The big switch to IMO 2020 compliant fuels has finally arrived, and VLSFO demand is expected to surprise to the upside to the detriment of MGO. So while there is probably a little bit of upside to calendar 2020 ICE gasoil cracks due to IMO 2020, those looking for a blowout at the start of the transition are going to be disappointed, especially as conventional demand is poor. Specification changes often result in the most volatility before they take effect, and past experience shows these events are often followed by a correction without a lot of new buyers.
The early success of VLSFO can be seen in bunker sales data. While the number of clean fuel deals reported are still relatively few, numbers are growing and spot VLSFO volumes are usually exceeding MGO volumes. Our soundings with shipping companies suggest many are still waiting for November until they begin fuelling vessels with IMO 2020-compliant fuel. Thus far, however, none of the feared stability and compatibility issues with VLSFO have come to light.
Still, not all barrels of VLSFO are the same, with viscosities of some grades reported to be 50 cst or lower, indicating high proportions of heavy gasoils like VGO in the blends, whereas viscosities of other blends much closer resemble traditional residual fuels. Similarly, not all MGO grades are alike, with DMB-type MGO sharing some properties with residual fuels. LCO, a low-quality distillate produced by FCC units, is likely to find its way into both products. But LCO is often used as a feedstock for hydrocrackers to make road diesel, which implies a tightening of traditional diesel supplies.
To meet the roughly 1.5 mb/d rise in MGO demand from 2018 levels, refinery runs must rise in the rest of Q4 19 and Q1 20. Much of this rise will come from Asia, though the recent jump in freight rates raises the question whether this will be possible. We remain sceptical that deep cuts in throughputs are occurring now that freight costs have started to unwind and given that demand for industrial and heating fuels is growing ahead of its winter peak, reducing the likelihood that regional refiners will allow the market to run short. Thus ‘run cuts’ are more likely to be reductions in throughput from aspirational targets than anything else, although weak Chinese refining margins could weigh on runs towards year-end.
One of the factors that has helped dirty freight rates ease is owners converting clean tonnage to dirty tonnage. But when clean tankers shift to dirty service, the return to clean service is neither swift not simple. For instance, tankers can only return to shipping jet fuel once they have carried several other types of clean fuels first. As such, it may take longer for rates to move jet fuel to normalise if shippers choose to switch, meaning Middle Eastern jet quotes will remain under pressure, while Asian flows to Europe could slow amid high costs.
High freight rates only add to the complications for supply into PADD 1 this winter, raising the chance of a sharp rise in diesel prices if it gets cold. But with plenty of VLSFO inventory built up ahead of the transition, the early phase of IMO 2020 could be a disappointment for the diesel market. Q2 20, however, may be a different story, once VLSFO stocks are depleted and refinery maintenance returns.