Floating storage: assessing the risks

Floating storage is one of the common by-products of conventional crude oil trading practices: as charterers await market fluctuations, vessels remain stationary en-route to their discharge port. This trading strategy is particularly effective in scenarios when future deliveries are trading at a premium to those in the spot market, a market feature generally known as contango.

For this reason, when oil prices plunge significantly, floating storage can become extensively widespread, as traders wait for a cyclical price surge.

This topical phenomenon raises a series of specific questions on the legal challenges that ship owners and charterers face when dealing with floating storage.

The trading history of floating storage

The concept of oil-storage trade developed in early 1990 and reached global attention during the “super contango” phenomenon of 2008, when the West Texas Intermediate (WTI) spot pricing plummeted from US$145 to US$40 per barrel within 5 months. The collapse encouraged a global frenzy to purchase crude oil, and those with access to cheap credit hoarded oil on ULCCs, VLCCs, and Suezmaxes. As a result, during the peak of the “super contango”, over 100 million barrels of oil became stored at sea and, by the end of 2009, one in twelve of the largest crude oil tankers were primarily utilised as floating storage units, rather than for transportation.

‘By the end of 2009, one in twelve of the largest crude oil tankers were primarily
utilised as floating storage units rather than for transportation.’

Today, the oil glut of 2015-2016 has prompted a second wave in global floating storage peaks, and brought new attention to this phenomenon.

As global oil production outpaced demand, by 2014 the world market became oversupplied with crude oil: whilst the demand for floating storage increased, tanker rates soared to new heights. By November 2016, floating storage had reached levels of just over 90 million barrels, a third of which were held in the West African Gulf, Iran and the North Sea. In response to the glut, OPEC and non-OPEC members signed a supply reduction agreement (which was further prolonged by nine months last November), with the intention of coordinating a production cut of 1.8 million barrels a day.

Recently, as the market rebalanced, the Brent Forward curve has transitioned from contango into backwardation, providing Charterers with an incentive to sell oil, rather than store it.

Currently, the Brent forward curve overall remains staunchly in backwardation and floating storage volumes have fallen significantly.

The legal implications

The fluctuations of floating storage volumes over the past few years have raised a series of legal and insurance concerns that ship owners, as well as charterers, should consider. The area of anchorage of a vessel chartered as floating storage can carry significant risks. In particular, charterers will have to be wary of factors such as weather, piracy and terrorism.

The risks associated with adverse weather can affect annual hull and machinery insurance, as weather conditions can cause significant hull damage and volumes spills. This is especially true in highly dense ports and areas of anchorage, where collisions between vessels are more likely.

Piracy and terrorism have a further impact on a vessel’s War and Piracy Insurance, which, in its standard form, would usually exclude areas of higher risk. As piracy and terrorism affects floating storage in a series of regions across the globe, such as Somalia, Nigeria, the Malacca and Singapore Straits, it is essential for a charterer to consider the potential legal and insurance liabilities which might arise when halting vessels in these areas.

Vessels used for floating storage are often of vintage age and, in the current state of the oil market, their seaworthiness is an issue of particular importance: as the backwardation curve releases units from floating storage charters, it becomes evident that many vessels might not satisfy the seaworthiness standards imposed under domestic and international law. As a consequence, it might prove difficult to charter older vessels for trading opportunities, especially when taking into account freight costs, which inevitably reduce trading yields.

‘Vessels used for floating storage are often of vintage age and, in the current
state of the oil market,  their seaworthiness is an issue of particular importance.’

The impact of unseaworthiness is very serious and its consequences are not to be underestimated.  Under the UK legal regime, ship owners have an ongoing obligation to ensure that vessels are seaworthy. In fact, an unseaworthy ship will not only trigger an insurance policy default (Marine Insurance Act 1906), but also potential criminal liabilities (Merchant Shipping Act 1995).

Both international and domestic provisions for the carriage of goods reiterate a ship owner’s responsibility to maintain seaworthiness. In particular, the Hague-Visby Rules provide for a carrier’s duty to exercise due diligence in order to make a vessel seaworthy before the commencement of a voyage. A charterer, on the other hand, will have the right to refuse a vessel’s delivery until any defects affecting seaworthiness are remedied, and might eventually be able to end a charterparty, or bring a claim against the ship owner. On this note, it is important to bear in mind that further requirements might come into play in the future, and that potential new international law developments under the Rotterdam Rules might extend a carrier’s duty to maintain seaworthiness even throughout voyage.

Finally, from an insurance perspective, insurance premiums can become a considerable expense, as old ships might be more prone to incidents of fire, grounding, or breaking up. Nevertheless, marine insurance will only be granted to vessels registered under a classification society, which, although it does not automatically attest to a vessel’s seaworthiness, establishes that the ship in question is subject to continuing compliance to the society’s relevant standards.

It is important to highlight that a floating storage vessel’s old age, combined with potentially lower maintenance levels, could increase the likelihood of spillages caused by damage to a vessel’s hull. Insurers will factor these elements when assessing insurance coverage and premiums.

The International Convention on Civil Liability for Oil Pollution Damage (CLC) is the main international convention addressing the availability of adequate compensation in oil damage involving oil tankers.  The convention provides for a ship owner’s strict liability, without a liability cap in instances where the ship owner is found guilty of oil pollution. Further, the Convention imposes limitations of liability in cases where the ship owner is not found at fault, and allows the victims of the damage to have direct access to the ship owner’s insurers.

It is to be considered that the Convention itself imposes a duty to maintain insurance or financial security sufficient to cover the maximum liability of one spill in vessels above 2000 tons in oil cargo. In light of the average size of floating storage vessels used in the industry, this provision will be applicable to the greatest majority of storage tankers at sea.

Conclusion

In conclusion, it is evident that fluctuations in oil prices and production levels can have a huge impact on the number of tankers at sea chartered as floating storage. In instances of strong market contango, this correlation can be so significant that it will be seen as a market balance indicator.

The challenges associated with these market changes carry a multitude of legal and insurance considerations, which affect both ship owners and charterers. Among those risks, widespread vessels’ unseaworthiness might harden the insurance market, leading to significantly premiums upsurges. Having a knowledge of the legal framework around such issues can assist market players reduce their risk and improve trading yields.

Matteo Lissana is a trainee solicitor at DWF, the global legal business with 26 offices around the globe. DWF is a corporate member of Asia House.