IMO 2020 winners and losers

For the last three to four years we have listened to the dire warnings and Armageddon-toned rhetoric of the potential impact of IMO 2020; the effect on global shipping, bunkering, refining, international trade, as well as national and global economies. Now that we are fully in the midst of the transition, we can – thankfully – discount many of the more outrageous ideas. Happily, crude will not triple in value! Of course, that’s not to say that pain points, disruption and confusion don’t exist; there’s been an abundance.

The US refining and oil markets have been frequently cited as beneficiaries of the impending global sulphur cap. To be clear, being a winner with IMO 2020 is all about being able to produce as much distillate product, very low sulphur fuel oil (VLSFO) or VLSFO components as possible, while ideally not producing any high sulphur fuel oil (HSFO), which is now almost obsolete. The US is a significant producer of low sulphur crudes, although some are a little too light to be useful for producing fuels for a post-2020 market.

In addition, the US is frequently identified (evidenced by the major refiners’ attraction as a ‘hot stock’ pick) as having a refining base that is highly versatile, flexible and focused on the production of diesel. In a global oil market where gasoline production is rapidly going out of style, US refiners are viewed as being able to switch quickly out of gasoline production to substitute increased diesel and new VLSFO production. The US refiners are considered to be in a stronger position than their global counterparts. Subjectively, the European refining sector has a reputation for being old and outdated, Latin America even more so. And while Asia and the Middle East are considered modern and new, they still have much less flexibility than the US.

The strength of refining in the US has inspired many US-based refiners to talk glowingly in their analyst earnings calls about IMO 2020. Companies such as Marathon, Valero and P66 are at the forefront of bunker market engagement looking to replace the independent physical suppliers of the past. But how is this shaping up?

The modern US refinery will generally do very well, because it is focused on producing diesel rather than fuel oil (HSFO or otherwise). The US refineries’ contribution (in most cases) to VLSFO production will be based on providing low sulphur components (VGOs, LCOs, slurry, etc.) that can be blended into VLSFO, with very little low sulphur residual fuel being produced by those refineries. This has two key consequences. Firstly, the majority of 2020 compliant fuels made in the US will be heavily blended. And secondly, blend components coming from US refineries will be valued in dollar terms against existing alternative refinery uses.

Through the initial phases of the IMO 2020 transition in the US, it already appears that blending is a problem. Specifically, the much discussed and forewarned debate over the concoction of paraffinic and aromatic fuels is causing concerns – as well as some sludge – and the issues of compatibility and stability continue to dominate. In addition, many of the component blends produce a very low viscosity VLSFO and this is not what shipowners and fuel buyers want. Rather they require a higher viscosity low sulphur residual fuel that is likely to be imported into the US or produced by a topping or flashing unit (such as GCC in Galveston and PBF/Maersk in Delaware). With a shortage of low sulphur residuals, the easiest solution for US suppliers is to import this fuel. However, this will most likely make the price of US VLSFO higher in relation to other locations.

But where will this higher viscosity VLSFO come from? Ironically, the majority could come from the less sophisticated refining areas around the world such as Brazil and Argentina using their own domestic low sulphur crudes. Products could also come from Canada and Europe where North Sea crude will be processed to produce higher viscosity VLSFO. Europe – once viewed as a region with short VLSFO supply – may actually become a significant exporter after adjusting crude slates to low sulphur. We can already see early indications of a new ‘pricing order’ with – at the time of writing – US Gulf Coast wholesale 0.5% VSLFO trading at $490/mt as opposed to Rotterdam VLSFO trading at $460/mt, and the US East Coast trading at $475/mt.

Refineries will also have other uses for individual components. Over the last two years, the majority of refiners forecast their general price expectation for IMO 2020 compliant VLSFO at a price between $30-$50/mt below wholesale diesel prices. VLSFO needed to be relatively close to diesel otherwise the components would not be diverted into VLSFO production. However, this position has now changed, with discounts more in line with $100/mt (or more) below diesel; the incentive to divert components into VLSFO production is therefore much less interesting. That is not to say that these transitional prices will last, however they will certainly concern refiners who have committed to VLSFO supply. As a result, these refiners are much less excited by their 2020 opportunities We will still see some of the components being offered by refiners to others for blending, but it is much less likely that refiners will jump into supplying VLSFO bunkers especially at these price levels.

Even though the pricing and product quality picture for new fuels in the US is challenging, it would be wrong to assume that the US will suffer any major shortages of post-2020 compliant fuels. HSFO will be abundant from Latin-American (Mexico and Ecuador) and some domestic sources (such as Chevron’s Richmond, California refinery). In addition, diesel production will remain dominant at US refineries and while the price will not always be the cheapest, it will at least be there.

VLSFO production, however, is a little more complicated. The wholesale 0.50% postings give early indications that the US East Coast and specifically New York harbour will be the cheapest US location to source VLSFO. Canadian imports, local refinery barrels from P66 and PBF/Maersk and the occasional arbitrage opportunity from Europe should keep this market competitive. As already stated, the US Gulf Coast has enormous potential to supply VLSFO, but only at a price that makes sense for refiners to produce or sell components. This would appear to make the US Gulf a more expensive location than others, and also a convenient place for arbitrage cargoes with its additional outlet to the Panama market.

To almost everyone in the US bunker industry the most challenging VLSFO supply location would appear to be the US West Coast. Canada has some supply as does the Pacific North West. However, the cost of transporting this to Southern California may present a real challenge to this being a consistent supply source to Los Angeles and Long Beach. Local Southern California refiners, such as Marathon, will produce some VLSFO, but again others (not unlike the US Gulf Coast) need to be truly incentivised by price to divert components from diesel and gasoline production. West Coast diesel is generally much higher priced than the rest of the US, so local refiners are unlikely to rush into VLSFO production, particularly as their customer base (transpacific container companies) will be comparing prices to the new VLSFO powerhouses in China and Korea. Based on this, a contraction of the Los Angeles bunker market seems a likely outcome.

In conclusion, it’s safe to say that the refiners will play a slightly lesser or different role than we, or they, might have expected. This puts the emphasis for new VLSFO supplies on those who can blend components and those who can arbitrage cargoes. The oil traders and commodity houses will also play a greater and more influential role in the US market than might have once been anticipated. Blending new fuels is not easy and it will only be those who have spent time gaining experience and learning how to avoid problems that will thrive. A critical question though is whether these challenges will be passed onto and impact the shipowner. It certainly can’t be ruled out, however in all probability, stability issues will show themselves (as they have already done so) prior to the products being loaded onto the barge, and before they are sent to the ship for delivery.

And so to the predictions on the winners and losers in the US market. Current betting would appear to favour the US East Coast which will lead the US Gulf Coast on price. Conversely, the US West Coast seems to be destined to be at the back of the field; or at least this is how it seems at the time of writing. As ever, the build-up to IMO 2020 has never been plain sailing, and only a brave (or foolhardy) person would say that anything is definitive; the only thing that can be guaranteed is that there will no doubt be further surprises and curve balls ahead!

Adrian Tolson
BLUE Insight Lead