Thursday, January 24, 2008

Sailing Ships and Resid Conversion

The romance of the Age of Sail, with iconic "tall ships" like the Cutty Sark, stands in stark contrast to the dull container ships and tankers that carry the world's trade, today. However, with fuel costs rising and wind turbines gaining market share for electric power, it shouldn't be surprising that entrepreneurs are looking at ways to enable cargo vessels to derive some of their motive power from the ocean breezes. Yesterday's Wall Street Journal described one such effort, by SkySails AG. In the long run, this could have implications beyond just reducing operating costs and emissions for ship owners. The tighter global crude oil supplies become, the more attractive the fuel that powers these ships today will look as a feedstock for making gasoline, diesel and jet fuel.

Although most of the world's warships employ either nuclear energy or powerful and efficient gas turbines, cargo vessels still generally run on heavy fuel oil that is the residue of the oil refining process. A major technology shift occurred in the 1980s, when the cargo fleet converted from boilers and steam turbines to enormous diesel engines requiring fuel oil with a lower viscosity than that burned in the old steamships. While somewhat higher in quality than bunker fuel, this oil is still made up mostly of refinery leftovers, and it normally sells at a significant discount to crude oil. For example, the current price of IFO380, a common grade of marine fuel, equates to about $70 per barrel in Los Angeles, or about $6.50 per barrel less than the posted price of the San Joaquin Valley heavy crude (plus freight) from which it is most likely derived.

For many years, the refining industry has had the technology to convert this low-quality material into higher-value fuels, limited mainly by the economic return available on the large capital investments involved. With the steady growth of US "resid destruction" capacity since the 1970s, more than 2 million barrels per day of this material finds its way into delayed coking units, resid hydrocrackers, and residuum fluid catalytic crackers, reducing the amount of crude oil required to produce a given slate of gasoline, diesel and jet fuel, and leaving only about 700,000 bpd for the marine and other heavy fuel oil markets.

A recent report from Cambridge Energy Research Associates (CERA,) a sister company of my sponsor John S. Herold, Inc., suggests that the rate of decline in production from the world's existing oil fields is 4.5% per year. This is somewhat less than has been feared but still substantial, requiring the replacement of essentially an Iran each year. Given the risk of project delays and the relatively flat recent non-OPEC output, this figure seems unlikely to allay fears of an impending peak in global oil production. Whenever Peak Oil occurs, the incentive to convert more residual fuel should increase, perhaps rendering it too valuable as a feedstock to continue burning in large quantities onboard ships. If it makes sense to spend $100 billion on the hardware to exploit remote oil sands deposits and convert them into synthetic crude oil, how much sense does it make to sell large volumes of comparable hydrocarbons that are already inside existing refineries?

Although the amount of marine fuel freed up by the application of high-tech sails to cargo ships appears to be modest, it looks too important to ignore, as crude oil output struggles to keep pace with demand. It's timely for the shipping industry to explore its options for higher efficiency and alternative propulsion now, before they are forced to do so by further shifts in the global oil supply and demand balance.

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