There has been much discussion this spring and summer about the potential impact from the implementation of the IMO 2020 regulation. Due to the timing of the changeover to low sulfur, concerns have been raised about potential supply issues, particularly in the Northeast as we hit peak heating season.
Though we covered this in detail in our May article for this magazine, here’s a quick primer. IMO stands for International Maritime Organization and is a United Nations agency. This specialized agency is responsible for safety and security in the international shipping space. It also is charged with the prevention of marine and atmospheric pollution produced by ships. In 1997 the MARPOL Convention essentially called for the shipping industry to address its share of global emissions. In October 2016 a resolution was passed to reduce the sulfur content of marine fuel by a whopping 86%; from the current 3.5% limit to .5% or 5,000 ppm. The deadline is January 1, 2020, hence the abbreviated reference to IMO 2020.
So, why is this a big deal? Well, the impact on demand is significant for one. Though estimates vary, most analysts predict the switch will add 3.5 million barrels per day (bpd) to global demand for ULSD. To put this number into perspective, total U.S. demand for the distillate market was over 4.0 million barrels per day in 2018. Several factors will alter the 3.5 million bpd demand number. Level of compliance, the use of scrubbers, and enforcement are the prominent influencers. On the supply side, the International Energy Agency (IEA) predicts that global production will increase by 2.3 million bpd by 2024 – not very encouraging. They also predict that less than 40% of Middle Eastern and European refiners are prepared to meet the new demand. Meanwhile, U.S. Gulf Coast refiners, due to their relative complexity and access to ample light, sweet shale oil production, are well positioned to take advantage of this new market.
There’s been much discussion around the impact to prices in the U.S. And, of course, the timing is conspicuous to this industry. Though the actual regulation goes into effect in January of next year, supply and logistics will be impacted as early as this summer and certainly will be full throttle by the fourth quarter of this year. NEFI officials have had numerous meetings with other trade organizations in trucking and aviation as well as the appropriate U.S. administration insiders.
The big question that has come up in the heating oil dealer space, including among our clients, is what will be the impact on East Coast supply and logistics. Will there be price spikes and/or supply disruptions? What are the proactive measures one should take? Should you be locking up supply with your suppliers? Should you hedge against potential price spikes?
Since there has been a significant amount of discussion around these questions, I thought this would be a good time to share my thoughts and advice. A huge amount of caution that we have passed on to our clients is around the price issue. Though predictions abound in the press and in various discussions at conferences and meetings, “price spikes” are not a guarantee and have distinctly different meanings in the commodity space. Will there be price spikes in the absolute price? Will there be price spikes in the crack spreads or refiner’s margins? Will basis spike? And where? Will it be in the cash markets such as New York Harbor or Gulf Coast spot prices? Or will the potential spikes occur locally such as your supplier’s terminal? Addressing these questions is critical since it will significantly impact the way you hedge for these potential disrupters.
For example, let’s look at the absolute price spike. Though many so-called gurus have predicted price increases of as much as 80 cents per gallon, none have mentioned the absolute price in these predictions. As of this writing (June 15 – apologies to my editor, Sam Diamond), the price spikes have been nonexistent. Now that doesn’t mean we won’t see prices surge near the predicted levels. But from what basis point? Crude oil prices over the past week have dropped nearly $10/barrel, dragging ULSD prices down a whopping 40 cents per gallon in just three and a half weeks! This after prices languished in the same 17-cent range the prior four months.
Does it make sense to lock in outright prices via wet barrel contracts with your supplier next winter? We advise against it on the grounds that it would be pure speculation, and business profitability would suffer greatly if prices were to drop. What about hedging the locked-in wet barrels with put options? Though it makes sense to hedge your exposure here, the cost of such a hedge is likely to absorb a significant portion of your margin.
How does one get the security of a supply contract commitment without speculating on the absolute price? How can you acquire some insurance and mitigate the IMO 2020 disruptors?
One effective tool is to lock in your basis. By locking in your basis at your local rack you can mitigate sudden price spikes caused by supply disruption while also adding the security blanket of a supply commitment from your supplier. Critical to the success of locking in the basis is the structure of that hedge, however. I can’t overstate the importance of having the proper framework in this contract, as is it so often misunderstood.
Here is how to structure the local basis hedge. First, it is important to understand the difference between locking in a wet barrel “differential” and locking in a basis differential. Often times this distinction is not offered or understood by the supplier, so it is best to explain the pricing “rules” for the wet barrel differential by example: A February wet barrel differential must be triggered, or priced, prior to the end of January and cannot be accessed until you are in the month of February. Research will show that when there are local supply disruptions and the basis is blowing out, the spot contract is always the highest price point. That means that the February contract would be highest price point and would need to be priced in advance of the delivery month. Meanwhile, the basis blowout that you wanted to mitigate with this differential you locked in is happening in January. Which makes the differential not only ineffective as a basis hedge, but can put the buyer in an unenviable position when the local basis is blowing out. This is because you are now forced to lock in the February contract days prior to having access to the oil. All the while you do not have basis protection covered during the period of the actual blowout (January).
The remedy to this is to ask for a basis differential that allows you to price the oil over the NYMEX month of delivery while enabling you to lift the oil in that same month. In the example above, this structure would allow you to price the oil at the agreed upon differential on any given day in January and to have access to the oil at that time.
Another tool is to lock in a differential over a cash market index such as Platts or Argus. Platts and Argus are publishers that report the various cash market prices in real time. If you can acquire a contract with a fixed adder to one of these indexes, you will find that it will mitigate a basis spike. It is not as effective as a NYMEX basis contract as mentioned here, but it will blunt the basis spike while giving you the security of a supply contract.
Though the upcoming IMO 2020 phenomena will likely cause some disruptions at some point, it is highly unpredictable as to the degree of disruption and the price impact. You should carefully consider all of the tools and options at your disposal. Most importantly, you want to have a perspicuous understanding of the rules and composition of the contract, as well as the remedies it offers you.
As always, please feel free to contact me with any questions. You can reach me at rlarkin@hedgesolutions.com or at my office: 603-644-3343.
