#IMO2020: The big structural oil market change everyone is forgetting

Last year everyone was waiting for a big moment in the oil and fuel markets: #IMO2020, a seemingly small change around the type of fuel ships burned. In summary, the sulphur content of ship fuel, which is a residual fuel from refining operations, was being reduced by more than 80%. Crude oil is mostly categorized based on how “sour” it is, or how much sulphur it has, and how “heavy” it is, in other words how dense (non viscous) it is. Those two qualities, density and sulphur content, drive the entire refining supply chain. Refiners make gigantic investments over years based on these chemical properties of the oils they refine to make fuel.

The #IMO2020 change had the potential to make dramatic changes in how the refining complex (and thus the entire oil market) operated, and we had already started to see a few short term effects only days in to 2020:

  • Oil tanker earnings went through the roof due to changing trade routes, a storage build of compliant fuels as well as excess HSFO, and increased US gulf exports
  • There was a wild repricing in crude grades, with heavy and medium sweet crudes commanding at one point more than a 50% premium to Brent
  • The “old” residual fuel price (produced from refining heavy/medium sour crudes) collapsed while the new residual fuel price was priced at an incredible premium

Then COVID-19 hit. Oil and fuel demand began plummeting overnight. An oil price war erupted between Saudi Arabia and Russia as market participants freaked out and struggled for market share to support their oil revenue dependent societies.

Total chaos in oil and fuel markets followed. Oil traded negative for the first time. Oil traders lost billions. Oil and fuel are looking anywhere and everywhere for any demand. Saudi Arabia put barrels on ships without knowing where they were going and Texan and Dutch refineries sent naphtha to Japan. An armada of tankers built up off the coast of California. Oil tanker earnings have exploded. Product tanker rates have risen to never seen levels of insanity previously seen only in the largest crude carriers (An MR tanker booked for nearly $100k!)

In the refining complex, we see some making money and others not. We see delays. We see force majeures. We see production shut ins. We see an unprecedented level of chaos and unpredictability in oil markets. The only clear short term winners have been owners of storage, especially floating oil and fuel tankers (ships). Tanker companies have seen their earnings rise exponentially — something absolutely noone was predicting in mid February as the pandemic spread.

And now what will happen? That’s the trillion dollar question. Will oil/fuel demand see a V-shaped recovery? Will restrictions be eased? Will there be a second wave of infections? Will we get a miracle vaccine? Absolutely nobody knows. However, there is one thing that is absolutely certain: the oil market underwent a massive structural change starting January 1 and due to COVID-19 everybody basically forgot about it. The oil market was already seeing severe disruptions in crude and fuel differentials when COVID-19 hit. Those disruptions will return with a vengeance due to the highly destabilizing effects of fending off a global pandemic.

Right now there is a glut in basically everything. There is far more oil and fuel than the world needs, resulting in the greatest super contango ever seen (a condition where the spot price of a commodity is much lower than the future price). As oil markets normalize, and it’s anyone’s guess if, when, and how they will — structural changes introduced by #IMO2020 will once again have visible effects. This is what I foresee:

  • There will be high levels of residual fuel builds as the world works through massive inventory builds in heavy/medium sour crudes which flooded the market during the oil price war and demand slump. Scrubber consumption will be lower than anticipated as many scrubber retrofits were cancelled due to COVID-19 collapsing the LSFO/HSFO spread.
  • Low sulphur fuel stocks (currently also at very high levels) will deplete much faster than high sulphur fuel stocks. LSFO/HSFO spread will once again widen.
  • Heavy/medium sour crude stocks will deplete much more slowly than heavy/medium sweet crude stocks.
  • Storage of high sulphur residual fuel will be a long term structural problem.

In other words, many oil market analysts seem to view oil as a single commodity. They see “de-stocking” as something that happens uniformly — all crudes being equal and levels reducing uniformly. I think this analysis is faulty. I think some crudes stored during COVID-19 demand destruction will stay in storage much longer than anyone thinks due to a return of refining economics driven by #IMO2020 structural changes. I think the future of the oil market, which is ultimately driven by the refining complex, is more unpredictable than ever.

Is it hard to model? Yes. But I believe this is a thesis that merits real exploration as I believe there is a lot of opportunity here. High level profit ideas?

  • Scrubbers are cool again (spreads widen)
  • High complexity refiners (if they can survive) will experience a return to the glory we saw in Q4
  • Heavy/medium sweet crude will dramatically outperform the rest of the crude oil market. The prime fields are found in the North Sea, West Africa, Western Australia, and South America. There’s a reason KSA bought a billion dollars worth of Equinor.
  • Tanker earnings and oil trading routes will continue to be highly unpredictable. We will continue to see things with no historical precedent.

#IMO2020 was widely viewed as a “hurricane” about to hit the oil industry. Companies spent years shifting their entire business strategy to focus on the structural changes it would bring. Then COVID-19 hit. Oil traders literally went bankrupt betting on its structural effects, and refiners and bunker suppliers saw their business plans evaporate overnight.

It has not been cancelled but delayed. Mark my words, #IMO2020 is still the most important long term investment theme in the oil markets, and COVID-19 could even exacerbate its effects, which were partially masked by historic shale capacity coming online.

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