INDUSTRY INSIGHT

IMO 2020: It Wasn’t Supposed To Be Like This

By David Fyfe, Chief Economist, Argus

January 2020 saw the introduction of tighter marine bunker fuel sulphur specifications overseen by the International Maritime Organisation (IMO). In brief, this required shippers to stop using fuel containing up to 3.5% sulphur (HSFO) and to replace it with fuel with a limit of 0.5% sulphur. Those operating vessels installed with exhaust gas emission reduction equipment (“scrubbers”) were allowed to continue running on (usually cheaper) HSFO.

Conventional wisdom before the switch envisaged the specification change would likely see:

  • sharply wider sweet-sour crude price differentials;
  • plummeting HS fuel oil values and the potential for HSFO to price into power generation markets;
  • a preference from shipping companies for marine gasoil (MGO) over untested low sulphur fuel oil (VLSFO) blends, at least during an initial transition phase.

In reality, a 2019 squeeze on sour crude supply (OPEC+ production restraint, sanctions on Iran and Venezuela, disrupted Russian crude exports) and strong refinery upgrading additions combined to keep both sour crude and HSFO prices well supported. By the turn of the year, it also appeared that early bunker sales and stock-building at major ports was much more heavily oriented towards VLSFO than MGO. The scramble to obtain sufficient supplies of on-spec fuel that many anticipated had, so far, failed to materialize.

“A 2019 squeeze on sour crude supply and strong refinery upgrading additions combined to keep both sour crude and HSFO prices well supported.”

“The shipping sector is now sailing in genuinely untested waters and faces conflicting pressures from a maelstrom of market developments underway simultaneously.”

Still, the narrative remained one of “disruption deferred, not disruption avoided”. Moving towards spring 2020, so received wisdom went, accelerating economic growth, rejuvenated emerging market commodity and oil demand, and increasing international crude and products long-haul trade would bring upward pressure to bear on shipping activity generally and test bunker fuel supply chains for new grades to the limit.

In the event, prices for VLSFO have collapsed, firstly in the aftermath of the freefall in global oil demand resulting from coronavirus, then augmented by the disintegration of OPEC+ producers’ market management policy since their fractious 6 March meeting in Vienna. Never before has the market seen a combination of collapsing world oil demand and at the same time a deliberate policy by OPEC to flood the market with more crude.

The shipping sector (alongside the rest of the global economy) is now sailing in genuinely untested waters and faces conflicting pressures from a maelstrom of market developments underway simultaneously.

A decision by Saudi Arabia, Russia and other OPEC+ producers to flood the market would normally signal a surge in freight rates, as cargoes of heavily discounted crude move to market. Being producers of predominantly medium-to-heavy and sour crude, such a strategy  would also normally result, all things equal, in widening sweet-sour crude differentials.

Such an impact might be further enhanced after six to nine months if falling prompt crude prices were to also limit supplies of higher cost, light, sweet crude from the US shale basins and elsewhere among non-OPEC producers.

Indeed, this is one result from the market share strategy that may indeed come to pass during 2020. IMO 2020 in a normal world of OPEC and non-OPEC members competing for market share would usually be expected to result in wider crude quality spreads, weaker HSFO cracks and upward pressure on middle distillate-rich VLSFO precursor material.

Were onshore refined products demand in 2020 rising by anything like the 1 mb/d+ originally envisaged, competition for supplies of vacuum gasoil (VGO – a cracker feedstock) between gasoline/diesel manufacture on the one hand, and marine fuel blending on the other, would become intense. Prices for MGO and VLSFO marine fuel would be expected to rise as a result.

But these are of course very far from normal times. The global economy has been plunged into recession as governments worldwide have mandated schools, factories, retail outlets and airlines to close in an effort to curb the spread of the coronavirus.

What initially looked like a high-impact/short duration event, largely restricted to Asia, and confined within 1Q2020, has become a global phenomenon whose effects may persist into 3Q2020 and beyond. Health services worldwide risk being over-run, and few national governments or international agencies wish to preside over a public health disaster, with a death toll in late-March already approaching 25,000.

2020 was originally expected to be a year in which resurgent emerging market economies drove stronger world oil demand growth after the anaemic 0.6 mb/d seen in 2019. Latest projections from the depths of the COVID-19 epidemic suggest that global oil demand this year may in fact contract by anything between two to five million b/d, levels of decline not seen since the early-1980s.

Early global trade indicators for Q1, 2020 already show steepening contraction after the simmering US-China trade war prompted weak performance in 2018/2019. And an initial spike in VLCC freight rates after Saudi Arabia announced it would raise supply by around 2.5 mb/d to 12.3 mb/d from April has proved short-lived.

Tanker rates may again see some support in the months ahead, but not due to underlying strength in market fundamentals. Instead, relief for vessel owners may derive from a global oil market glut that risks overwhelming onshore storage capacity sometime around mid-year. In such a scenario, floating storage becomes the only option.

“The global economy has been plunged into recession as governments worldwide have mandated schools, factories, retail outlets and airlines to close in an effort to curb the spread of the coronavirus.”

“With western markets likely in lock-down for weeks if not months to come, China faces a long march back to full industrial recovery.”

Nor is maritime oil trade the only casualty in the shipping sector. Recent weeks have seen at least six major cruise line operators cease operations, axing several hundred thousand barrels per day of bunker fuel demand.

Container freight and bulk commodity shipments are also juddering to a halt, albeit tentative steps to re-start Chinese industry as the virus looks to have been brought under control there may be a prelude to activity pick-up. However, with western markets likely in lock-down for weeks if not months to come, China faces a long march back to full industrial recovery too.

With gasoline and jet kerosene the worst affected oil products, there will also be less competition for supplies of VGO at refineries. Cracking capacity utilisation may remain muted for months. The prospects therefore for an imminent tightening in MGO and VLSFO from either a supply or a demand standpoint look slim.

Ultimately of course, the virus is likely to be combatted. Some see the northern hemisphere’s summer months likely to mark the end of this phase of the crisis. Economic growth will rebound, oil demand and global trade will pick up and pricing relationships in the bunker fuel complex may then finally begin to take on the complexion that many envisaged for early-2020.

Massive fiscal stimulus and infrastructure build-out will tighten gasoil/diesel supply, likely lending support to MGO values once again. And as bunker demand begins to rise, the underlying problems of compatibility between disparate VLSFO quality blends may re-emerge. High asphaltene blends manufactured at refineries East of Suez and more paraffinic material derived from VGO in the Atlantic Basin cannot be mixed in either storage or fuel tanks. But more costly MGO and segregated tankage are costs the shipping industry would gladly swap in exchange for today’s battle for survival.