It’s all over but the shouting.
That’s an old phrase that translates as everything is in place and now things just need to play out to see what happens. Politicians will sometimes say it on Election Day.
It’s a perfect description of where the oil market stands – and by extension, the trucking and rail markets – as we await the introduction of IMO 2020 over the next few months.
We say “it’s all over but the shouting” because the market is at the point where the conferences have been held, various research agencies have produced their reports, and there is, quite frankly, nothing that hasn’t been said or speculated. The amount of insight that has been poured into what has been described as the biggest change in oil product specifications ever – more than cutting back on sulfur in diesel and gasoline in the first decade of the millennium, more than the reformulated gasoline changes of the 1990s – is staggering. A lot of brain power has been put into this issue.
The rule governing sulfur content in marine fuel – also known as bunker fuel – takes effect January 1. But by September, ships’ tanks will need to be cleaned out, new blends will need to be put into inventory, they’ll need to be tested before they can be used in ships; in short, January 1, 2020 will be more like three to four months into the new regime.
And yet, most forecasters have steered clear of trying to predict what the price of marine fuel will do in the wake of IMO 2020. There are some predictions, but if there are more, they are being revealed privately by forecasters to paying clients. There isn’t a lot of public soothsaying.
But there’s some. Rick Joswick of S&P Global Platts, in a recent webinar, gave its forecast on what is going to happen to diesel cracks, the relationship between Brent and a refined product. A simple crack spread between Brent and ultra low sulfur diesel (ULSD) on the CME shows recent cracks holding around $14 to $15/barrel (b). Its scenarios for the movement on cracks sees them moving up to anywhere from $25/b to $35/b.
The simple math then is that if we start with a $15/b crack, and it goes up to $25/b, $10 per barrel turns into an increase of 23 cents/gallon, based on 42 gallons per barrel. A move to a $35/b crack is 47 cents/gallon. But note that is a spot price, not a wholesale or retail price. It would translate to more than that in either of those markets.
Platts’ projections on the crack spread between diesel and Brent.
Meanwhile, the U.S. Energy Information Agency (EIA) forecasts about a 30 cents/gallon increase in the wholesale price of diesel by the end of 2020. That assumes the price of crude to be largely stable from where it is now. The EIA has held to that forecast pretty much all year.
What retail will do on top of that is a forecast that most people like to stay away from.
If you’re a trucking company and you want to understand how the price is going to get constructed in the real world, away from the forecasts, you need to understand the diesel fuel version of “the ankle bone is connected to the heel bone.” (Or is it “the ankle bone is connected to the shin bone”? Maybe it’s both.) What are the price movements that are going to lead to increased numbers at the pump for truckers buying diesel? And what should you be looking out for if you have access to data that shows the various building blocks?
Step-by-step, here goes:
– The basics are that IMO 2020 requires significantly less sulfur in marine fuel, dropping to 0.5 percent sulfur from a limit of 3.5 percent at present. The best estimate is that there’s about 3.5 million barrels per day of high-sulfur marine fuel, also known as high sulfur fuel oil (HSFO) that is affected by the rule.
– There are four main ways of replacing that much HSFO. One is to ignore the rule, but estimates of non-compliance which started high have been dropping as third-party enforcers, such as ports and insurance companies, are making clear shipping companies had better comply if they want to do business with them. The second are scrubbers that allow a ship to burn HSFO by taking sulfur out of emissions. Most estimates think scrubbers will allow about 700,000 to 800,000 b/d of HSFO to continue to be used. The third involves changes in the amount and types of crude to be processed by refiners, using crudes that on their own can produce a compliant fuel. And there’s the fourth option, the biggest of all in terms of barrels – making more of an existing diesel-like product called marine gasoil (MGO) or blending the intermediate products that now go to make over-the-road diesel into the new blends of a product known as very low sulfur fuel oil (VLSFO). The low sulfur content of VLSFO allows the production of that product.
– These switches are expected to divert as much as 1.5 to 2 million b/d of diesel intermediates into the marine fuel market, mostly in the form of an intermediate diesel-like product called vacuum gasoil (VGO). That diversion is what should have trucking companies concerned. If the VGO is going into VLSFO, it isn’t going into making over-the-road diesel.
Here is your roadmap then on what to watch for in the coming months. Some of the information is public; other information is out there but not without cost. All of them together should give some indication on how the over-the-road diesel market is shaping up as IMO 2020 nears.
– The forward curve for the ULSD market, available on the CME site, is not showing any concern about a squeeze on diesel starting in September or even out into early next year. Prices are higher on the curve in the fall and into next year, but that’s normal. The fact is that forward curves are a complex brew of inventories and interest rates and are notably poor predictors of what a price will be in the future. It’s interesting but also a poor crystal ball.
– Is the price of oil dropping? That seems like a basic question but at recent forums, it’s been noted that if the price of oil plummets to $40/barrel – it sits now at slightly more than $50, basis WTI – the increase in diesel relative to the price of crude because of IMO 2020 would be off a base so low that it won’t cause the sort of raw fear that the market saw back in 2007-2008, when diesel soared well above an already high crude price that topped out at more than $140/b. (One argument back then was that the price of crude got to that level because of diesel, that changes in the sulfur content of fuels the prior year led to a diesel squeeze that pulled up the price of crude, not the other way around.) But a spike in price brings about conservation – slow steaming of ships, independent owner/operators who can’t handle the burden of the higher price and go out of business or at least drive slower, and so on. That in turn has an impact on demand and price relationships. As the saying goes, the solution to high prices is high prices.
– Are U.S. refiners making more distillate, which includes diesel? Are they putting more crude through their refineries? Is the yield shifting to distillate and diesel and away from other products? Are they laying in more inventory, getting ready for the switch? All that data is available from the EIA at the highlighted links.
After that, it starts to get trickier as the market breaks into the shin bone song. Petroleum markets are interrelated to an almost incomprehensible degree to an outsider. Gasoline’s strong, so refiners make more gasoline and less distillate and then distillate gets strong. The supply of Venezuelan crude oil drops because of the chaos there and U.S. sanctions, and suddenly the world needs substitutes for the heavy crude that country produces. The price of heavy crude relative to light crude rises. There is a great deal of natural gas liquids coming out of the ground in the U.S., which means the world doesn’t need naphtha, a competing product in the petrochemical field but which is also used to make gasoline, so gasoline economics are impacted.
And so on. The list of relationships isn’t infinite, but it seems that way. Here are some of the ones the oil market will be looking at to determine how smooth things are transitioning to a new era.
– The most basic will be the spread between key physical ULSD diesel prices and the Brent crude oil benchmark, and to a lesser degree, the domestic WTI crude benchmark. But they won’t be looking at the price of ULSD on CME; that price is for product delivered in New York harbor a month out. They’ll be looking at the physical prices for barge or pipeline delivery over the next few days or a bit before that. On January 3, for example, the ULSD price on CME is for a barge in New York harbor that could be delivered as late as February 28. For people worried about diesel supplies in the short-term, that CME price will tell them little. It’s the physical price they will care about. They will care about it in the New York harbor, on the Gulf Coast and in the Midwest. They will also care about it in California, though that market already tends to operate on its own due to location and environmental regulations. And when refiners go to set their wholesale rack price for diesel, the CME price won’t matter to them. They’ll be looking at the physical prices published by price reporting agencies such as S&P Global Platts, Petroleum Argus or OPIS.
– Traders will be looking at a new spread that has been dubbed the “high five.” It’s the relationship between the new 0.5 percent VLSFO marine fuels and HSFO, the latter price generally expected to plummet as it falls into non-compliance. The spread between MGO and HSFO doesn’t have a cute name, but it’s the same idea – if HSFO falls a long way relative to the others, it makes scrubber economics look better. And every new scrubber installed means less need to burn diesel-rich MGO or VLSFO.
– What’s the price of MGO or VLSFO vs. the price of over-the-road diesel? If the price of IMO 2020-compliant fuels surges and refiners choose to increase their production at the expense of over-the-road ULSD, how long does that situation last before the reduced supply of ULSD drives the price high enough to incentivize refiners to crank up the output of the diesel that trucks need? And in the meantime, how high does the price of over-the-road diesel soar?
Before we get to where we’re going, there will be signs. Watch for them.