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IMO 2020's Impact On Oil, Diesel Markets A Feature Of 4Q2019 Review

FreightWaves

While the seers of the future continue to predict the ultimate demise of the nation's oil and gas industry, there are still markets that need to be serviced, including the marine fuel low-sulfur market that is now operating under IMO 2020.

The quarterly reports of several companies, both integrated firms like ExxonMobil (NYSE: XOM) and independent refiners like Valero, echoed what other analysts and companies have been saying about the switch to lower-sulfur marine fuels, a move that is expected to boost diesel demand: It's been smooth so far but it isn't over yet.

Here are some of the key highlights from energy company management calls with investors and analysts Thursday and Friday on issues that have the potential to directly impact transportation markets:

— The spread between lower- and higher-sulfur crudes, which was expected to blow out under IMO 2020, hasn't done so to the degree that some people thought was likely. The lower-sulfur crudes are more favorable for making fuels compliant with IMO 2020; the higher-sulfur crudes are the opposite. And by extension, that "failure to launch" can be seen in the fact that diesel prices relative to crude have weakened when they were expected to strengthen. On the ExxonMobil earnings call, CEO Darren Woods said he expects that situation to be temporary. "The reason why we are convinced that eventually we'll get back to parity is because the fundamentals associated with IMO are pretty clear and...the economics of refining aren't real hard to figure out," Woods said, according to a transcript of the earnings call provided by SeekingAlpha.

Eventually, the requirements of IMO 2020 need to be reflected in the value between low- and high-sulfur fuel oils. And while Woods did not say this specifically about diesel prices, it wasn't hard to imagine this observation being easy to transfer to the diesel market: "That's a pretty foundational element of crude markets and refining, and eventually those will hold," he said. "And then, in the short term, depending on the different actions that folks have taken and what their position is and what moves it did earlier and what inventories look like, it's going to take time to work itself out."

— Jeff Dietert, the director of investor relations at Phillips 66 (NYSE: PSX), noted that the gasoline market is almost certainly helping the market for fuels compliant with IMO 2020. The new grades of very low sulfur fuel oil (VLSFO) are made largely by using a product called vacuum gasoil (VGO). VGO can be used to make gasoline or diesel besides being blended into VLSFO. But the weak gasoline market doesn't pull VGO away from blending into VLSFO, which means plenty of supply. "I think with the weakness in gasoline cracks, that's pulling low-sulfur VGO out of the(gasoline market)  and into the marine fuel market," Dietert said. But that is not likely to continue. "As we move into the summer-grade gasoline season, that's not likely to be the case. So that probably cleaned up the gasoline market faster than otherwise would have been the case in the spring and provided some incremental diesel demand for the marine fuel market in the summer."

— Phillips 66's Deitert also said the transition to IMO 2020 has been mostly smooth. There have been "few compatibility issues. ... I think there will be strong enforcement." The new grades of VLSFO have "been rapidly adopted with its high-energy contact viscosity and lubricating qualities." So why hasn't diesel reacted upward? "I think the disappointment has been on the diesel side, and diesel has been weak following manufacturing activity that's been disappointing," he said. Dietert also cited the warm winter that has hurt demand for heating oil — like diesel, a distillate — in both the U.S. and Europe.

— Dietert was reluctant to talk about the impact on oil demand from the coronavirus. "I think it's still early," he said. There has been "some impact" on diesel and jet margins because the biggest impact from the coronavirus is expected to be felt first in the jet fuel market from weaker demand for air travel. (As the chart below shows, the spread between Platts Dated Brent assessment and for jet fuel in the U.S. Gulf Coast has been a lot more than "some impact.") Dietert noted that the impact from the SARS virus in 2003 was about a lost 300,000 barrels per day of demand but that China's economy is far bigger now. "We are still dealing with a lot of uncertainty as to the impact of the coronavirus," he said.

— The potential impact on diesel prices from the coronavirus was spelled out by Lane Riggs, president and COO of Valero (NYSE: VLO). If the company sees a drop in jet fuel demand, "we have the ability to put that into diesel if jet demand got soft, and I suspect that's what would happen," he said.

— It has been a challenging time for investors in oil and gas companies. ExxonMobil's stock is near a 10-year low. The earnings report resulted in a decline Friday of 4.12% to $62.12. Since its 52-week high in April, it has dropped about 25%. The Friday decline happened even though its revenue for the quarter beat consensus by about $2.6 billion though its non-GAAP EPS of 41 cents missed consensus by 4 cents, according to SeekingAlpha.

But ExxonMobil has always been known for taking a long-term view, and that was on display Friday in Woods' comments. "We know demand will continue to grow driven by rising population, economic growth and higher standards of living," he said. "We know that excess capacity will shrink, typically faster than people think, and margins will rise, then, new capacity will be needed. These are the classic price cycles of capital-intensive commodity industries." He described investing in oil now as a "win-win, capturing high margins at a lower cost."

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