Fuel oil markets have been roiled by the Trump administration’s withdrawal from the Iran nuclear accord. Not only does the market face the loss of heavy crude from Iran, as well as its exports of fuel oil, but deeper structural problems in the market have been made much more prominent. Huge short crack positions along the curve in anticipation of IMO 2020 are anchoring the forward curve, creating massive backwardation in fuel oil both in Europe and Asia. As a result, arbitrage flows to Asia are totally inviable due to the mismatch in pricing. The result will eventually be an explosive move, either in Asia to the upside to secure resupply, or in Europe to the downside to reopen the arb.
Fuel oil stocks in Singapore are near levels last seen in 2014 and demand is strengthening seasonally. Though Middle Eastern fuel oil exports to Asia have been heavy, they may fall with renewed Iran sanctions. Meanwhile, regional cooling demand is building to its summer peak. Saudi Arabia is buying heavily in Europe to meet domestic needs, meaning flows of West of Suez material to Singapore will be limited in June and July. Furthermore, refinery upgrades are tightening the Asian market. India has become a net fuel oil importer due to new cokers and South Korea’s S-Oil has started a new RFCC that will cut its fuel oil output, while Chinese fuel oil production is falling alongside its lightening crude slate.
We think Singapore will need to bid for resupply before Europe needs to sell off. Short term, the Atlantic basin is likely balanced by Saudi buying, declines in Venezuelan output and new fuel oil upgrading equipment in Europe, such as ExxonMobil’s Antwerp coker, due to start this summer, and the SDA unit at Shell’s Pernis refinery. Seasonally higher runs will increase European and Russian fuel oil production, but yields are likely to come off due to refinery upgrades.
Europe may only get a few months of relief. Steeply backwardated prices will only worsen this year, given that the biggest bets against fuel oil cracks are in H2 19 and 2020. Crude backwardation is also steepening, thus amplifying fuel oil backwardation and slamming the arb to Asia shut. If the Atlantic basin needs to clear into Asia again (likely when Saudi buying ebbs after summer), then the whole European curve would need to shift lower to reopen the arb.
The problem for the fuel oil market is two very big stories are building to their climax at the same time. In crude oil, there is a growing realisation that the plunge in oil prices since late 2014 has done tremendous damage to non-OPEC production capacity outside of the US shale sector while stoking rampant demand. Prices need to go higher to attract investment back to the sector and blunt demand growth. In fuel oil, there is a growing consensus that HSFO will be heavily backed out of the market in due to IMO 2020. This makes the short crack positions in late 2019 and early 2020 likely to be resilient.
Backwardation in fuel oil is now more than three times as steep as in crude, and this will only worsen given the lack of fuel oil buyers for 2019 swaps. The unique circumstances of IMO have introduced significant market distortions that will only grow in complexity going forward. In the meantime, oil must flow and prices must start reflecting today’s realities as well as tomorrow’s forecasts.