One of the hottest trades this year across energy markets is proving one of the trickiest to profit from.
Starting Jan. 1, oceangoing ships will need to burn fuel that contains some 86% less sulphur. The change means that some of the so-called bunker fuel will contain more gasoil — a lighter oil that goes into more-expensive diesel — and less of the gunky “resid,” which is the stuff left over after squeezing all the valuable bits out of crude oil.
On paper, the trade seemed an easy one: buy the lighter, cleaner fuel and, at the same time, sell the heavier, dirtier stuff. But supply of the lower-quality fuel proved less robust and demand far higher than forecast. As a result, the trade has become this year’s “widowmaker,” making and breaking some of the biggest commodities firms around the world.
“Supply and demand balances told you that low sulphur fuel oil was going to be very strong,” said Andy Lipow, president of Lipow Oil Associates LLC in Houston. “But the perception of when that was going to happen, the timing, was key.”
Specific trades within the commodities world have been known as widowmakers: Bets so risky as to cause catastrophic losses. Those able to weather the swings, however, could catapult careers and pay.
The most famous example happened in 2006 when hedge fund Amaranth Advisors LLC bet on the difference between March and April natural gas futures. When the trade moved against the firm, it lost more than $6 billion — then the biggest-ever hedge fund implosion. Other examples include the spread between gasoline and heating oil futures and between Brent and West Texas Intermediate crude, though trades of this type can also exist outside of commodities.
What Happened?
The drama unfolded in late 2018 when traders estimated that a typical IMO 2020-compliant 0.5% fuel blend could be made from approximately 7 parts gasoil — which has far less sulfur — and 1 part of the currently used 3.5% sulphur resid. The extra demand from that and from some shipowners choosing to just use 100% marine gasoil in their engines would drive up the price of that fuel relative to high-sulphur resid, a bet that many firms put on, according to traders and dealers.
In a twist, though, forward prices of both heavy fuel and gasoil moved together in the first few months of this year. One reason was that shipowners held off switching away from dirtier fuel until very late in the year, so demand remained high. Broader concerns about slower global economic growth weighed on gasoil prices too, because of their link to industrial activity.
In its 2019 annual report, commodities trader Trafigura Group Ltd — which last year merged its gasoil, fuel oil and bunker business in preparation for IMO 2020 — said its “profitability increased strongly” in the division. It added that high-sulphur fuel was tight in 2019 as a result of U.S. sanctions, but that the longer-term removal of high-sulphur fuel demand weighed heavily on the back of the curve, leading to “extreme volatility and disconnects between paper and physical markets.”
Vistin Pharma ASA, a Norwegian drug company turned energy trader, became one of the early victims when the value of its IMO 2020 derivative positions — captured through the difference between ICE gasoil and Singapore high sulphur fuel — developed “negatively” in the first half of the year, according to its second quarter earnings presentation. Their bet resulted in an unrealised loss of NOK 10.2m ($1.1m USD) in the second quarter and a total NOK 88.8m ($9.7m USD). The firm shut its oil-trading venture.
Winning Trade
As the dust settles, it appears the winning trade may have been bullish gasoline. Intermediate products such as vacuum gasoil can be blended into very-low-sulphur fuel oil rather than further processed into motor fuel.
The threat of lower gasoline output, along with a large number of facilities undergoing maintenance ahead of IMO 2020 and the shuttering of the largest U.S. East Coast refinery, helped boost gasoline futures by 23% this year, including 43% in the first quarter alone. Gasoil futures are up 13% in 2019.
“We’ve heard it from our investors and everyone else for about a year and a half now: how are you preparing for IMO?” said Marwan Younes, president and chief investment officer at Massar Capital Management in New York. “Whenever you have a trade so well advertised, it’s also very, very hard to perform. People can become a prisoner of their marketing sometimes.”