WORKING PAPER

IMPACT OF THE 2015 0.1% SULPHUR

REGULATIONS IN N. AMERICAN ECA

Current as of May 13, 2013

LQM Petroleum Services

30 years of excellence in the bunker industry 1

Table of contents

Regulations refinery and supply changes

Cost impact ship owners and operators

Technical consequences

Factors influencing price and hedging to manage price risk

2

Regulations in 2015

MARPOL Annex VI:

Maximum sulphur in the ECA will be 0.1% S max from 1st Jan 2015

Current indication is that yes, the regulation will go into effect in 2015, and ship

owners/charterers will be required to comply, otherwise be subject to fines by port state

controls

SOLAS: Minimum flash point 60 C for vessels in international trade

ISO 8217: Bio components limited to de minimis or 0.1%

Sources: IMO

Note: U.S. and Canadian ECA are both in effect as of time of this documents publication.

3

2015 reduction to 0.1% sulphur in ECA

Enforce-

ment date

Sulphu

r limit

(%

m/m)

Grade Operating area Engines Reference

1 August

201311.00 IFO / (MDO /

MGO)

Puerto Rico / US VI All machinery ECA enforced approx. 50 miles of

coast

1 January

201420.10 MGO (DMA)

MDO (DMB)

California waters and

24 NM of the

California baseline

All machinery CARB (mandatory use of either MGO

or MDO with the set maximum

sulphur limits to all engines)

1 January

2015

0.10 IFO / MDO /

MGO

USA / Canada ECA All machinery Decreased in line with Baltic /

North Sea ECA - within 200 miles of

coast

1 January

2015

0.10 IFO / MDO/

MGO

Baltic ECA All machinery Revised MARPOL Annex VI adopted

by Resolution MEPC.176(58)North Sea ECA All machinery

1 January

202030.50 IFO / MDO /

MGO

Global limit All machinery Revised MARPOL Annex VI adopted

by Resolution MEPC.176(58)

1. A fourth area, the United States Caribbean Sea ECA, covering certain waters adjacent to the coasts of Puerto Rico and the United States Virgin Islands, was designated

under MARPOL amendments adopted in July 2011, with expected entry into force on 1 January 2013, with the new ECA taking effect 12 months later on 1 January 2014.

2. January 1, 2012 implementation of the Phase II 0.1% sulphur limit was delayed from 2012 to 2014 (CARB Marine notice: Sept 1, 2011). Will be confirmed end October

2011 by the CA legislature.

3. A review, to be completed by 2018, will establish whether this grade of fuel will be available. If not, this implementation date may be changed to 1 Jan 2025.

At this time it is unlikely that IFO with a sulphur content of

Regulations: refinery implications

Reason why refiners will be affected differently:

Refiners unique attributes will impact their ability and decision-making about what to

produce, and in what quantities (e.g., IFO, MGO)

The crude slates* that refiners buy and then refine vary dramatically

Once slates are established, they are hard to change (e.g., a refiner who refines

light North Sea Crude is set up very differently from a U.S. refiner who refines

heavier crudes from Venezuela or Mexico)

Light crudes (i.e., higher API) are commonly more expensive, inherently easier

to refine into distillate products and typically come from locations such as North

Sea, Saudi Arabia

Light sweet crudes (i.e., higher API gravity and lower sulphur) are more desirable

now because of ECAs, and often demand a price premium

Heavy crudes (i.e., lower API) are typically cheaper:

May require more refining in order to produce distillates

Enable production of cheaper residual fuel products such as IFO

Lower API crudes with higher sulphur levels are referred to as heavy sour crudes

and are sourced from Venezuela and Mexico

Sources: Presentation by Colin Crooks of Shell Marine Products Ltd., at the 32nd International Bunker Conference, April 7,

2011; Purvin & Gertz Marpol effect conference, 2010; interviews with U.S. suppliers.

*Crude slate: natural characteristics of crude that are inputted into the refinery for processing

5

Refinery sourcing: U.S. fuel imports

Sources: U.S. Energy Information Administration, April 19, 2013.

6

Key takeaways:

1. Overall imports to the

U.S. have declined in

recent years

2. More of U.S. imports

are consolidated with

a few key players

3. Greater portion of

imports have been

sourced from Canada

4. Iraq is now supplying

again, and has

replaced Nigeria as

number five supplier

5. Expectation is that

Canada may grow to be

an even greater

producer in coming

years

6. New energy usage may

also increase (e.g.,

LNG) to displace

imports of crude

Refinery output varies based on economics

and crude inputs

Sources: July 5, 2012, U.S. Energy Information Administration

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Gasoil/distillate

Also typically referred to as

No. 2 oil

Crudes that are lighter may

produce more distillate per

bbl than heavier

alternatives

Bunker fuel residual fuel oil

Also typically referred to as

No. 6 oil

Depending on the refinery, its

economics and crude slate,

10-40% of crude bbl may be

turned into Intermediate fuel

oil (IFO)

Regulations: Supply Infrastructure

Supply situation in 2015

Market is expected to adjust to demand

Refineries in USG and USWC are advising physical suppliers that they will have minimal

difficulty meeting demand

Refiners on the USEC have already experienced difficulty in meeting current LS DMA

demand (e.g., finding gasoil that is compliant for marine use) in 2013, and this trend

may continue

Barges will have to adjust to meet requirements

Increase in gas oil volumes will increase the demand for barges dedicated to clean 60C

flash gas oil supply

Clean barges and trucks also carry clean products with low flashpoint, they must be fully

drained to ensure no contamination

Few barges in the U.S. have the ability to carry and segregate clean and dirty products

simultaneously

Shore Storage will increase for DMA

More gas oil demand will require more shore storage

2020 and beyond

DMB is a minority interest currently, but this will change with the 0.50% global cap in

2020/2025

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Supplier perspectives - responses

Questions Responses

Have suppliers been

planning?

YES - Every major supplier contacted for LQMs survey said that they were planning.

Some were unable to comment in detail because planning in too early a stage

Will gasoil (0.1%) be

used to meet the

regulation?

YES suppliers have not said a 0.1% fuel oil will be available.

Do you expect flash

point to be an issue?

USWC and USG Coast NO although select suppliers believe avails may initially be

tighter as not all refineries will supply spec with marine-grade flash.

USEC YES not all distillate produced on East Coast meets the min flash (60 C) for

marine use

Do you see any other

potential supply

challenges?

USWC and USG Coast NO refineries are stating that will have ample supply.

USEC YES supply may be an issue, getting on-spec fuel (e.g., with appropriate

flash, no bio diesel) has already been an issue

How much do you

expect your

requirements to

increase?

Gasoil only suppliers: 40-60% above current demand

IFO and gasoil suppliers:

VARIES BY SUPPLIER - majority of LS IFO demand will be replaced by gasoil demand.

Do you plan on having

a dedicated LS MGO

barge?

VARIES BY SUPPLIER suppliers will either have dedicated barges, or will have

barges that have both HSFO and LS MGO (segregated).

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Table of contents

Regulations refinery and supply changes

Cost impact ship owners and operators

Technical consequences

Factors influencing price and hedging to manage price risk

10

Cost impact: supply and vessel changes

Supply impact:

Immediate budget impact end of 2014 in switch from LS IFO

Future price rise (above todays price) for gasoil due to increased demand

Vessel impact:

Initial for new piping and re-direction of lines (e.g., new piping or risk of

contamination if vessel has no independent system)

Energy value of gasoil vs. intermediate fuel oil

Price change for vessels that burn heavy fuel versus gasoil in generators

Cost of Scrubbers (if owners opt in)

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Cost impact: distillate vs. IFODistillate vs. intermediate fuel oil costs

Immediate per metric ton budget impact end of 2014 when ship owners/charterers will have

to switch to LS DMA (0.1%) within the North American ECA

Whether this spread increases, decreases or remains the same will depend on: supply

dynamics, macroeconomic factors, extent of abatement technology adoption, and others

It is reasonable to assume that the spread will be different across ports and markets as unique

port attributes/supplier competition come into play

Assumptions:

- Bbl to metric ton conversions for IFO and distillate: 6.35 bbl/mt and 7.3bbl/mt respectively

- Retail premia (USG 3% to RMG 380 3.5% pricing of approximately $50/mt), though this premia is subject to change

- For U.S. Gulf analysis assumes port of New Orleans for comparison purposes with cargo indices

* Based on responses from suppliers interviewed about upcoming 2015 regulations, there is a potential price rise for gasoil.

Sources: Cargo index data and LQM internal data from Cal2012 March 2013.

Current spread: ~$250 b/w LSDMA and

LSFO

Current spread: ~$100 b/w LSFO and

HSFO

Assumption: ~+$200/mt increase

possible for East and Gulf Coast gasoil in

2015 depending on supply/demand

dynamics at the time*

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Budget impact due to switch to MGO

*Assumes current price premia of LS DMA over LSFO. This spread is subject to change due to dates and port.

Assumes vessel does not have scrubbers installed, which would obviate need for LS MGO to meet ECA.

What you would pay over today

Depending on the supply/demand dynamics for LS MGO in 2015, there could be a dramatic impact to pricing

Demand for LS MGO will certainly be higher than it is today

Based on assumption of lifts in New Orleans, premium estimated at ~$260/mt (LSFO $670/mt and gasoil $930/mt on April 23, 2013)

Assumes all LS IFO consumption will be transferred to LS MGO

LS MGO volume

estimate (mts)

% of volume

purchased

Current price

premia over LSFO

Budget impact

10,000 100% $260/mt $2.60 million

15,000 $3.90 million

50,000 $13.0 million 13

Table of contents

Regulations refinery and supply changes

Cost impact ship owners and operators

Technical consequences

Factors influencing price and hedging to manage price risk

14

Flash point and bio contaminationFlash point

Potential difficulties with flash point since marine gas oil market is much smaller than domestic on-

shore market

Marine flash point is 60 C (140 F) minimum but US domestic limit is 52 C (125 F)

USCG may view flash point differently for vessels working exclusively in US waters

Regardless, if time charter clause is ISO 8217, the min flash is 60 C

Bio contamination

Potential issues with bio contamination (bio diesel or other bio components such as bio waste)

U.S. government mandates gas oil suppliers to ensure that they supply a certain minimum % of bio

diesel in their total product sales

Some say this authorizes them to mix bio diesel with all marine gas oil supplies but this is not

correct - product will not meet ISO 8217

We can expect to see more problems with microbiological contamination, especially when product is

stored in tropical areas and in tank for more than 1 month

De Minimis

This expression in the ISO 8217 limits the percentage to 0.1% bio components in gas oil, and implies

that there must be no bio components used in blending of fuel oil or gas oil. Given issues with this

requirement as stated above, ISO is examining the possibility of a new grade, DMF*, which will

contain up to 7% and have additional test parameters specific to bio diesel performance.

De Minimis

This expression in the ISO 8217 limits the percentage to 0.1% bio components in gas oil, and implies

that there must be no bio components used in blending of fuel oil or gas oil. Given issues with this

requirement as stated above, ISO is examining the possibility of a new grade, DMF*, which will

contain up to 7% and have additional test parameters specific to bio diesel performance.15

* Further detail on specs forthcoming.

Lubricants

Ultra Low Sulphur Diesel* with sulphur below 0.05% has poor lubrication qualities

The lubricity test involves a test to wear a flat on a ball bearing and then measure the diameter

of the flat spot (wear scar)

The test is ISO 12156-1 (ASTM D 6079)

The test takes 2 hours and 50 ml of sample

Not considered a routine part of an analysis package

Additives

Many specialist additive companies will market extensively to the marine industry but only two

products are likely to see genuine demand

Lubricity improver, to meet the 520 micro meter wear scar test

This is routine in countries which use ULSD for automotive fuel

Relatively low volume and low cost (e.g., Innospec OLI 970.x)

Biocides to remedy microbiological contamination (e.g., FPPF Chemicals Killem biocide)

Ocean going vessels have engines that operate happily on 40 cetane minimum so cetane

improvers should not be needed

Lubricants and additives

Areas of concern for lubricity and additives

Lubricity limits on ultra low sulphur gas oil will likely cause problems in less developed countries.

Despite prevalence of additives in the U.S., current thinking is that additives will not be able to

remedy difficulty with storage stability, fuel system materials and interaction with water on any bio

diesel blend over 7%

Areas of concern for lubricity and additives

Lubricity limits on ultra low sulphur gas oil will likely cause problems in less developed countries.

Despite prevalence of additives in the U.S., current thinking is that additives will not be able to

remedy difficulty with storage stability, fuel system materials and interaction with water on any bio

diesel blend over 7%

* Many suppliers in the U.S. carry ultra low sulphur diesel with 0.0015% sulphur content, and use this (in combination with

a lubricity package) to meet requirements for LS DMA (0.1%)

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Storage on board

5-10 days consumption of gas oil instead of fuel oil required on each U.S. bunkering

due to transiting times for North American ECA

Sufficient segregated storage for trading routes

Cleaning, sludge removal and two valve segregation to transition LS IFO storage into

distillate storage

Modified pipelines and service tank arrangements to minimise change over

consumption

Commingling

There is no stability risk when commingling gas oils

Though, there is a risk of contaminating good gas oil with an off spec gas oil

Change-over

Most change over issues have been confined to the CARB areas, where the change

has to be effected only 24 nm from shore.

The problems are: a lack of competence on board and a lack of controlled adjustment

of fuel temperature. When change over was regular and routine (in the period from

1950 to 1980) vessels did not experience regular difficulties

Storage, commingling and cross-over

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Oxidation stability and viscosity

Oxidation stability

This parameter was introduced in 2010 to control the tendency of poorly blended

distillate to oxidise in storage

Oxidation stability will be a problem in certain areas where sellers are actively

blending different distillate stocks to meet marine specs

Gas oil blended in this way will start to break down through exposure to air

promoting sludging, gum deposition and chemical changes

The test is ISO 12205 (equivalent ASTM 7545) it takes 400 ml of sample and 16 hours

It would not be a routine part of an analysis package

Viscosity

ISO 8217 details maximum and minimum viscosities for distillate fuel (see table below)

Some on board equipment may be compromised by very low viscosity gas oil (below 3

cSt at 40 C) although historically this has not been a concern

There is a new grade DMZ with a min viscosity of 3 cSt at 40 C

Specification min visc @ 40 max visc @ 40

DMA 2 6

DMZ 3 6

DMB 2 11

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Table of contents

Regulations refinery and supply changes

Cost impact ship owners and operators

Technical consequences

Factors influencing price and hedging to manage price risk

19

Factors likely to impact market in coming

year (bearish and bullish factors)

20

Geopolitical events

North and South Korea, Middle East, Iran, etc.

Worldwide economy and commodity trader behavior

Bearish or bullish sentiment and consumer confidence

Flight to safety in U.S. equities vs. other riskier countries and commodities

OPEC production

Decision to raise or lower production levels to manage price

Movement on line of formerly disrupted supply (e.g., Iraq)

Refinery economics

Existing crude slates

Capital expenditure allocated to adjusting to new regulations

Supplier economics

Land side or marine use (e.g., gasoil)

Presence on a port by port basis

Demand by product

IFO: low sulphur (max 1.0%) and high sulphur (max 3.5%)

MGO: low sulphur DMA (0.1%)

Strategic hedging

Goals of hedging

Improve and maintain competitiveness

Companies dont exist in isolation

Competitors do hedge and can pass savings to end buyer

If shipping oil purchases and cost are part of an internal

transportation cost then goal of hedging would be to lower

that cost

Some strategies to consider

Use swaps and capped swaps for forward 12 months

Attempt to buy strategically:

2013 World Scale rate or other U.S Flag rate

structure

Current spot

Past 100 day or 240 day moving average

Buy 25% of total lift volume (or as decided by

management risk profile)

Hedging is contingent

on the preferences

and risk tolerance of

its shareholders

Tramp operators are

short fuel every day

the ship sails and are

at risk of price impact

every 30-60 days in

the replenishment

cycle

Many companies

choose to mitigate

risk through hedging

or lock in profit for

COAs

Hedging is contingent

on the preferences

and risk tolerance of

its shareholders

Tramp operators are

short fuel every day

the ship sails and are

at risk of price impact

every 30-60 days in

the replenishment

cycle

Many companies

choose to mitigate

risk through hedging

or lock in profit for

COAs

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Tactical considerations when hedging

1. Limit basis risk

Confirm relevant correlation between index and physical port where bunkers lifted

Evaluate whether index will still be viable in year in which physical lift will take

place

2. Pick highly liquid indices

Already well traded with numerous buyers and sellers

Expected to be relevant in time period in consideration (e.g., will still be viable

index to buy/sell against in future)

3. Time hedge or swap at a market low, to give greatest protection against price rise

Opportunistically consider backwardated markets to lock in price

Look for seasonal lows in indices (e.g., summer for heating oil) to lock in swap

4. Understand the range of spreads between HSFO, LSFO and LSDMA for given time

periods and how this information can be used to plan effectively

Estimate fuel costs for upcoming COAs

Plan budgets for coming years 22

Indices and correlations

Both HSFO and gasoil will be viable bunkers to hedge in 2015:

HSFO (max 3.5% sulphur) will still be required for ocean-going vessels outside of ECA zones

LSFO (max 1.0% sulphur) will all but disappear, as it was mainly required in the current ECA zones

LS DMA (0.1%) in the U.S. is still expected to be the spec supplied, noting that the actual product is

typically an ultra low sulphur (i.e., 0.0015% sulphur or 15 ppm)

For HSFO the following are the key indices to hedge:

3.0% US Gulf Waterborne

3.5% FOB Rotterdam Barges

3.5% FOB Med Cargoes

380 CST Singapore Cargoes

For LS MGO the following are the key indices to hedge:

NYMEX Heating Oil

Gasoil No.2 Waterborne (less commonly hedged than NYMEX)

Many of the gasoil indices are highly correlated, so suppliers place their hedges based on highest

liquidity and the most closely correlated to their physical supply*:

Correlation = 0.986 Gasoil No. 2 NY Harbor Cargo and Gasoil No. 2 USGC Waterborne

Correlation = 0.981 Gasoil No. 2 USGC Waterborne and Diesel LS 500 ppm USGC Waterborne

Correlation = 0.999 Diesel LS 500 ppm USGC Waterborne and ULSD USGC Waterborne

* Correlations calculated based on daily close of index data from Jan 5, 2012 March 27, 2013.

Sources: Based on survey of U.S. suppliers regarding upcoming 2015 0.1% sulphur regulations.

23

Correlations: ~0.83 between

USGW #6 Oil and 0.1% MGO

Dip strategies that could be used for

hedging fuel and gasoil

Buy on dips and establish what magnitude of dip

Examples:

if $6/mt buy lower monthly volume (250 mts) per strip

if $7-15/mt - 500mts per month

if $25/mt 1500mts per month

Track following data in monitors and graphs for daily transparency

Spot price

Futures curve

Past 100 and 240 day

Spreads to spot and futures (backwardation and contango/actual stem prices/World Scale levels)

Evaluate liquidity of index being used, and gather input on other indices coming into play that can be used effectively as hedging tools as market evolves 24

Picking timing to hedge:

Below gasoil example illustrates importance of picking right time to hedge

Heating oil market highly volatile (and often seasonal) in the U.S.

Opportunity to lock in low price for swap for future planned bunker lifts

Source: ULSD heating oil cargo data from Jan 5, 2012 March 28, 2013.

Recent days market

has softened off of

February highs, but is

poised for rebound

Hedging

opportunity

during

seasonal

market low

25

Hedge spreads to spot & actuals

240 day avg.

= $980/mt

100 day avg.

= $970/mt

26

Avoid buying when

spot rises sharply

(e.g., $15-$20/mt)

Minimize buying on dips

if spot and swap is above

100 / 240 day moving

average

If market falling AND

below averages, consider

a good time to buy

Hedging strategies may vary buyer to buyer, some suggested approaches are indicated below

Having a strategy in place ahead of time avoids reactive buying as well as second guessing of

decisions made (e.g., goal is to refine strategy to continually improve)

Source: based on data pulled April 3, 2013.

Opportunity for hedging gasoil

27

The current index in use for hedging gasoil in the U.S. is the NYMEX index until 2015

Highly liquid / highly traded

Well correlated to heating oil / gasoil indices in the U.S.

After 2015, there is some debate about which index will be the most common index to hedge for

gasoil given new regulations

Potential for the Ultra Low Sulphur Diesel 61 index

Or, may be the NYMEX 0.1% index, but remains to be seen

Spread:

(Range has

been $40 -

$120/mt in

time period

shown)

Opportunity to hedging gasoil in 13 and 14

28

Heating oil curves for relevant U.S. ports are currently backwardated for coming years

Indications for future prices (SWAPS) that could be taken on heating oil (current index) were as

follows on April 4, 2013:

Balance Cal 2013 - $914/mt

Cal 2014 - $895/mt

Cal 2015 - $878/mt

Savings of ~$86/mt

off current spot

levels in NOLA

Assumptions:

1. Based on data current as of April 4, 2013 (futures curves and spot prices in New Orleans as a comparison port)

2. Indications for hedges change every day, goal is to time most favorable hedge (i.e., low day)

3. Spreads between index and spot fluctuate, objective is to lock in reasonable profit based on strategy adopted.

Savings of ~$105/mt off current spot levels

in NOLA

Illustrates

backwardated

market

Hedging Tools

Plain SwapBuy a call (right to buy)

Establish future time period

Choose Indices USG 3%, Rott FOB barges, NYMEX, Sing 380 cst cargoes

Set volume per month

Set strike price

In month of settlement if market average (platts mean of daily is above strike) the trader pays the buyer the difference and if average is below the average the buyer pays the trader

No payment is needed at time of contract

Capped Swap

Buy call and sell call

Owners feel market could drop and they want to reduce the exposure of payback to trader

They can lower the swap floor but will cap ceiling or the level to which they can get cover up to if market rises (limits the upside)

Synthetic CallBuy a call and Sell a put

Owner feels market could drop and wants no risk below a certain floor but wants protection over a certain ceiling

Other tools: there is also ZCC (zero cost collar) and straight options

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SoftwareSoftware

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Clients come first

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www.bunkervision.com

Access to live bunker prices

Online Tools and Analytics

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Singapore

Telephone: +65 6673 3104

General email: singapore@lqm.com

Thank you, and please feel free to contact us

for additional information

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