Barrons on IMO 2020; worthwhile read
Posted: Sun Oct 06, 2019 8:16 pm
Shipping Fuel Is About to Get Cleaner. What It Means for Investors.
By Avi Salzman
Oct. 4, 2019 7:00 am ET
Global trade is powered in large part by one of the dirtiest fuels on the planet.
Every year, some 60,000 oceangoing freight ships carry $7 trillion in goods and commodities around the world. Just one of the largest of those ships can belch as much sulfur oxide gas—a major contributor to acid rain and respiratory diseases—as 50 million diesel-burning cars.
Now, big changes are coming, changes that will reorder the oil and shipping markets—and perhaps make the planet a cleaner place. For investors, the shift presents big opportunities.
Ships will need to use cleaner fuel or be outfitted with new exhaust systems to abide by new international rules that go into effect on Jan. 1.
“It’s the biggest thing happening in the freight market and in the oil market,” says Tor Svelland, chief investment officer at Svelland Capital, a hedge fund that started a new fund this year to profit off the changes. He thinks the new rules will cause a demand spike in the oil market four to six times as big as 2008, when oil rose to $145 from the high $80s.
U.S. companies may have the most to gain. Indeed, industry groups representing U.S. oil explorers and refiners are so confident that it will help their businesses that they are lobbying to make sure the Trump administration doesn’t try to delay the rules.
Expected beneficiaries include refiners like Valero Energy (ticker: VLO) and Marathon Petroleum (MPC) that process low-sulfur fuel, and companies that transport and store crude and refined products. Some shipping companies should also gain, despite high upfront costs.
Others are using derivatives to play the changes. Some hedge funds are betting on a shift in fuel prices, under the expectation that the price of cleaner marine fuels will jump in value.
The fuel that ships currently use literally comes from the bottom of the refining barrel. The new rules, adopted in 2016 by the International Maritime Organization, or IMO, an agency of the United Nations, mandate that the maximum sulfur content in marine fuels be reduced to 0.5% from 3.5%. A 2016 study by the Finnish Meteorological Institute predicted that the rules could extend the lives of 570,000 people who would have died prematurely from 2020 to 2025.
It is an enormous shift, affecting as much as 5% of global oil demand. And it won’t come cheap.
The dirtier fuel costs roughly $325 a ton, while one kind of compliant fuel goes for $600, according to IHS Markit. And that spread could widen further once the deadline passes.
IMO 2020, as the new rules are called, could cost the shipping industry $60 billion a year to put into effect, according to energy research firm Wood Mackenzie. Assuming full compliance, the total cost of the regulations could be as much as $240 billion, Goldman Sachs estimates—with much of that cost eventually borne by consumers.
Those costs will first fall on shipowners. They can switch to cleaner marine fuels, install “scrubbers” that can reduce emissions from sulfur-heavy fuel—or try to skirt the regulations.
Evading detection could prove difficult, however. The IMO has broad authority to set rules for international shipping, and countries around the world are expected to enforce compliance.
Despite the costs, some investors expect certain shipping companies to benefit from the changes. Those that install scrubbers, for instance, can run their ships on sulfur-heavy fuel oil, which will probably get much cheaper once other shipowners are forced to buy low-sulfur blends.
“Shipping companies that install the scrubbers should be more profitable in the near term, as the spread between high and low sulfur fuel continues to grow,” David Marcus, CEO of Evermore Global Advisors, wrote in an email to Barron’s.
Among Evermore’s holdings is Frontline (FRO), which operates tankers that carry crude around the world. Evermore owns nearly 3% of the company. Frontline will benefit because the U.S. is likely to export more crude as IMO 2020 is adopted, in part because U.S. crude is lighter and easier to turn into low-sulfur shipping fuel. In addition, Frontline has a 28.9% equity stake in privately held FMSI, which makes scrubbers.
Evermore also owns Scorpio Tankers (STNG), another tanker company, which transports refined products. Scorpio’s fleet comprises mostly newer ships. Marcus expects companies with older fleets to scrap ships that are too old to make it worth installing a scrubber.
Jonathan Chappell of Evercore ISI says the new rules could help the industry’s supply-demand balance. Shipyards are already backed up with ships that need scrubbers. “That’s removing a lot of capacity,” he says. “It’s over 1% of the fleet, which doesn’t sound like a lot, but it’s an industry with a very delicate supply-demand balance.”
Svelland agrees that shipowners are likely to scrap older ships. “And steel prices are high, so the scrap value of the older tankers is very high,” he says. He likes Frontline and Scorpio, as well as Teekay Tankers (TNK), Golden Ocean Group (GOGL), Star Bulk Carriers (SBLK), and DHT Holdings (DHT).
The biggest impact is likely to be in the petroleum markets, affecting commodity prices and the companies that refine and move fuel around the world. Only 5% of the world’s merchant ships are expected to add scrubbers by January, meaning that most will need to start buying cleaner fuels.
Svelland is primarily playing IMO 2020 with commodity futures. Marine gas oil, which complies with the new rules, is likely to become more expensive before Jan. 1. Svelland doesn’t think the shift is fully priced into futures yet. “People are just waiting to see if this is actually happening,” he says.
This has been a complicated trade, however. Refiners are starting to shift their production to provide lower-sulfur fuel oil, but ships are still using the dirty stuff.
“The supply of high-sulfur fuel oil has started to decline in preparation for that decrease in demand, but the demand hasn’t actually gone away yet,” says Kurt Barrow, an oil expert at IHS Markit. “That has created a shortage in the supply today that is holding that price up.” And refiners are now making a new product called very low sulfur oil that could pull demand from marine oil.
Other U.S. energy players are well situated to profit. U.S. crude is known for being lighter than crude produced in other countries like Venezuela and Canada. Lighter crude is easier to refine into marine oil, so there is a good chance that demand for U.S. crude from overseas refineries will rise, helping domestic producers.
The companies that transport and store those products will likewise profit. Among those beneficiaries is Enterprise Products Partners (EPD), which is expanding its capacity at shipping terminals to make it easier for oil companies to ship crude and petroleum products overseas. Magellan Midstream Partners (MMP) is similarly building out its crude export facilities, and is well positioned to profit, according to a recent report from energy analytics company Alerian. PBF Logistics (PBFX) signed a deal with Maersk this year to process and store IMO 2020-compliant fuel in New Jersey.
“It’s a positive, no doubt,” says Chris Eades, a portfolio manager who manages midstream funds for ClearBridge Investments. Eades sees IMO 2020 as one aspect of the much larger trend of growing U.S. crude exports. His largest investment is in Enterprise, and he calls Magellan a “core holding” too.
Stocks That Can Benefit From the New Fuel Rules
Company / Ticker Recent Price YTD Change Market Val (bil) 2019E EPS 2019E P/E Dividend Yield
Refiners
Marathon Petroleum / MPC $59.20 0.3% $39.0 $4.18 14.2 3.6%
Valero Energy / VLO 82.80 10.4 34.3 4.98 16.6 4.4
Shipping & Transport
Frontline/ FRO $9.39 69.8% $1.8 $0.74 12.2 N/A
Scorpio Tankers/ STNG 30.23 71.8 1.8 -0.44 N/A 1.3%
Midstream
Enterprise Products Partners / EPD $28.09 14.2% $61.5 $2.19 12.8 6.3%
Magellan Midstream Partners / MMP 65.17 14.2 14.9 4.29 15.2 6.2
E=Estimate; N/A= Not applicable
Source: Bloomberg
U.S. refiners are in a good position, too. Most domestic refineries were designed to process heavy crude. They make relatively little heavy-sulfur fuel, so they won’t be hurt by the new rules. And they will benefit from higher demand for products like marine gas oil, as shipowners scramble to find compliant fuel.
“The result is potentially a swing of upward of three million barrels a day of demand from lower-quality, high-sulfur fuel oil to some sort of distillate,” says Morningstar analyst Allen Good. And as the price spread between high-quality and low-quality fuel oil widens, better refineries that can refine heavier crude oils should profit.
“I don’t think it’s reflected in the prices of the refiners,” Good says. “They look pretty cheap,” he adds, pointing to Valero and Marathon Petroleum, two of the largest U.S. refinery companies.
Larger oil companies like Exxon Mobil (XOM) also own refineries, but their stocks move on other factors. “The integrated firms aren’t as much of a pure play on IMO as the refiners,” Good says.
The market’s reaction to IMO 2020 may take a while to play out, and there is always the wild card that the Trump administration tries to slow the rollout of the regulations. A White House spokesperson did not respond to requests for comment.
Yet U.S. refiners and oil producers have joined together to support the rules. Given the momentum, investors should anticipate that the rules are coming.
“The U.S., is a signatory to it; it’s a U.N. action,” Good says. “In political terms, there is no real constituency behind not doing it. It seems like the boat has sailed.”
By Avi Salzman
Oct. 4, 2019 7:00 am ET
Global trade is powered in large part by one of the dirtiest fuels on the planet.
Every year, some 60,000 oceangoing freight ships carry $7 trillion in goods and commodities around the world. Just one of the largest of those ships can belch as much sulfur oxide gas—a major contributor to acid rain and respiratory diseases—as 50 million diesel-burning cars.
Now, big changes are coming, changes that will reorder the oil and shipping markets—and perhaps make the planet a cleaner place. For investors, the shift presents big opportunities.
Ships will need to use cleaner fuel or be outfitted with new exhaust systems to abide by new international rules that go into effect on Jan. 1.
“It’s the biggest thing happening in the freight market and in the oil market,” says Tor Svelland, chief investment officer at Svelland Capital, a hedge fund that started a new fund this year to profit off the changes. He thinks the new rules will cause a demand spike in the oil market four to six times as big as 2008, when oil rose to $145 from the high $80s.
U.S. companies may have the most to gain. Indeed, industry groups representing U.S. oil explorers and refiners are so confident that it will help their businesses that they are lobbying to make sure the Trump administration doesn’t try to delay the rules.
Expected beneficiaries include refiners like Valero Energy (ticker: VLO) and Marathon Petroleum (MPC) that process low-sulfur fuel, and companies that transport and store crude and refined products. Some shipping companies should also gain, despite high upfront costs.
Others are using derivatives to play the changes. Some hedge funds are betting on a shift in fuel prices, under the expectation that the price of cleaner marine fuels will jump in value.
The fuel that ships currently use literally comes from the bottom of the refining barrel. The new rules, adopted in 2016 by the International Maritime Organization, or IMO, an agency of the United Nations, mandate that the maximum sulfur content in marine fuels be reduced to 0.5% from 3.5%. A 2016 study by the Finnish Meteorological Institute predicted that the rules could extend the lives of 570,000 people who would have died prematurely from 2020 to 2025.
It is an enormous shift, affecting as much as 5% of global oil demand. And it won’t come cheap.
The dirtier fuel costs roughly $325 a ton, while one kind of compliant fuel goes for $600, according to IHS Markit. And that spread could widen further once the deadline passes.
IMO 2020, as the new rules are called, could cost the shipping industry $60 billion a year to put into effect, according to energy research firm Wood Mackenzie. Assuming full compliance, the total cost of the regulations could be as much as $240 billion, Goldman Sachs estimates—with much of that cost eventually borne by consumers.
Those costs will first fall on shipowners. They can switch to cleaner marine fuels, install “scrubbers” that can reduce emissions from sulfur-heavy fuel—or try to skirt the regulations.
Evading detection could prove difficult, however. The IMO has broad authority to set rules for international shipping, and countries around the world are expected to enforce compliance.
Despite the costs, some investors expect certain shipping companies to benefit from the changes. Those that install scrubbers, for instance, can run their ships on sulfur-heavy fuel oil, which will probably get much cheaper once other shipowners are forced to buy low-sulfur blends.
“Shipping companies that install the scrubbers should be more profitable in the near term, as the spread between high and low sulfur fuel continues to grow,” David Marcus, CEO of Evermore Global Advisors, wrote in an email to Barron’s.
Among Evermore’s holdings is Frontline (FRO), which operates tankers that carry crude around the world. Evermore owns nearly 3% of the company. Frontline will benefit because the U.S. is likely to export more crude as IMO 2020 is adopted, in part because U.S. crude is lighter and easier to turn into low-sulfur shipping fuel. In addition, Frontline has a 28.9% equity stake in privately held FMSI, which makes scrubbers.
Evermore also owns Scorpio Tankers (STNG), another tanker company, which transports refined products. Scorpio’s fleet comprises mostly newer ships. Marcus expects companies with older fleets to scrap ships that are too old to make it worth installing a scrubber.
Jonathan Chappell of Evercore ISI says the new rules could help the industry’s supply-demand balance. Shipyards are already backed up with ships that need scrubbers. “That’s removing a lot of capacity,” he says. “It’s over 1% of the fleet, which doesn’t sound like a lot, but it’s an industry with a very delicate supply-demand balance.”
Svelland agrees that shipowners are likely to scrap older ships. “And steel prices are high, so the scrap value of the older tankers is very high,” he says. He likes Frontline and Scorpio, as well as Teekay Tankers (TNK), Golden Ocean Group (GOGL), Star Bulk Carriers (SBLK), and DHT Holdings (DHT).
The biggest impact is likely to be in the petroleum markets, affecting commodity prices and the companies that refine and move fuel around the world. Only 5% of the world’s merchant ships are expected to add scrubbers by January, meaning that most will need to start buying cleaner fuels.
Svelland is primarily playing IMO 2020 with commodity futures. Marine gas oil, which complies with the new rules, is likely to become more expensive before Jan. 1. Svelland doesn’t think the shift is fully priced into futures yet. “People are just waiting to see if this is actually happening,” he says.
This has been a complicated trade, however. Refiners are starting to shift their production to provide lower-sulfur fuel oil, but ships are still using the dirty stuff.
“The supply of high-sulfur fuel oil has started to decline in preparation for that decrease in demand, but the demand hasn’t actually gone away yet,” says Kurt Barrow, an oil expert at IHS Markit. “That has created a shortage in the supply today that is holding that price up.” And refiners are now making a new product called very low sulfur oil that could pull demand from marine oil.
Other U.S. energy players are well situated to profit. U.S. crude is known for being lighter than crude produced in other countries like Venezuela and Canada. Lighter crude is easier to refine into marine oil, so there is a good chance that demand for U.S. crude from overseas refineries will rise, helping domestic producers.
The companies that transport and store those products will likewise profit. Among those beneficiaries is Enterprise Products Partners (EPD), which is expanding its capacity at shipping terminals to make it easier for oil companies to ship crude and petroleum products overseas. Magellan Midstream Partners (MMP) is similarly building out its crude export facilities, and is well positioned to profit, according to a recent report from energy analytics company Alerian. PBF Logistics (PBFX) signed a deal with Maersk this year to process and store IMO 2020-compliant fuel in New Jersey.
“It’s a positive, no doubt,” says Chris Eades, a portfolio manager who manages midstream funds for ClearBridge Investments. Eades sees IMO 2020 as one aspect of the much larger trend of growing U.S. crude exports. His largest investment is in Enterprise, and he calls Magellan a “core holding” too.
Stocks That Can Benefit From the New Fuel Rules
Company / Ticker Recent Price YTD Change Market Val (bil) 2019E EPS 2019E P/E Dividend Yield
Refiners
Marathon Petroleum / MPC $59.20 0.3% $39.0 $4.18 14.2 3.6%
Valero Energy / VLO 82.80 10.4 34.3 4.98 16.6 4.4
Shipping & Transport
Frontline/ FRO $9.39 69.8% $1.8 $0.74 12.2 N/A
Scorpio Tankers/ STNG 30.23 71.8 1.8 -0.44 N/A 1.3%
Midstream
Enterprise Products Partners / EPD $28.09 14.2% $61.5 $2.19 12.8 6.3%
Magellan Midstream Partners / MMP 65.17 14.2 14.9 4.29 15.2 6.2
E=Estimate; N/A= Not applicable
Source: Bloomberg
U.S. refiners are in a good position, too. Most domestic refineries were designed to process heavy crude. They make relatively little heavy-sulfur fuel, so they won’t be hurt by the new rules. And they will benefit from higher demand for products like marine gas oil, as shipowners scramble to find compliant fuel.
“The result is potentially a swing of upward of three million barrels a day of demand from lower-quality, high-sulfur fuel oil to some sort of distillate,” says Morningstar analyst Allen Good. And as the price spread between high-quality and low-quality fuel oil widens, better refineries that can refine heavier crude oils should profit.
“I don’t think it’s reflected in the prices of the refiners,” Good says. “They look pretty cheap,” he adds, pointing to Valero and Marathon Petroleum, two of the largest U.S. refinery companies.
Larger oil companies like Exxon Mobil (XOM) also own refineries, but their stocks move on other factors. “The integrated firms aren’t as much of a pure play on IMO as the refiners,” Good says.
The market’s reaction to IMO 2020 may take a while to play out, and there is always the wild card that the Trump administration tries to slow the rollout of the regulations. A White House spokesperson did not respond to requests for comment.
Yet U.S. refiners and oil producers have joined together to support the rules. Given the momentum, investors should anticipate that the rules are coming.
“The U.S., is a signatory to it; it’s a U.N. action,” Good says. “In political terms, there is no real constituency behind not doing it. It seems like the boat has sailed.”