Vistin Trading has entered into oil derivatives contracts which we believe will benefit from our analysis of the global change in sulphur specifications for the shipping industry in 2020. Oil derivative contracts offer the cleanest way to achieve exposure to the market developments that are set to take place due to the new sulphur regulations. One could also invest more indirectly through for example buying shares in companies that produce scrubbers, buy shipping companies that will get scrubber deliveries before 2020, buy efficient airliners or buy complex refiners. If you buy shares in companies like these, you do however take on a lot of basis risk (company spesific risk). All the IMO 2020 effects on the mentioned companies starts with wider light-heavy spreads and wider sweet-sour spreads in the oil market. When you for example buy shares in a complex refiner like Reliance and then suddenly the Indian government orders refineries to subsidize the diesel price for indian fuel consumers, your bet could fail even though the IMO 2020 analysis of the global oil product market was correct. Why then not instead invest directly into oil derivatives, which is the starting point for the IMO-effects that will hit the companies?
The International Maritime Organisation (IMO), which governs the international shipping society has decided that by 1st of January 2020 it will be illegal for any ship to burn fuel with more than 0.5% sulphur content unless the ship can desulphurize the emissions from the fuel (through so called scrubber equipment). Today the international shipping fleet mainly burns fuel with 3.5% sulphur content. This regulatory change is the by far largest fuel specification change that has ever hit the global oil market.
We can already now be certain that this specification change will pose a major challenge for the global refinery system. The reason is that time is running out for the shipping industry to install enough scrubbers for this to not affect the global refinery system. According to DNV-GL there is now ordered about 1.618 scrubbers for delivery inside 2020. This number would have needed to reach about 30.000 in order to avoid any effects on the refinery system. There are about 23.000 ships in dry bulk, tankers and container ships alone and we are now only 14 months from implementation of the new rules. In addition, we hear and read in many industry updates that the delivery time from order to instalment of a scrubber is now surpassing one year. Also the process of physically installing scrubbers has not really been tested in any meaningful way yet, even though many shipping companies have ordered the equipment. Basically time has run out for scrubbers to be the solution for 2020. Come 2025 and the story is probably very different. The timing issue is hence of the utmost importance for our view on price effects.
This means that at least for 2020, the refinery industry will have to step up to the challenge. The key challenge for the refinery industry is that the equipment which desulphurizes the resid fuel used in the shipping industry takes a long time to build. The key equipment is the “Hydro Cracking Unit” and the “Delayed Coker”. Both of these units use high sulphur resid fuel as feedstock to mainly maximise diesel output from the refinery. It is however a large investment decision for a refinery to build a new "Hydro Cracking Unit" (could easily cost 1 billion USD) and the lead time included the engineering process, licensing and building of the unit is about 5 years. There are hence very few investment decisions initiated from the IMO 2020 sulphur regulations in the global refinery system that will be helpful by 2020. The final decision to not postpone the new sulphur regulations to 2025 was taken in October 2016, and there was hence never enough time for the refinery industry to make meaningful contributions to desulphurization capacity by 2020.
This means that most of the new refining capacity that comes on stream before 2020 was planned before IMO 2020 was finaly decided in October 2016. In addition it is very difficult for a refiner to use IMO 2020 as justification to make a 1 billion USD investment in a new “Hydro Cracking Unit”. What if the global shipping industry by 2025 has installed scrubbers on the 15.000 largest ships? Then the investment in the “Hydro Cracking Unit” was a bad decision, because in order to justify the investment it will not be enough to see a couple of years with a large price differential between diesel and high sulphur fuel oil. The refiner needs to have a view on the cash flow in a 20-30 year perspective to make such an investment; a blow out in price spreads in 2020-21 is not enough to justify the decision.
Since time has run out to solve the 2020 challenge through new investments, the refinery industry needs to make operational changes in how the refineries are run in order to solve the oversupply of high sulphur fuel oil and the deficit in diesel that we believe is set to take place in 2020. The shipping industry today consumes about half of the global production of resid fuel and when 70-75% of this consumption must change to lighter products (we believe scrubbed volume will be about 15-20% and cheating will be low), either through blending or direct consumption, it implies a very large challenge for the refinery industry. For this behavioural change to take place from the refiners there is a need for price signals (motivation). Price spreads between the different refined products needs to be gradually wider in order to incentivise refiners to make the required operational changes. Complex refineries must run their existing “Delayed Cokers” harder, they need to segregate the different product streams better (building new tanks and pipelines), they need to change the product yields (steal from gasoline/jet fuel and give to diesel through change in cut points and on which units that are fed the VGO), etc. We also believe simple refineries that do not have “Hydro Cracking Units” and “Delayed Cokers” will have to run more crude through their "Crude Distillation Units" (CDUs) in order to make even more make so called "straight run diesel" in 2020.
This should be very supportive for crude oil demand in 2020. At the end of the day, all these operational changes may not not be enough to both produce enough diesel and at the same time destroy enough high sulphur fuel oil and we could end up in a situation that resembles 2008. Then simple refineries geared up crude demand to maximise diesel output and in that effort pushed crude prices from 100 USD/b to almost 150 USD/b in the four months from March to July that year. It also looks as if there will not be enough capacity available to “crack” (destroy) the high sulphur resid fuel that the shipping industry will no longer consume in 2020. That product may at the end of the day have to be stored for a while until enough scrubbers are built in the shipping industry and until enough “Cracking/Coking” capacity comes on stream in the global refining industry. If there is not enough capacity to store the product, the price of high sulphur fuel oil will have to drop enough to compete with natural gas and coal in the power sector in emerging markets (countries like Iraq, Mexico, Pakistan, Iran, Egypt, Russia, Cuba, Ukraine).
The oil derivative positions entered into by Vistin Trading are based on the above expected changes and should not be mistaken for a directional bet on crude prices. We believe crude and refined products with a low sulphur content will price better than crude and products with a high sulphur content. It would also be beneficial pricing for diesel and crude oil streams that are naturally rich in diesel content in 2020. A higher crude price is a small positive for the positions we have entered into so far but we do not need a higher crude price for the positions to be profitable.
The key risk to our case is a large global recession which could remove the yearly layer of 500-700 kbd global diesel demand growth. If the world no longer has the base layer of gradual diesel demand growth (mainly related to heavy duty trucking in emerging markets) then our positions may not move as much.
As portfolio managers at Vistin Trading we strive to make the best investment decisions for our shareholders and in our view the IMO theme offers a unique risk-reward opportunity. Our investments are based on thorough analysis of the IMO specification change and our hypothesis is that this change will be very disruptive and have a major impact on pricing and price differentials throughout the whole oil space.
It is important that our shareholders understand our investment strategy and the at times high volatility in our positions. Our current positions are not a short term bet or contracts we will trade in and out of frequently, but rather a bet on a specific situation unfolding in 2020. Any investors looking for gains based on short term trading of oil price volatility would hence be advised to look elsewhere for now. The expiry of the contracts we have entered into so far are in 2020 and the marked-to-market value needs to be booked every quarter. In our view most of the IMO effects have yet to be priced into the oil derivatives market. We expect this to change during 2019.