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IMO 2020: The biggest macro event you have never heard of

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      By Stewart D. Taylor, Investment Grade Fixed Income Portfolio Manager, Eaton Vance Management and Alfred Bonfantini, CFA, Senior Credit Analyst/Team Leader

      Boston - A new regulation limiting the sulfur content of the fuel used by marine shipping is likely to have a significant impact on the global economy and inflation in 2020.

      Maritime shipping is the backbone of the world's commerce. Over 90,000, tankers, bulk cargo, container and general cargo vessels transport 90% of the world's trade goods. No other method of transport can move large volumes of goods as efficiently. One reason that these vessels are so efficient to operate is that they use very inexpensive fuel. However these inexpensive fuels have a high sulfur content. They are responsible for a significant amount of the planets remaining acid rain and are a contributing factor in climate change.

      While the maritime shipping industry accounts for only 7% of transport oil demand, it produces 90% of the transport sectors sulfur emissions. Amazingly, as few as 15 of the largest freight carriers will annually emit more sulfur and oxides of nitrogen than all the world's automobiles combined. To address this problem, a new international maritime environmental regulatory standard (IMO 2020) will sharply reduce allowable sulfur emissions. This new rule becomes effective on January 1, 2020 but price impacts should begin to materialize as early as the fourth quarter.

      There are only a few practical ways for shippers to comply. They can purchase more expensive compliant fuels, install sulfur scrubbers, or retrofit their ships to use liquid natural gas (LNG). Installing scrubbers or LNG capability require large upfront outlays of capital. Because of these costs, current estimates suggest that 95% of ships will switch to higher cost, lower sulfur content fuels. At the same time, refiners have proven hesitant to add new capacity to refine the higher sulfur content distillates to acceptable levels. This means that the demand for cleaner distillates will rise sharply without a commensurate increase in supply. This translates to higher prices for diesel and other middle distillate fuels. There should also be some spillover effect to consumer gasoline. The result will increase the cost of shipping over the road and by rail. It will also push consumer diesel prices higher.

      While the new regulations will produce meaningful improvements in the environment, it is likely that the higher shipping costs will slow global economic activity and increase CPI inflation. There are several transmission mechanisms. The largest and most direct is higher freight rates. Fuel costs represent 15-30% of the total operating expenses involved in ocean shipping. Adding higher fuel costs for over-the-road truckers, rail shipments and consumers and the impact is substantial. The added costs will propagate throughout the value chain increasing costs of everything from the mining of commodities to the delivery of finished consumer goods. Estimates of global costs differ widely. Best estimates are that total direct costs will be 250-350 billion annually and that the impact on global inflation could be as high as 1%.

      The global economy is struggling to produce organic growth and the trade war is hotter by the day. A much weaker economy going into early next year might be reason for delay. However, there are no provisions in the regulations permitting a delay and prior attempts to move implementation to later years failed.

      Bottom line: IMO 2020 is likely to produce slower growth and higher inflation. We will provide updates as events warrant.