman Sachs found in a May analysis. One study published in February estimated that the the new rule, once implemented, will prevent 150,000 premature deaths and 7.6 million childhood asthma cases each year.

"I think we'll look back at the marine fuel market and think, 'What were we thinking?'" says Tom Kloza, global head of energy analysis at Oil Price Information Service.

In choosing when exactly to institute the rule within a window that spanned 2020-2025, however, the maritime organization opted in 2016 for the earliest date. And in the face of years of procrastination by shipowners to respond to the rules, experts say that decision will soon lead to a sudden shift in oil demand, leaving refineries and global markets deeply unprepared. A looming supply crunch in crude oil, caused by years of under-investment in exploration and new production, could compound the issue.

"A year from now, it's going to start. And in 2019 you might have apocalyptic prices for diesel, like we saw in 2008," Kloza says. "Diesel was $4-5 a gallon at the pumps, and that hurts."

Verleger, writing this spring in the Magazine of International Economic Policy, declared that "it is not extreme to assert that many if not most of the officials making the IMO rules are descendants in spirit and experience of Edward John Smith, the captain of the ill-fated RMS Titanic."

Ship companies have essentially two options under the maritime organization's rules: install "scrubbers" that would remove sulfur oxides and nitrogen oxides from their emissions or switch from heavily polluting maritime "bunker fuel" to cleaner-burning diesel blends that comply with the new limits on sulfur.

With scrubbers being prohibitively expensive for most ships, the vast majority will almost certainly instead shift to diesel, which they can start using without major changes to equipment. That, in turn, is expected drive-up demand and cause prices to soar on diesel, a fuel that's already experiencing the strongest demand in years.

Refineries, Verleger says, simply won't be able to keep up with the sudden new demand from shipping, creating a costly and catastrophic bottleneck that could cause gasoline prices to double and the global gross domestic product to drop as much as 5 percent.

"The global economy likely faces an economic crash of horrible proportions in 2020," he writes in his analysis. "Economic activity will slow and, in some places, grind to a halt. Food costs will climb as farmers, unable to pay for fuel, reduce plantings. Deliveries of goods and materials to factories and stores will slow or stop. Vehicle sales will plummet, especially those of gas-guzzling sport utility vehicles (SUVs). One or more major US automakers will face bankruptcy, even closure. Housing foreclosures will surge in the United States, Europe, and other parts of the world. Millions will join the ranks of the unemployed as they did in 2008. All for the want of low-sulfur diesel fuel or gasoil."

The bulk of the problem relates to how well refineries are able to produce fuel from the two main types of crude oil that different regions produce.

State-of-the-art refineries in the U.S. Gulf region, Northwest Europe and India are able to take the heavy, sour crude that's produced in much of the Middle East, Canada, Venezuela, Alaska, Mexico and from U.S. rigs in the Gulf of Mexico and process it into light products such as diesel.

Older and less complex refineries, however, aren't able to as easily produce as broad a range of fuels. They're able to use heavy, sour crude to produce the bunker fuel that ships currently use – a fuel that emits huge amounts of harmful sulfur oxides and nitrogen oxides.

But to make diesel, they depend on the light, sweet crude produced in part parts of Africa, Southeast Asia, Russia, and certain areas of the U.S. and Canada. Their capacity to produce diesel, in other words, is much more limited – in turn creating a cap for how much diesel refiners can produce overall.

Global demand for diesel has risen by about 600,000 barrels per day each of the last three years, Kloza says, buoyed by relatively robust economic growth in sectors ranging from agriculture to shipping to transportation. Diesel prices in the U.S., meanwhile, are at their highest point since July 2014.

The changeover in maritime fuels is expected to perhaps double the projected increase in demand, abruptly adding 1 to 2 million bpd of demand, analysts say.

In spite of that increase, some experts say that fears about the fuel rule's impact are likely overblown. Morgan Stanley in its analysis in June, for example, predicted a more modest climb for benchmark Brent crude prices to $90 per barrel, up from about $75 presently.

Verleger "is always a good read, always thought-provoking and very articulate, but often a bit sensational," says Antoine Halff, senior research scholar at the Columbia University Center on Global Energy Policy and former chief oil analyst at the International Energy Agency. "You would expect them to have a price impact during the initial period of adjustment. I wouldn't necessarily be as alarmist. At the risk of more boring, you have to be a bit more balanced."

Some refineries have already started taking steps to ramp up their diesel output, and fuel consumption by the shipping industry, though difficult to track, appears to have leveled off or even declined. In a report commissioned by the maritime organization to evaluate the fuel rule, a consortium of consultants concluded that refineries would be able to meet new diesel demand from the shipping sector. And though global demand for diesel has ticked up in recent years, that increase followed a period of decline, Halff says.

"Diesel demand growth outside the shipping sector looks more precarious than it has – I wonder if I would say in history, certainly in the last 20 years," Halff says. "There's very many moving parts in this. You can't just look at the shipping sector, but the broader context."

However, another consulting firm – hired by an oil and gas industry group and the world's largest shipowner's association – submitted a rival report to the maritime organization that reached a different conclusion: that refineries would be vastly overwhelmed, causing prices to skyrocket.

"It's not something that everyone can simply ramp up, wave a magic wand or flip a switch and suddenly produce greater volumes," says Dan McTeague, senior petroleum analyst at GasBuddy.com. "A hundred dollars would be enough to bring the economy to its knees. Two hundred would be cataclysmic."

Crucially, the firm hired by the maritime organization made two assumptions that could prove fatal, Verleger says: first, that production from Venezuela would remain level or increase – instead, it's plunged amid the country's financial crisis – and, second, that Saudi Arabia would steadily expand its crude oil production. OPEC nations, in the face of rising U.S. crude production, have instead reduced their oil development to help stabilize prices.

Moreover, analysts are also predicting that low levels of investment in oil exploration and new production – a consequence of the collapse in benchmark oil prices in 2014 – will mean that rising demand, especially in China and India, will soon outpace supply, further driving up prices.

Compared to the role that rising oil prices played in contributing to the Great Recession, Verleger says, "This is potentially much worse." Even a smaller increase in benchmark prices to $90, as Morgan Stanley predicts, represents a 20 percent jump from current prices.

The mechanisms for enforcement appear to be in place: Insurers and banks have both said they won't back ships that don't comply with the new rules, a signal of the measure's broad support.

"The bank's and the insurance industry's ability to verify and monitor compliance might still not be completely foolproof, but the fact that they have signaled this policy strengthens the outlook for compliance very significantly," Halff, of Columbia, says.

There remain some 17 months until the rule's implementation, and experts say that a gradual phase-in of the rule would mitigate its impact, especially compared to the abrupt changeover that's presently expected Jan. 1, 2020. However, there's little sign that shipping companies – which have already had a decade to respond to the fuel rule – wouldn't simply procrastinate further in the face of delay.

"It is not as if industry did not have time to prepare. The IMO has repeatedly signaled they wouldn't budge," Halff says. "Postponing at this late hour would also be extremely unfair to those market participants that have taken steps to prepare and made the required investments."

Few experts expect any changes. Among the International Maritime Organization's member states, the United States – with comparatively few ships in the industry – has relatively little clout, and the rule enjoys especially strong support from the organization's European members. In a vote in April on a similar measure aimed at cutting emissions that contribute to climate change, the U.S. was outvoted 174-3, joined only by Saudi Arabia and Brazil in opposition.

Another factor, though, could further dampen its impact: a decrease in global demand, perhaps caused by one dynamic in particular:

"The impact might not be as great if the trade war slows things down," Verleger says. "The economic slowdown in China, which seems to be developing, if the U.S. economy starts to slow down, that could change things.

"One way or another, you wind up with troubles."

Copyright 2017 U.S. News & World Report

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