The demise of diesel has been well documented over recent years, as global efforts to curb greenhouse gas emissions continue to power the rise of hybrid and electric vehicles. However, far from a diesel death knell, we expect to see a resurgence in the use of the fuel.
This thesis is not predicated on witnessing a rise in use of diesel-powered automobiles, where evidence suggests demand is fading. Our view surrounds an area of the market not often discussed in the investment community – shipping.
In a bid to cut the shipping industry’s greenhouse gases, the International Maritime Organization (IMO) has implemented a 0.5% sulphur cap on marine fuel from 2020. This decision is perhaps the most important development for the industry since moving away from coal. It is worth remembering the largest 16 ships in the world emit more nitrogen oxides and sulphur oxides than all the cars in the world. (Source: Fred Pearce)
The IMO sulphur cap is 3.5%, while the average sulphur content in the most commonly used marine fuel is currently about 2.7%. To continue using the same fuel, vessels will be forced to take on exhaust gas cleaning systems or ‘scrubbers’. However, less than 5% of the world’s shipping fleet will be scrubber ready by 2020 and less than 1% will be able to fit scrubbers annually thereafter. Consequently, the vast majority of the fleet will have to switch away from the 3.5m bbld (million barrels a day) of high sulphur fuel oil to distillates, which includes diesel. (Source: RS Platou, Carnegie)
Dislocation in desulphurisation
This switch is likely to kick distillate demand higher by circa 10%. (Source: RBC) For the fuel market to make such a substantial shift in such a short period of time is a monumental challenge. Therefore, we are likely to see exaggerated price differentials opening up between the different fuel types as we witness shortages and bottlenecks. This type of pricing dislocation will create both winners and losers.
Older vessels unable to slow steam – reduce speed in order to curb fuel consumption – or refiners with less flexible refining set-ups, are likely to be the losers. The winners will be refiners with more complex or advanced set-ups, with the ability to adapt to price fluctuations between heavy and light crude inputs and different fuel outputs. Shipping companies with modern fleets, which either have scrubbers already fitted or are able to slow steam more efficiently, will also benefit.
Shifting exposure to offshore oil
Diesel is a middle distillate, which is more prevalent in heavier crude oils. However, supply of this type of oil has been losing market share across the world. Normally, heavier crudes are sour – high in sulphur. Finding heavy, low-sulphur oil is particularly difficult. The main supply comes sporadically, from areas such as offshore West Africa, some parts of South America and the North Sea. Because the quantum of this heavy sweet crude will not be sufficient to avoid the need to desulphurise, refiners will have to make significant investments into desulphurising equipment. However, because the timeline is so compressed, this might not be possible by 2020 and we may see refiners resorting to blending bunker or shipping fuels with gasoline, a factor that may send gasoline demand and prices higher.
It is interesting to note that, with the evolution and development of US shale oil, the only area of the oil market currently seeing any significant growth in supply is at the lighter end. However, we are continuing to witness further evidence of infrastructure bottlenecks in this space, which is beginning to hit operators in the Permian Basin. The rig count in the Permian has flattened over the last two months, as regional prices continue to languish behind other grades of crude. The price of oil from this bottlenecked area of the US (Midland, Texas) is down 13% on the year, whilst Brent crude is up 6%. We had previously been quite bullish on this area of the market, but have subsequently shifted our investment emphasis towards the offshore fields.
Oil price strength to continue
As for the broader oil market, our thesis of continued oil price strength remains intact. The collapse in the approval of new oil projects since 2014 has meant we are rapidly heading towards a new reality of undersupply and low storage levels – far from the environment of a market drowning in oil that was evident just a few years ago.
Last year, the world discovered the least amount of oil since the 1930s, while 2016 and 2017 were not much better – uncovering the lowest levels since the 1940s. At the same time, the market continues to face heightened risk to supply as a result of the lack of spend and increasing political volatility in oil-producing nations, such as Venezuela, Angola and Iran, at a time when spare capacity has shrunk to levels only seen once in the last 20 years on a ‘days of forward cover’ basis.
With the positive outlook for the oil price unfolding over the next few years, integrated oil companies are beginning to show significant cash balances and industry reserve replacement ratios appear increasingly challenged post 2020, a problem that needs addressing now. As a result, we believe capex in the offshore space is poised to move higher, driven by a fundamentally well supported, stronger oil price over the foreseeable future.
Richard Robinson is the manager of the Ashburton Global Energy fund at Ashburton Investments.