After a lot of uncertainty, IMO 2020 has finally started to make its effects felt in the clean fuels market. Liquidity is starting to emerge in Asian markets for very low-sulphur fuel oil (VLSFO) and the high-low (hilo) sulphur spread has ripped as traders have started buying up and storing LSFO for future blending. However, HSFO prices have not yet completely collapsed, much to the chagrin of complex refiners, which continue to compete with their simple counterparts on dirty fuels. We are at a curious intersection where prompt prices are still encouraging HSFO production—though not for much longer—while future LSFO prices are sending strong signals to simple refiners to switch crude slates soon.
With VLSFO structure in contango, interest in making and storing VLSFO has perked up. The European hilo spread for December has doubled from its March lows, so there is no doubt that storing LSFO is a very lucrative business. The case for storing LSFO is further boosted by developments in the physical markets, where premiums for VLSFO over LSFO and HSFO have moved higher from levels seen earlier this year. In fact, any low-sulphur blending component is catching bids. This is important because it suggests stability and compatibility concerns will not prove as high a barrier to VLSFO adoption as some market players believe.
However, growing VLSFO production provides a threat to diesel demand in 2020 and provides a floor to Asian gasoline markets as more FCCs trim runs to free up VGO to be blended into VLSFO. This holds particularly true for those refineries equipped with RFCCs, as these units often run residual fuels that have been treated in residual fuel hydrotreaters, meaning they are well equipped to swing between gasoline and marine fuel production as prices dictate.
The incentive to divert feedstocks from gasoline-making to marine fuel is less pronounced in Europe, but given the region’s relatively large amount of simple refining capacity, as well as the fact that the west is already long HSFO and exposed to dwindling Asian demand, this is no barrier to VLSFO production. Indeed, hydroskimming margins indicate that the gap between HSFO and with LSFO will widen beyond $110 per tonne by January 2020. Based on current swaps prices, simple refiners are getting strong signals to switch to sweet crude slates by October at the latest.
Just how much switching will be required is the key question. The loss of Iranian and Venezuelan heavy crudes has sent European fuel oil production into a nosedive, but still roughly 1 m/d a month of fuel oil production remains, about 75% of which is HSFO. Given that our baseline estimate of global VLSFO demand in 2020 is 1 mb/d, there is a clear need to raise LSFO supply over the next few months. By the same token, European HSFO output still needs to be cut significantly, perhaps by as much as 19 mb per month.
Given the number of companies that have announced plans to make and sell VLSFO, the huge premiums seen today should ease in 2020. The emerging dynamic between gasoline and marine fuel is strongest in Asia, and given that this it is the region where fuel oil prices are traditionally highest, it may well remain the bellwether for gasoline-to-marine fuel switching. For West of Suez markets, the lesson is a little different. The conversion of sweet residue into light ends needs to be reduced to free up fuel for ships.