A recent report by JPMorgan Chase sees a diesel market reaction coming as a result of IMO 2020, but its tone and forecast are restrained and hint at a market that is on the verge of any sort of spike in prices.
In an exhaustive 100-plus-page report published by the team led by analyst Phil Gresh, the focus is often on the equity price of U.S. refiners like Delek (NYSE: DK) and Marathon Petroleum (SONAR: STOCK.MPC). The current equity price of those companies, the report said, has “a fair amount of the IMO 2020 upside potential (that) now feels priced in,” sitting at more normal levels of price-to-equity ratio and free cash flow yield. Marathon Petroleum is up more than 32% since its 52-week low in August, and Delek is up approximately 16.5% in the last 12 months.
The range of forecasts in the industry on the demand impact of IMO 2020 on diesel demand is a large one. There have been estimates of as much as 2.5 million barrels/day of distillate demand needed to displace the high-sulfur fuel oil that no longer will be used as ships seek to stay compliant with the 0.5% sulfur restriction of IMO 2020, down from 3.5%.
JPMorgan’s estimate is a more conservative 1.8 million b/d. But it also says that there could be a “one-time step-up” increase of 2 million b/d next year during the transition.
The report is mostly optimistic about the refining industry’s preparation for the IMO 2020 transition. Among existing refineries, the report said, distillate yield (which includes diesel) in 2019 was probably a record level of 30.1%, meaning distillate output was that percentage of total output. “Looking toward 2020, we see the diesel yield creeping even higher, averaging 30.4%,” the report said.
It also projected that gasoline yields will decline about the same 300 basis points. The swing between gasoline and diesel in refineries as the industry prepared for IMO 2020 is a complicated one. It hinges in part on the use of a product called vacuum gasoil (VGO), which can be sent to a cat cracker to make gasoline or to a hydrocracker to make diesel. But it can also be blended to make another IMO 2020-compliant produced called very-low-sulfur fuel oil (VLSFO). JPMorgan’s forecast of an average yield in 2020 between diesel and gasoline doesn’t reflect the fact that over the course of the year, there will be significant swings of VGO going into diesel production or gasoline production depending upon the relative economics of the two products.
Overall, the impact on refiners from IMO 2020 is expected to be a positive for the industry, the report said. But the numbers projected in the short term are small enough that they signal only minor increases at the pump as a result of the new rule. For example, the report says that JPMorgan sees a $2/b “uplift” in the diesel crack because of IMO 2020. The crack is the spread between the price of crude and the price of the product. At 42 gallons to a barrel, that works out to a little less than 5 cts/gallon. For a refiner to get a long-term boost in its refining margins of $2/b, the impact of IMO 2020 would be considered significant. Translating it into the pump price of diesel is not.
On other issues, the report was mixed on the short-term future of crude-by-rail. The key margin incentivizing crude-by-rail is the spread between Brent and WTI. The physical spread between the two of them is currently about $7/b (as opposed to the spread for paper contracts, which is closer to $5). The report sees the Brent/WTI spread moving to a $5 level, with slower growth in U.S. production and more pipeline capacity going to the U.S. Gulf slowing the buildup in the middle of the country that drives the spread wider. Any narrowing of the spread is considered bearish for crude-by-rail.
But the forecast for crude by rail in Canada is better, according to JPMorgan. It used the phrase “rail over curtail” to describe the Alberta government’s permission to allow now-constrained production to be increased if it’s moved out of the province by rail. “We think that more barrels could move via rail as (Canadian) producers look to the positive net-back impact of additional volumes,” the report said.