Investment Research General Market Conditions 03 June 2010 Commodities Bunker fuel: crack spread to stay compressed for now In this note, we take a closer look at the market for residual fuel oil. We consider the supply-demand mechanics of the market and then look at possible ways to hedge exposure to bunker fuel. Finally, we consider the current market outlook. We expect bunker prices to rise as crude oil edges higher. In addition, we look for the bunker crack spread to stay compressed as OPEC keeps production in check. As a result, we see higher bunker prices in 2010 and 2011 than the market at present. Mechanics of the bunker fuel market Residual (or heavy or no. 5-6) fuel oil is essentially the left-over after a refiner has squeezed as much value out of a barrel of crude oil as possible, i.e. it is what remains after gasoline and distillates have been extracted through distillation. As such, it is a residual product that generally returns less money per barrel than the cost of crude oil. Residual oil is usually less functional than lighter oils, mainly because it is highly viscous, so it has to be heated in a special fashion before it can be put to use. This limits its usefulness substantially and notably means that it cannot be used in road vehicles or smaller boats as the required equipment for heating would simply take up too much space, as well as adding weight. Also, burning residual fuel releases a range of pollutants, as the product contains a significant amount of sulphur. Residual fuel is therefore mainly used for running marine vessels or power plants, hence the name bunker fuel. Demand for residual fuel has been declining in the OECD region over the past decade, mainly because power stations increasingly use coal and gas for energy generation. Thus, nowadays the main use of heavy fuel oil can be attributed to shipping, so demand is highly sensitive to global growth and trade. Within the bunker fuel complex, it is likely that going forward low-sulphur fuels - such as the 1% - will increasingly be used over high-sulphur equivalents - such as the 3.5% - due to stricter environmental standards for CO 2 emissions and sulphur contents in energy generation. Fuel oil crack spread to stay compressed Key points Bunker fuel has been trading at a relatively small discount to Brent since OPEC cut production in the wake of the crisis. We expect bunker prices to rise as crude oil edges higher. In addition, we look for the bunker crack spread to stay compressed as OPEC keeps production in check. As a result, we see higher bunker prices in 2010 and 2011 than the market at present. Risks to our forecast lie mainly on the downside as a ramp-up in refinery utilisation and/or OPEC output could imply that relatively more fuel oil is produced. Prices of refined products relative to crude oil HSFO LSFO Brent Gasoil Diesel Jet/kerosene Naphta Gasoline Crude price Crack spread Source: Danske Markets. Note: indicative product price spread to crude oil price. Senior Analyst Christin Tuxen +45 4513 7867 tux@danskebank.dk.
An important other source of demand for residual fuel is minor/independent Chinese refineries (so-called teapot refiners) which process fuel oil rather than crude to a large extent. Independent refining capacity amounts to around 2 mb/d, up close to 10% since 2009. More than half of the feedstock used by China s teapot refiners consists of fuel oil since only state oil companies have a license to import crude directly from abroad. As a result, the teapot refineries take in fuel oil and process it into low-quality gasoline and diesel. Activity at the teapot refineries can vary substantially depending on end-user prices in China, i.e. the teapots may be priced out if bunker prices rise above the capped prices of gasoline and distillates. Finally, fuel oil serves as part of the benchmark for pricing long-term natural gas contracts, i.e. oil-indexed gas prices are often linked to the 3.5% fuel oil price. Feedstock of Chinese teapot refiners Quota crude Off-shore crude Imported SRFO Domestic crude Other crude Dometic fuel oil 9% 20% 5% 22% 32% 12% Source: C1 Energy, Danske Markets. How to hedge bunker exposure? For shipping companies and similar enterprises, bunker fuel is a major cost component. It may be possible for shipping firms to raise freight rates to reflect bunker price levels under some circumstances, e.g. via an agreement with customers that a bunker adjustment factor (BAF) is used in pricing. However, given the volatility in oil prices witnessed in recent years, it is hardly surprising that bunker fuel exposure is a key driver of P/L swings within the industry. In order to mitigate income volatility, it may be preferable for a company exposed to oil prices in general and bunker fuel in particular to hedge cost exposure via financial-market contracts. This may, for example, be done using OTC swaps tied to the Platts Index. A client entering a swap would then be paying a fixed price for a chosen amount of fuel oil, and the financial counterpart the variable market price in return. The client should continue to conduct its physical purchase of fuel oil from its usual supplier, and it would then be reimbursed by the swap counterpart if spot prices rise, and vice versa. Swaps based on 3.5% FOB Barge Rotterdam or 1% FOB Cargo NWE may be used to hedge exposure. These contracts have good market liquidity up to 24 months, but they are less liquid ranging up to 48 months out. Standard lot sizes for these are 100 mt/month. Settlement is conducted financially, usually based on Platts fixings. An example of a swap written on fuel oil is presented below. Swaps are rather flexible and can be tailormade to account for seasonality in demand, settlement in other currencies, etc. Example of swap contract written on fuel oil Product Fuel oil 1% FOB Cargo NWE Payer of fixed leg Client Payer of floating Danske Markets Period One year commencing 1 July 2010 Fixed price USD460 per ton Notional 1,000 tonnes per month Settlement Monthly cash settled Price source Platts European fixing Floating reference price Spot price for fuel oil 1% FOB Cargo NWE Reference price calculation Arithmetic average of floating reference price over each month Source: Danske Markets. 2
Recent developments: light-heavy spreads have narrowed during crisis In the wake of the deepening of the global financial crisis in late 2008 and the corresponding plunge in oil prices, OPEC cut production quotas markedly. Production fell from close to 30 mb/d to a mere 25 mb/d, as members initially delivered very high rates of compliance with pledged cuts. Although global inventories of oil have risen significantly as a result of the slump in demand during the recession, there is little doubt that the massive OPEC output decline eventually helped to stabilise the oil market. A relatively quick recovery in Asia, expectations of an eventual recovery in OECD demand and a search for yield in an environment of plentiful liquidity helped induce a gradual rise in the oil price throughout 2009. Residual fuel crack spreads to Brent. OPEC has cut quotas but compliance is down sharply Heavy-light discount has been falling Source: Bloomberg, EcoWin, Danske Markets In terms of crack spreads, one important effect of the OPEC production cuts was that the cartel put less heavy and relatively more light oil on the market: when required to produce less, members choose to produce the more valuable light oil. At the same time, a lot of new refining capacity using new technology that enables refiners to tilt production towards more light products per barrel of crude came on stream just as the crisis accelerated. Notably, the reaction of refining capacity to prices is subject to an approximate five-year lag. Taken together, this implied that relatively little fuel oil was produced, leading global fuel oil stocks to be run down and, correspondingly, prices to edge higher, despite the simultaneous collapse in global trade. Refining-capacity additions lag prices by five years US residual fuel stocks depleted in wake of crisis 3
OECD residual fuel stocks US refinery utilisation edging higher 175000 1000 bbl 165000 155000 145000 135000 125000 2000 2003 2006 2009 Source: IEA, Danske Markets At the start of 2010, residual oil stocks started to rise across the OECD region and US inventories have seen a noticeable spike since March. This coincides with a rise in OPEC output, which introduced relatively more heavy oil to the market. At the same time, the US has seen a rise in utilisation of existing refining capacity, which means that less up-todate technology is being used, thus producing more fuel oil out of each barrel of crude. These factors contribute to explain the build-up in OECD stocks lately. However, since April the discount to crude at which fuel oil trades has narrowed once again, and it now stands at a mere USD10, in spite of the rising stocks. Although demand for fuel oil within the OECD has yet to see a marked rebound, strong growth in world trade has increased, not least Asian demand for bunker fuel. Chinese imports of freight-intensive commodities higher still Global trade, and freight indices, collapsed during crisis Our fair-value model for bunker fuel suggests that current pricing is close to fair. Our corresponding model for crude prices indicates that the same can be said for the Brent crude price. These models are based on the assumption that fundamentals stay the same in the coming months, but supply and demand fundamentals are changing within the fuel oil market at present. Bunker fuel close to fair pricing Source: EcoWin, Danske Markets. Note: the model is based on monthly data since 2002 for Chinese industrial production, US residual fuel stocks, EUR/USD, world export volumes and OPEC production levels. 4
Outlook: bunker fuel to rise above USD500 per ton next year On the supply side, OPEC has raised production in recent months but we think that the cartel will be careful not to increase output too much going forward. We have already seen the first signs of some OPEC members worrying about the recent price slide, hinting that a discussion of quota cuts may be necessary in order to stabilise the market after the recent correction. As a result, we believe that the cartel will keep production around current levels during the course of the year. This should imply that the composition of crude oil in terms of heavy vs. light fuel is likely to remain more or less unchanged. However, refiners look set to increase run rates as margins are improving in line with higher crack spreads; this could mean greater use of old refining technology, thereby shifting the product composition towards more fuel oil. In contrast, on the demand side we remain confident that global oil consumption will exceed OPEC s current forecast. Therefore, we see a faster-than-expected rise in OECD demand, and hence drop in stocks, than both OPEC and the market anticipate at present. This could work not only to put upward pressure on crude prices, but also to postpone a normalisation of the bunker fuel crack spread, as demand for fuel oil should rise relatively fast due to the ongoing pick-up in global trade. Going forward, we see the fuel oil market as largely balanced and thus look for the bunker crack spread to stay compressed, i.e. to continue to trade at a USD5-15 per barrel discount to Brent for the rest of the year. Specifically, we look for the 3.5% fuel oil contract to trade at an average of USD460 per ton this year and USD510 in 2011. However, we view the risks to the crack spread as lying more heavily on the downside, i.e. a decline in prices cannot be ruled out if OPEC continues to increase production and refining utilisation increases rapidly. Residual fuel demand 5000 4500 4000 3500 3000 2500 2000 2007 2008 2009 2010 Source: IEA, Danske Markets OECD demand (b/d) IEA forecast Danske Markets forecasts (USD/bbl) Brent Fuel 3.5%, Spread 10Q2 79 68 11.2 10Q3 79 68 11.0 10Q4 84 73 11.5 11Q1 86 74 12.0 11Q2 88 75 13.0 11Q3 91 77 14.0 11Q4 93 78 15.0 Source: Danske Markets. Fuel oil to rise on higher crude prices but discount to widen as well Fuel oil 3.5%: Danske Markets vs. fwd 650 600 550 500 450 400 350 300 250 200 3.5% fuel oil, USD/ton Danske forecast OTC swap ind (USD/ton) Danske forecast OTC swap indication Front 447 n.a. 10Q3 449 421 10Q4 479 430 11Q1 488 441 11Q2 495 447 11Q3 508 453 11Q4 515 457 Source: Danske Markets. Note: price indication is for fuel oil 3.5% FOB Barge Rotterdam.. Note: OTC swap is indicative prices as of 2 June 2010. 5
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