By John Dunham, managing partner of John Dunham & Associates, jrd@guerrillaeconomics.com.
“People get ready, there’s a train a comin.’ You don’t need no baggage, you just get on board. All you need is faith, to hear the diesels hummin’…”
So began the title track of the 1965 People Get Ready album by the Impressions. Written by guitarist Curtis Mayfield, the song became the Impressions’ top hit—reaching number 14 on the Billboard Pop Charts.
People need to get ready now for potential changes in both pricing and availability of diesel fuel in the coming months. New rules on the type of fuel that maritime vessels can use went into effect on the first of the year. These UN International Maritime Organization (IMO) rules will dramatically limit the sulfur content of fuel, down from 3.5% today to just 0.5%. While most people in America discount the UN and pay little attention to its edicts, the IMO has considerable authority over seagoing vessels and will work with the insurance industry to declare them to be unseaworthy if they fail to comply with its regulations.
Most ships used a high-sulfur fuel known as Bunker C, which is also called Number 6 fuel oil. This is a high-viscosity residual oil remaining after the more valuable cuts of crude oil have boiled off during the refining process. About 70% of all fuel used on ships was this high-sulfur Bunker C.
The Impact
According to the risk management firm DNV GL, about 70,000 vessels are impacted by the new rule. A report produced by academics at the Chalmers University of Technology in Sweden cites one consulting firm’s suggestion that the costs to the shipping industry could be as much as $60 billion annually, and that most of the vessels would comply by changing fuels rather than by installing scrubbers.
Thus far, disruptions in fuel supplies have not occurred in most of the main trading countries, as both refiners and shipping companies have been preparing for the mandate for some time. Diesel has been prepositioned and refineries have been producing more low-sulfur diesel to meet the expected increase in demand. Low-sulfur diesel production rose from about 3 million barrels a week just 10 years ago to over 5 million barrels per week today. Even so, the sharp increase in demand for diesel fuel will likely begin to bite over the next few months.
Under the new IMO guidelines, ships must either begin using more expensive low-sulfur grades of fuel or install expensive scrubbing equipment. This will have three effects. First, shipping costs will surely rise, and carriers pass on costs to shippers. Second, refineries will no longer have a market for Number 6 oil, and will see their revenues fall. These revenue losses will need to be made up elsewhere in the refining process, leading to higher prices for diesel fuel. Third, and likely most importantly for the food industry, demand for low sulfur fuel will increase dramatically, and as the price of marine gas oil increases, so too will diesel and jet fuel. The rise in the price of diesel means the cost of moving food and agricultural products will become more expensive.
Rising Costs
According to economist Philip Verleger, competition for fuel could raise the price of diesel by 50% and jet fuel by between 30%-40% in 2020.
This has not happened yet; however, it is likely there will be sudden and substantial disruptions in the transportation sector that many companies are ill prepared to handle, particularly as contracts for fuel begin to expire this year. The U.S. Department of Energy’s Energy Information Agency expects the IMO regulations will encourage global refiners to increase refinery runs and maximize the production of low-sulfur distillate fuel. The agency also forecasts substantial increases in diesel wholesale margins, which rise from an average of 45 cents per gal. in 2019 to a forecasted peak of 61 cents per gal. in the first quarter of 2020 and an average of 57 cents per gal. for the whole year. Even so, it expects only minimal price increases at retail over the next two years.
This is likely a rosy projection. Many areas that are highly dependent on marine cargo, including Singapore, Rotterdam, and Houston, experienced a considerable rise in marine fuels beginning in Dec. 2019, suggesting that supplies of low sulfur diesel fuels are tightening. The maritime industry needs roughly 48 million gallons of diesel per day of fuel, and trucking in the U.S. uses about 105 million gallons per day so it’s likely that at least for the next year there will be demand price inflation for fuel. Simply put, upwards of 70,000 ships switching to Number 1, 2, and 3 oil will dramatically increase demand for diesel fuel leading to higher prices.
Not only will these costs be passed through to businesses and eventually to consumers, but so too will losses for refineries. Based on data from the U.S. Department of Energy, American refiners will earn roughly $3.9 billion on high-sulfur Number 6 fuel oil in 2019. This accounts for between 3.0%-4.0% of refinery production in the U.S. In order to keep up current investments, companies must make up lost profits from these sales by increasing prices on other products, such as jet fuel or diesel.
The bottom line for food producers, distributors, and retailers is there is a very good chance that fuel price increases on all aspects of food and ingredient distribution will rise over the coming months—even without turmoil in the Middle East. With fuel prices accounting for roughly 20% of the cost of trucking, even a modest 61 cents per gal. price increase would amount to a 4% rise in trucking costs. For rail transport, the increase would be equal to roughly 2.4%. All of this will be passed through the production, wholesale, and retail channels so the actual costs to consumers might be even higher.
While deep sea shipping is not a hugely visible part of the American economy, food-related firms throughout the country will likely see the effects of the new regulations.
“People get ready, there’s a train a comin.”