After a dreadful Q1 19, the global demand picture for fuel oil has at least stopped deteriorating. The Baltic Dry Index has edged up on an increase in shipping activity and containership lines are securing rate increases from US retailers, which signals that cautious optimism around global trade has returned to the market. As for utilities, weakness in demand should ease too, as a mild winter in Asia makes way for a forecast hotter-than-average early summer in the Middle East.
The uptick in demand coincides with Asian refinery maintenance and steady US demand for FSU and European fuel oil as sanctions prohibit the import of Venezuelan material to US ports. As a result, fuel oil markets are bound to find a floor in the short term after a heavy sell-off. While this is not to say that fuel oil demand is to recover fully, it is not getting worse. Prices may struggle a while longer until inventories are brought more under control. But time is limited, as there are signs that the downturn in HSFO demand ahead of IMO 2020 has started to begin.
The supply side of the equation looks supportive though, as refinery upgrades in Europe and the FSU lead to the transformation of HSFO into lighter, more profitable products. Global crude oil production will average around 80 mb/d this year, but heavy sour and medium sour output will fall. Compared to 2017, heavy sour crude output will have declined by 0.57 mb/d and medium sour crude by 0.88 mb/d, while light crude output will be 2.8 mb/d higher based on our crude quality model. This will keep heavy grades expensive and encourage simpler refineries to buy relatively cheaper light crude.
While the fall in medium sour output is largely due to OPEC+ output cuts, heavy sours are declining due to the inability of Venezuela sustain production amid US sanctions and recurring country-wide blackouts. Unsustainable decline rates at Mexico’s Maloob and Zaap fields mean that the country is a non-OPEC supply wildcard this year. Given that depletion rates at Maloob and Zaap echo the path taken by the Cantarell field in the 2000s, traders need to keep an eye fixed on Mexico.
Indeed, the fuel oil market has yet to feel the full effects of Mexico’s production problems as the loss of vacuum residue implied by recent Mexican oil output declines is relatively small. But if Maya crude output starts to decline, the loss of vacuum residue will be considerable, as is the case in Venezuela. The chance of a big decline in Mexico means the widespread assumption that the oil market will be flooded with unwanted HSFO following IMO 2020 needs to be re-examined. The potential for more declines in Mexico and a dearth of new heavy crude supplies mean the HSFO market looks a lot tighter in 2020 than our baseline scenario envisaged when formulated nearly six months ago.
The silver lining for shipowners is that the compression of the spread between gasoil and fuel oil is not yet at the point where those who have invested millions of dollars in scrubbers have to start panicking. But Q1 20 gasoil-fuel oil spreads in Asia have narrowed considerably. Some of this is due to relatively soft spot diesel pricing and strong fuel oil values. But the market may well be signalling that the decline in heavy oil production and a multitude of fuel oil upgrading projects means the IMO 2020 transition may be much easier than the doomsayers have feared.