Bottoms up

Published at 09:44 24 May 2019 by

The HSFO market is coming to terms with the collapse of the old IMO 2020 narrative. Backwardation in H2 19 timespreads is easing as 2020 prices find a floor and the market is even pricing in only a mild oversupply in 2020. This is a far cry from the disaster scenarios some observers have been predicting. As the backwardation in the HSFO market eases and deferred cracks are finding a floor, refineries are reconsidering their IMO 2020 options.

One trigger seems to be a growing realisation that the tightness in heavy crude that is weighing on complex margins is not going to be a transient phenomenon. With the political situation in Venezuela seemingly deadlocked and shale oil growth continuing apace, cash-rich complex refiners are clearly worried that big investments in fuel oil will only compound their recent struggles with poor margins.

For simpler refineries across Europe and Latin America, whose margins are generally more exposed to price fluctuations in fuel oil even when the bottom does not fall out of the market, the narrowing of deferred HSFO swap discounts to Brent means that there is less incentive to switch crude slates with the aim of tackling fuel oil output. In our view, there is a growing acceptance that the heavy crude tightness is not going away anytime soon, and that its unavailability will help mitigate some of the disruption caused by IMO 2020.

But at the same time, there are huge uncertainties around what a post-IMO world will look like, with many shipowners expressing concern over what types of fuel they will use. What is known, however, is that demand for low-sulphur fuels will rise before 2020, meaning bunker suppliers will need to roll out these fuels over Q3 19, in line with those refiners that are looking to offer MGO and VLSFO from September 2019. However, it needs to be acknowledged that a transition of this breadth and scope will not go without some volatility.

Indeed, we may be getting a foretaste of this transition today as high stocks in Singapore have put heavy pressure on the east-west arbitrage value. Given that the eastern fuel oil market is likely to be balanced in 2020 if our assumption that three-quarters of global bunker demand is going to shift to compliant fuels is correct, then this arbitrage trade is going to have to close.

IMO 2020 is a western hemisphere problem, since the Atlantic basic is structurally long fuel oil. But without the proper price incentives, HSFO production is unlikely to change much. A business-as-usual case would require the spread between HSFO and compliant bunkers to narrow to the point that shipowners would be indifferent between buying a scrubber and burning compliant fuel. Interestingly, this is roughly the current spread of between theoretical 0.5% fuel oil prices in Singapore and HSFO today.

Nevertheless, even if 2020 HSFO demand is double our baseline estimate of 1 mb/d, the fuel oil short in Asia Pacific will still be significantly diminished. Arbs will have to crunch in. Global coking capacity is set to rise by 0.21 mb/d, particularly in the west, meaning the industry will have a much easier time coping with IMO 2020 than many had expected, especially if the heavy crude market remains as tight as it is today, but there will still be too much HSFO even in this scenario.

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