IMO 2020 Shows Just How Difficult Commodity Markets Are

In commodity markets, the thing you expect to happen is often the exact opposite of what occurs. This lesson has been taught to industry veterans time and time again, and the impacts of IMO 2020 are another great example. In future weeks we plan to address the exciting developments stemming from IMO 2020, but today we will focus entirely on the price performance of high sulfur fuel oil (HSFO). The bunker fuel market is the main source of demand for high sulfur fuels. This market has historically given refineries an outlet for this residual material which had very few end-use options unless the refiner invested in upgrading and hydrotreating infrastructure. In some parts of the world high sulphur fuel can be used for power generation, however, it has to be heavily discounted to compete with coal or natural gas. This narrow collection of end uses means that HSFO trades at a significant discount to other products.

In 2016 the International Maritime Organization (IMO) decided that the sulfur content of all marine fuels used could not exceed 0.5%, starting on January 1, 2020. This global cap was a significant change from the previous limit of 3.5%. Companies in the shipping industry need to conform to these new rules and have a few options to do so. The first option is to use compliant fuels such as marine gas oil (MGO) or low sulfur fuel oil (LSFO). These compliant fuels currently exist and the markets have already begun to increase supplies as entities prepare to meet demand post IMO 2020 (for example multiple LSFO blends are being produced). The second option is to install scrubbers on ships to handle higher sulfur. Scrubbers extract sulfur from emissions by spraying the exhaust stream with water, capturing the sulfur particles and pulling them out of the air. The installation of scrubbers is a significant capital investment but allows a vessel to continue using HSFO, which presumably should be steeply discounted in a world where regulation is preventing its primary use. The final option is to use alternate fuel sources entirely. LNG is a good candidate for this alternative fuel as it is cost-advantaged compared to MGO. However, using LNG requires an engine retrofit or a new build. There are clearly a wide variety of options available to industry, but the predictable outcome common to all options is that HSFO will likely be worth less.

Surprisingly and in contrast to the logic above, HSFO crack spreads have hit new highs in many parts of the world over the last few weeks. The crack spread is the difference between the refined product produced and the crude input used to produce it. A positive crack spread, therefore, means it is profitable to refine that product. HSFO crack spreads have historically been negative, as refineries never targeted HFSO production specifically and it was produced as a by-product of the cracking process. Recently, the HSFO crack spread has turned positive in most markets. It seems to be a surprising outcome that a product with a demand cliff in less than a year is enjoying record performance. It is a great example of just how difficult commodity markets are.

A confluence of factors has resulted in the spiking prices of HSFO. In commodity markets, the perception of long-term oversupply will often result in near-term shortages. This is because companies that produce commodities are typically investing significant capital with a long-term strategy in mind. If all signs point to severely reduced demand for a commodity, individual actors will stop investing. While that reduced demand will eventually play out, and the price will fall, there will typically be a price spike first. This happens because the market still needs the commodity, but companies have begun to stop producing it. With HSFO, this supply decline was already occurring before IMO 2020, as refiners globally had been investing for decades to reduce fuel oil yields. They were doing this because it was never a profitable product for them to produce. Major regions such as India and China made significant pushes to modernize their refineries and fuel oil yields declined as a result. These reduced yields globally were then exacerbated due to the contraction of the energy industries in countries with heavy crude inputs and low refining complexity. The two primary examples of these countries are Mexico and Venezuela. Heavy inputs and low refinery complexity made these countries the perfect candidates for producing significant amounts of the fuel oil by-product. However, processing in these regions has been in decline. In Venezuela especially, political turmoil has put refinery runs into free fall.  Another factor that has decreased HSFO production is pipeline constraints in North America. These constraints have restricted the flow of Canadian heavy to US refineries. US refineries are instead processing more and more US shale, which, being significantly lighter, produces little to no fuel oil. All of these factors have led to a shortage of fuel oil at a time when demand remains and long-term demand appears supported by scrubber adoption.

It would have seemed a very safe bet to say that leading up to IMO 2020, the price of HSFO would continue to decline. Instead of this, crack spreads are reaching all-time highs. It is a great example of why we at Validere find the energy markets, and the quality concerns that drive them, so fascinating.

Mark Le Dain

Mark Le Dain currently runs strategy for Validere and previously worked as an energy investment banker. Mark has significant experience advising energy and infrastructure companies, successfully completing over $18 billion of M&A transactions and $5 billion of capital markets transactions.
Mark Le Dain