Hurdles Persist To Hedging IMO 2020 Fuel Fallout
The looming IMO 2020 rule is predicted to hike transportation fuel costs across the board, begging the question: With just four months left until the deadline, are those facing this risk hedging their exposure?
Starting Jan. 1, ships not equipped with exhaust gas scrubbers must burn fuel with a sulfur content of 0.5% or less. Those without scrubbers will opt for either low-sulfur fuel oil (LSFO), a new fuel type, often a blend, with 0.5% sulfur content, or existing ultra-low-sulfur (0.1% sulfur) fuels such as marine gas oil (MGO). Both LSFO and MGO are expected to be considerably more expensive than the currently used residual high-sulfur (3.5% sulfur) fuel oil (HSFO).
For trucking and air transport providers and/or their shipper customers, the threat is that refinery production dedicated to more LSFO and MGO for maritime consumption will compete with production of middle distillates such as diesel and jet fuel.
According to Deutsche Bank transportation analyst Amit Mehrotra, "We forecast the IMO regulation will push about 2 million barrels per day of global oil demand into the mid-distillate bucket (+5%) at the expense of residual fuel demand (-25%). With increased competition to procure mid-distillates, IMO 2020 is expected to be inflationary for diesel and jet fuel, which would have implications from the broader transportation landscape."
The good news for land and air transport is that there are well-developed futures markets that allow for hedging of diesel and jet fuel. In the maritime sector, however, it's more difficult. The highest-profile hedging proponent is London-based Enerjen Capital, which is advising clients and offering its own solution, the Enerjen Capital IMO 2020 Note, a curated hedge basket with upside leverage.
But there are significant challenges to maritime hedging. The hurdles faced by ocean shipping participants seeking to hedge IMO 2020 risks were highlighted during a conference call on Sept. 5 held by executives of Euronav (NYSE: EURN), one of the largest tanker owners in the world.
The core problem, they said, is that the paper market for LSFO is thin and not yet developed enough, and there is not enough confidence in correlations between LSFO and other products that do have more evolved derivatives markets.
According to Euronav CEO Hugo De Stoop, "We strongly believe that there will be a dynamic derivatives market in LSFO, which does not exist today. We have not reached the point where we believe we can rely on that paper, but we do believe that once the LSFO is being used [in the physical market], which will happen ahead of January 2020, there will be a possibility to take a hedge.
"We have been asking ourselves this question [how to hedge] for at least the last three months and we haven't come up with a perfect solution, because a perfect solution does not exist. But I don't think we need to be impatient. I believe the [paper] market for LSFO is going to develop sooner than people expect, because people are starting to buy [physical] LSFO.
"We've looked at this many times and we've tried to find the right correlation between LSFO and something else," he continued. "That something else could be Brent or WTI [crude]. It could be MGO. It could be HSFO.
"But no one can guarantee that the current correlations, to the extent they exist, between these products and LSFO will exist beyond 2020, because the supply and demand of these products will be completely different then," he explained.
"At first, MGO had seemed to be the natural hedge, simply because a lot of people believed LSFO was going to be produced on the basis of six parts MGO and one part HSFO. Very quickly, everybody realized that this [mix] was so unstable that it wouldn't be the perfect recipe to make the product. It would have to come from other sources. Refineries would produce LSFO from straight runs and there would also be some degree of blending, but not blending in the way that was first thought.
"And the more we thought about it, the less convinced we were that MGO was a good way to hedge [exposure to post-Jan. 1 LSFO pricing].
"We were almost at the point of taking a hedge based on MGO and we decided not to do that, because we thought that the correlation was not high enough. And we're very happy we didn't do that, because in the early part of August, there was a complete decoupling of MGO from LSFO. In fact, there has been more of a correlation between LSFO and HSFO than with MGO," De Stoop said.
An analyst asked Euronav execs about which derivatives strategy they would use when they could match the paper closely enough with commodity consumption, i.e., when the LSFO derivatives market properly developed. Would they go with futures, swaps or options?
According to Rustin Edwards, Euronav's head of fuel oil procurement, "We're looking at futures hedges. Nothing has really developed in the swaps market that we feel comfortable with."
De Stoop added, "We would probably be more comfortable with an option [than a swap], and obviously a put option, but you have to pay for options, and given the volatility in the market, it's more expensive. Going forward, it will be less expensive and less volatile," he said, implying that put options would be more attractive in 2020 when the pricing landscape is assumedly clearer.
The other important IMO 2020 hedging issue relates to the price of crude. Euronav has preemptively bought 420,000 tons of low-sulfur fuel (70% with 0.5% sulfur, 30% with 0.1% sulfur) as a physical hedge against an LSFO price rise.
If crude collapses, low-sulfur crude will also fall, potentially below the price Euronav paid for its stockpile. In this regard, said De Stoop, "it might not be a bad idea to book something [a hedge] on Brent or WTI, and we did a study and found Brent seemed more appropriate than WTI."
On the other hand, the commodity price risk faced by Euronav from its prepurchased fuel is inherently limited. If it ultimately consumes what it has already purchased, its potential loss is not the $201 million it paid for the fuel, it's the differential between what it paid and the market price when it's consumed.
De Stoop did not sound concerned about this possibility. "The indicators are that the prices will go up. Otherwise, we are all completely wrong – and I mean everybody." More FreightWaves/American Shipper articles by Greg Miller
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