IMO 2020 effect disrupts fuel oil contract renewals
A traded market trying to price in uncertain IMO 2020 implications is wreaking havoc with term contract negotiations
Fuel oil is nine months away from a drastic fall in global demand due to tighter emissions standards in the shipping sector. As a result, annual fuel oil contracts worth billions of dollars that have largely peacefully rolled over for years are this year becoming the subject of frantic renegotiations, forcing even the most risk-averse companies to, in effect, take large bets on the future.
The UN's International Maritime Organisation (IMO) is cracking down on the sulphur content of marine fuels. From 1 January 2020, the new ceiling is 0.5pc sulphur content, down from 3.5pc currently. This prevents much high sulphur fuel oil (HSFO), which averages over 2pc sulphur globally, from being used in the shipping sector.
According to an October International Energy Agency (IEA) paper, HSFO demand will more than halve from 3.2mn bl/d this year to 1.3mn bl/d in 2020. Other analysts see an even deeper demand crash, given that only 5-10pc of the shipping fleet will have the exhaust gas cleaning systems, or scrubbers, installed which enable them to continue legally burning HSFO from 2020 onwards.
A demand drop of this magnitude cannot fail to reduce prices; in the forward swaps market, HSFO in 2020 is trading close to $20/bl below Brent crude futures, compared to a discount of only $4/bl for prompt loading.
This unusually steep backwardation in the forward curve, based on market consensus expectations of a price crash, is playing havoc with the renegotiation of long term HSFO contracts—while spot price movements garner greater attention, in terms of volume the spot markets are dwarfed by term contracts, in both crude and refined products.
The volumes of these contracts are agreed on in advance, to give certainty to refiners, producers, and end users. But the price is defined in reference to a fairly small range of benchmark assessments.
Only around half the global demand for residual fuel oil comes from the shipping sector—the rest is used by industry and power generation. But all large fuel oil contracts, whether for consumption far inland or at sea, legally reference the shipping, or bunker, fuel spot market, centred on the 3.5pc sulphur barge and cargo markets in Rotterdam, Singapore and Houston. These have historically been the most liquid, responsive spot markets for price discovery. A seaborne market is naturally responsive to supply and demand across regions, whereas much of the inland industrial fuel oil use happens in isolated locations, without active trading between different companies.
Destruction of shipping sector HSFO demand this year will leave land-based consumption the dominant demand base, and yet specifications, locations, and parcel sizes will remain in a legacy marine fuel format. It is hard to predict what will happen when an oil market becomes dislocated from its own pricing basis in this way. One threat is that dwindling liquidity leaves existing 3.5pc benchmarks more vulnerable to manipulation by unscrupulous market participants.
Fears over reduced liquidity are playing into the renegotiations of annual contracts across the business, according to oil traders. The big HSFO exporting refiners in Russia, the Middle East and Latin America are used to enjoying substantial contractual flexibility on volumes. But, for some trading, houses this flexibility is now seeming a dangerous liability. How can you commit to loading tens of thousands of tonnes of extra fuel oil on demand, without a reliable spot market into which to sell?
As a result, trading houses are either demanding cheaper differentials in their 2020 contracts to take on this volume risk, or just leaving the market altogether. As a result, liquidity in the spot market is already falling, well before 2020 hits. Traded volumes in the largest HSFO cargo market of Singapore, as reflected in the Platts market-on-close assessment process, almost halved in 2018, as trading houses withdrew and shifted staff to other products.
Nervousness over 3.5pc fuel oil benchmarks is reverberating through thousands of other contracts that reference them, from Mars crude to petroleum coke, bitumen to recycled waste oil. Sellers can stick to 3.5pc but argue that their product deserves a larger premium to the lower futures prices due to different fundamentals. But some sellers, particularly of medium-sulphur products, are trying to remove legal reference to 3.5pc in their contracts.
Outside the oil industry, 3.5pc fuel oil prices are also referenced in a variety of freight contracts. In tankers, the Worldscale Association provides a book of annual rates for all the main routes. Brokers then quote live daily rates as a percentage of these annual rates, to allow them to give a market value to benchmark inter-regional routes, while leaving to shippers themselves the necessary flexibility on which specific pair of ports to choose.
The annual Worldscale 'flat' rates are calculated using the previous year's bunker fuel price data. Currently this mostly relies on 3.5pc fuel oil prices, as it is the most commonly used bunker fuel. For its 2020 annual flat rates, Worldscale Association is switching to using 0.5pc fuel oil prices as the main compliance option (e.g. rather than HSFO use with scrubbers).
However, the previous year to 2020 will, of course, be this year, and active trading in 0.5pc fuel oil has yet to get serious-it is expected to take off in Q3 or, more likely, Q4. So Worldscale is having to rely on a 'constructed' blend calculation of the 0.5pc fuel oil price in various locations, and faces a choice of data providers, each with their own methodology of calculation. All this means guaranteed controversy over the 2020 annual rates when they are published-not to mention the likely emergence of a "two-tier" freight market, with different rates offered by vessels with scrubbers.
This tanker market controversy pales in comparison to that engulfing the dry bulk sector, where freight rates predominantly reference the Baltic Exchange. Forward freight agreements (FFAs) are freight derivatives contracts, settling against Baltic Exchange daily assessments. Some of the largest FFA traders are in dispute with the Baltic Exchange over how it has managed the transition of IMO 2020.
Baltic Exchange freight models include a component of bunker prices-mostly 3.5pc fuel oil. Through 2018 the exchange discussed whether to change its methodology from the start of 2020 to rebase on new 0.5pc fuel types or to launch parallel contracts based on 0.5pc fuels. The problem is that millions of dollars-worth of FFA contracts had already been traded for the months of 2020, and that any methodology change would rewrite their value.
Participants in any exchange always have the option of taking their business elsewhere. But this threat is made weaker by just how firmly established the Baltic Exchange is in dry bulk freight markets. The two biggest energy exchanges, ICE and the CME, both list dry bulk freight futures contracts, but their settlement is tied back to data published by the Baltic Exchange.
Some of the largest FFA trading houses have anonymously briefed various trade publications that, if the Baltic Exchange changed the fuel specifications within the dry timecharter indices (against which FFA contracts settle), they would pursue compensation claims through regulators and courts.
After delaying a decision expected by the end of last year, the Baltic Exchange eventually decided to go ahead with the methodology change to 0.5pc. Combined with a sharp crash in dry bulk rates in January and February this year, this has left several large FFA trading outfits severely disgruntled.
In March, an anonymous twitter account started a campaign to discredit the Baltic Exchange, alleging market manipulation behind the crash in dry bulk rates. But many market participants suspect a simple case of sour grapes by a trader on the wrong side of the price movement, and dispute any suggestion of manipulation, as does the exchange itself.