The long-waited International Maritime Organisation (IMO) rule change will come into effect on January 1 2020. The new rule will impose new emission regulations designed to curb pollution by the global maritime industry. Its aim is to ban shipping vessels that use a fuel with a sulphur content of more than 0.5%. At present the limit is capped around 3.5%.
The new regulations are a result of a recommendation that came from a subcommittee at the United Nations more than a decade ago and was adopted finally by the UN's IMO in 2016. This is a big change, but should have given maritime companies enough time to implement changes to their fleet, so it is a wonder why some ship owners still talk of uncertainty. Forgetting implications to the ship industry and compliance rate, what is of more importance is the demand for low-sulphur-content oil (referred to as "light sweet" oil) vs. demand for high sulphur oil (commonly known as "heavy" oil).
There is a genuine underlying bid towards light sweet oil in the industry and that is seen by the pricing of this type of oil that trades at a premium spread to its brethren. U.S. oil is typically qualified as light sweet oil, which is now in higher demand given the fuel regulations, but also because most of the older less-complex refineries are unable to process some of the heavier, sourer crudes into products as demanded. Ahead of this IMO 2020, record U.S. crude exports are being shipped to Europe over the past few months. And Urals exports to Europe, which is heavier oil, have been falling. But what does this mean for the energy space?
Given these oil market dislocations, where the pricing of certain crudes trade at different premiums and discounts to other crudes, a highly complex refiner is able to process all sorts of crudes and can maximize their output by using the cheapest, lowest cost of crude. A refiner's profitability is determined by its refining crack margin (difference of input crude used to produce output product). This past quarter is seeing a significant move in refining margins as they widen going into the IMO 2020 rule change. Refiners need to produce more and more low-sulphur fuels to comply with the higher demand from transport vessels. Currently only a few refiners have the capacity to leverage this theme.
Valero Energy $ (VLO) is one of them along with names like Marathon Petroleum $ (MPC) and Holly Frontier $ (HFC) . According to Valero, its conversion capacity is at 30% of crude distillation capacity, compared to its peers around 14%-30%. During this quarter, Valero's refining margins have risen in 3 out of the 4 regions it operates in. They have risen 31%, 34%, and 64%, respectively, YoY in the U.S. Gulf Coast, North Atlantic, and U.S. West Coast, but fallen in the U.S. mid-continent by 3% year-over-year. Oil spreads in the Gulf coast, like the Brent-LLS and Brent-WTI Houston, have increased about 58% and 7% respectively, allowing Valero a significant refining advantage and higher profitability prospects for Q4 2019. Marathon is also well placed to benefit from this secular change in the oil complex. According to the company, one dollar-per-barrel change in the blended crack changes its net income annually by $900 million. A dollar-per-barrel shift in the sweet and sour differential moves Marathon's net income yearly by $370 million and $450 million, respectively.
As most are focused on Fed policy, China credit stimulus, and inflation vs. deflation trade, regardless of what the oil price does, there is a lot happening underneath the surface benefitting select sectors and stocks. Seasonally, we are also entering winter demand seasons where we typically see a pick-up in distillate demand and by default a pick-up in crude oil to process it.
The jury is out on whether central banks' stimulation is having the desired effect of producing higher demand in the quarter, but the risk-reward is skewed to the upside. The U.S. Fed will not let any hiccups happen in the repo market over year end and will continue pumping enough money in the system to keep rates at check. This liquidity boost along with its balance sheet expansion should keep asset prices and oil supported for now, until we see actual demand pick up as well.