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The Scrubber Exercise

As the shipping industry is in the home straight towards 2020, discussions are concentrated more and more around scrubbers, as it looks like the industry has acknowledged the reality of the regulation looming and the inevitability of industry-wide adoption. As one can imagine, the opinions are quite polarised on the relative merits of scrubbers; either by adopting a pro or against scrubber mentality, with very few individuals sitting on the fence.

First of all, a decision to install scrubbers (or not to install scrubbers) should not aim to label the shipowner as either “good” or “bad”. As I had stated in my article of last year, “installing scrubbers, is a decision against the natural position (of a traditional shipowner)”. Shipowners are long on ships and are subject to the shipping market risk, being the equilibrium of supply and demand for tonnage and the underlying money-making ability of the owned assets expressed in TCE. Although bunkers are the most significant cost for shipowners, they are not subject to the risk of the crude oil market.

The freight rates and their daily equilibrium (short lived as it is) compensates the shipowners for both: (a) the supply and demand for tonnage; and (b) the bunker price environment. This is not clearly visible because these two elements may move towards the same or opposite direction. I appreciate that, it is even harder to separate out these discrete elements since shipowners do, literally, pay for bunkers. That does not mean, by any way, that shipowners undertake crude oil market risk. Whether the bunker prices are $100 or $1,000 per metric tonne, owners are going to get compensated, by an increase in freight rates, (as much as required) in order to maintain, all things being equal, the same TCE. Therefore, post 2020, it is reasonable to expect that freight rates in a healthy environment will rise to mostly* cover the higher fuel costs given the inability of the entire global fleet to install scrubbers. Of course, the extent of the increase will depend on the ability of shipowners (and subsequently the shippers/consignees) to pass on the additional cost (due to the increased bunker prices), down the chain to the end consumer. The ability to pass on this cost as described is also dependent on the elasticity of the shipping market during the transition period.

Consequently, the decision of any shipowner not to install a scrubber is, and should be, respected. The same way that shipowners do not speculate on bunker prices, if they wish not to take on an additional risk, it is very reasonable that they should not be wanting to install a scrubber and speculate on a spread between fuel prices. It is important to highlight the fact that a shipowner, by installing a scrubber, is converting the spread -and the spread only, between HSFO and the compliant fuel into a systemic risk of the shipping business along with FX and interest rate risk. It is very prudent as a shipowner not to want to inherit another risk, isn’t it?

I will answer my own question above with a yes, from the shipowner’s perspective. However, it would be very hard to say the same from a businessman’s perspective, and shipowners are naturally businessmen. A prudent businessman would try to understand the degree of risk that his business would inherit by installing a scrubber on his asset. Quoting Howard Marks from his book The Most Important Thing, “Here’s the key to understanding risk: it’s largely a matter of opinion…” and there is nothing wrong with having different opinions, as a matter of fact, it can often lead to healthy and meaningful discussions.

The scrubbers are followed by two risks in addition to fuel availability and technical performance. Firstly, the fiscal risk, i.e. the spread between the fuel prices and secondly, the regulatory risk that being the likelihood of the prohibition on the use of (open-loop) scrubbers in international waters. Banning open-loop scrubbers within port limits, even on a worldwide scale, does not harm the attractiveness of the investment, as the annual port consumption hardly exceeds 5-7% of the total annual consumption of the medium to large sized merchant ships.

Seemingly, the industry concentrates too much around how big the spread is going to be and how much the spread volatility could impact the scrubber payback. In reality, the question that needs to be answered is how narrow the spread could potentially be. One should try to understand the mechanism driving the fuel prices and how will this impact the price spread in 2020 and beyond. Within a reasonable time depth, whether the spread is, for example, $150 or $500/ton (and logic dictates that there should always be a minimum spread, unless someone believes that VLSFO is ubiquitous and prices the same as HSFO!), should not have a bearing on whether to install a scrubber or not, as long as the expected return from the scrubber investment itself (on one’s assumptions in regards to time depth and spread) exceeds the return generated by the underlying asset. The answer to that question therefore lies within whether the $150 spread mentioned above could potentially be $50 (or $0) and not whether it could go as high as $500. Getting the lower end of the spectrum right, after proper consideration and analysis of the fuel mechanisms, is much more important for the scrubber exercise (no one was ever blamed for generating more return than expected).

A prudent interpretation of the amount of risk present in the levers that can affect scrubber return is the most important exercise that must be undertaken before making the decision to install a scrubber. Not accounting properly for risk, can lead to significant losses whereas overestimating can lead to missing out on big profits.

Hopefully, the shipowners who installed scrubbers on their fleet made an informed business decision after taking everything into account and paying due consideration to the appropriate amount of risk within their business recipe. Contrastingly, the shipowners who do not install scrubbers run the risk of the scrubber installation materialising into a prudent business decision. As such, in the future these shipowners may well face being marginalised when trading. The only way out would be to install scrubbers at a later stage in order to maintain a competitive edge vis-à-vis with their industry peers.

* The use of word “mostly” in this sentence plays a significant role because it implies that the more ships fitted with scrubbers offered on the freight market, the lesser the increase in the freight rate with the HSFO-Compliant fuel spread remaining constant.
Source: John Yallouridis , Senior Analyst

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