London-based Baltic Exchange last week confirmed it would adapt its benchmark dry bulk freight indexes to upcoming marine fuel regulations of the International Maritime Organization, called IMO 2020, by continuing to use vessels not fitted with scrubbers in its underlying time-charter calculations.
The decision comes after several months of consultations and some backlash from financial market participants exposed to shipping derivatives affected by IMO 2020, highlighting the ripple effect of the IMO directive on shipping and fuel markets, and how the industry is struggling to cope with the changes.
The Baltic Exchange publishes freight rates for benchmark shipping routes across the tanker, dry bulk and container sectors, and freight indexes. S&P Global Platts competes with the Baltic Exchange in the publication of freight indexes including benchmark shipping assessments.
The indexes form the basis of shipping derivatives called Forward Freight Agreements (FFAs), that are used by ship owners and charterers for hedging, or traded by financial institutions like banks and funds. The most liquid FFA market is for bulk commodities like iron ore and coal.
The benchmarks are based on standardized specifications like the vessel type, major trade routes, bunker fuel costs and port charges, among others. Since IMO 2020 requires tighter 0.5% sulfur fuel specifications from January 1, 2020, an evaluation of underlying fuel specs was needed.
Vessels underlying the Capesize, Panamax, Supramax and Handysize timecharter indices will continue to be ships that are not fitted with scrubbers, the Baltic Exchange said Wednesday in a statement. Scrubbers are exhaust gas cleaning systems used by a ship burning high-sulfur fuel.
It told members in a circular that “no change was required to the existing fuel reference in the timecharter indices, which represents all the physical fuels a vessel is required to burn up to a limit of 380cst.”
It said maintaining the index vessel as a non-scrubber vessel was backed by Baltic panellists including a majority of Capesize panellists as no reliable prices for a scrubber fitted vessel were available based on the current market.
FINANCIAL MARKET IMPACT
The Baltic Exchange’s decision has been criticized by financial investors such as hedge funds who have FFA positions beyond January 1, 2020, and claim that not accounting for scrubber vessels will lower FFA prices and hurt millions of dollars in long derivative positions.
“We (and others) proposed and believed the ‘parallel index’ route best addresses the issue,” Dimitrios Tsouvelekakis, director of Oppenheim Group, said last week, referring to an alternative where parallel contracts are floated by exchanges allowing market participants to switch positions.
He said that as long as there is a fuel price differential between high and low sulfur fuels and there are vessels burning high sulfur fuel post-2020, anyone holding futures & options expiring post January 2020 would be affected.
The Baltic Exchange said it had approached a wide segment of shipowners, operators and brokers for information on scrubber installations.
“The impact of any decision on derivatives open interest was also carefully considered and the Baltic engaged with the FFA Brokers Association as well as the relevant clearing houses,” its statement said. A spokesman declined to take further queries.
“The Baltic Index Council does not consider that material market disruption to physical and derivatives open interest would result from this clarification,” its circular said.
INDUSTRY OPINION DIVIDED
Experts remain divided on how derivatives markets can tackle IMO 2020.
“The decision to settle for a ‘no scrubber” clarification makes perfect sense, and essentially was the ‘default’ option all along,” Ralph Leszczynski, head of research at Italian brokerage bancosta, said.
He said that in January 2020 no more than 10% of trading ships will have scrubbers installed, making no-scrubber vessels the standard benchmark vessel.
The IMO 2020 rules are an a exogenous factor that will lead to higher bunker costs, but not very different from other factors like OPEC or US sanctions, and therefore do not require a fundamental change in the benchmark vessel nor the functioning of the freight mechanism, he said.
Shipping consultant Barry Parker, of New York-based bdp1 Consulting Ltd, was in favour of parallel FFA contracts to reflect the emerging “two-tiered” physical market for bunker fuels and said that existing contracts should be allowed to settle with the original specs.
“Over time, the existing contracts will phase out,” Parker said.
“Both sides of the discussion are correct: an index based on a scrubber-fitted vessel will tend to be ‘too high’ compared to the current index and the non-scrubber-fitted index will be ‘too low’,” Roar Adland, professor at the Center for Shipping & Logistics, NHH Norwegian School of Economics, said.
He said the fairest solution may be to give weightage to both options to minimize disruption come 2020.
The IMO changes have been known for years and FFA holders should be aware of the uncertainty because current Baltic specifications would by definition be non-compliant anyway, Adland said.
“This is therefore a risk that all traders have taken on willingly,” he said, adding that running parallel indexes doesn’t solve the problem as neither would be identical to the current index.
A ship owner who uses futures or FFAs for strategic long-term hedging by locking in forward prices could also be affected, according to energy consultant John T. Driscoll, director of JTD Energy Services.
He said the properties of the underlying commodity are critical factors and implementing these with minimal market disruption is a tall order.
“There has to be an extended adjustment or grace period,” Driscoll said. “A lot of capital and assets are at stake. The benchmarks cannot be arbitrary. Markets and hedgers will need to adapt.”