Kub's Den

I don't spend a lot of time thinking about ocean shipping details; every once in a while, I'll check the Baltic Dry Index (BDI) to make sure freight prices aren't high enough to drive up the delivered cost of U.S. grain to export customers, but lately this benchmark for bulk shipping rates has remained relatively cheap. The BDI has been on a seasonal upswing since early April but remains within 4% of its 2018 low. Other than those shipping rates, one wouldn't think that the happenings on the deck of any Panamax vessel or in the boardroom of any Greek shipping company would affect Midwestern farmers very much, if at all. But then I heard about International Maritime Organization (IMO) 2020.

The IMO is changing its regulations about what kind of fuel ocean vessels can burn. Currently, when ships are at port or in a surrounding "emission control area," they are already obligated to run on cleaner low sulfur marine gas oil with less than 0.10% mass per mass (1,000 parts per million) of sulfur oxides, to limit the air pollution caused by those ships and to protect human health in those environments. However, out on the open water, they can still burn bunker fuel at a looser limit of 3.5% sulfur oxides (35,000 ppm), which is a relatively cheap, heavy, high-sulfur fuel oil that's left over from the crude oil refining process.

Starting on Jan. 1, 2020, that's going to change.

The IMO 2020 regulation will limit all marine fuels consumed everywhere to less than 0.50% sulfur oxides (5,000 parts per million), with the tighter in-port restriction of 0.10% also still in place. This has always been part of the plan from the International Conventional for the Prevention of Pollution from Ships (signed in 1973) and the 2020 specifics have been known since 2016, so it shouldn't be a surprise to the shipping industry or the fuel refining industry.

The problem (for the rest of us) is that in order to meet the new marine demand for this very low sulfur fuel oil, refiners will likely have to blend their high-sulfur fuel oil distillation leftovers with their supply of ultra-low sulfur fuel, i.e. diesel. The same diesel that gets used in over-the-road trucking of grain and the same diesel that gets used in agricultural equipment.

This blending demand would obviously increase the global competition for diesel availability, and, all other things being equal, likely increase the price. Yet, deferred diesel prices in 2020 and beyond aren't freaking out as much as we might expect them to be. Looking at heating oil futures as a proxy (which is imperfect, due to the highly seasonal nature of residential heating oil demand), the June 2020 contract, for instance, is sitting at $2.02 per gallon, right in line with the June 2019 contract at $2.03 per gallon. Over the past decade, it has not been uncommon to see deferred heating oil futures move from contango to light backwardation as we're noting now.

The relative calm of the market may be a reflection of some doubt that IMO 2020 will actually be implemented as planned. Apparently, ships could still keep running the high-sulfur fuel oil and stay in compliance if they retrofit their engines with on-board "scrubbers" that would remove sulfur from the exhaust. However, some marine analysts have noted that ship owners don't seem to be putting in lots of orders for scrubbers yet -- and time is running out. Ships may not physically have enough space to accommodate the extra equipment, and using the scrubbers would involve the extra hassle of handling and disposing of the sludge waste (dumping the sulfur into the sea?).

Therefore, it's still unclear how much extra very low-sulfur fuel oil, or how much diesel for blending, will really be needed by the marine industry to be in compliance with IMO 2020 on Jan. 1.

That's the other thing -- compliance. There seems to be doubts about how much enforcement could really be done out on the open water. Even at various ports, a ship's fuel could be tested for compliance with IMO 2020, but then what? And, as with most well-intentioned environmental or anti-pollution efforts, it seems likely that some countries (notably, richer, western countries) will be more likely to enforce the efforts than other countries (developing countries with fewer economic resources to spend).

Then there's the uncertainty about what refiners will be able to supply to meet demand from both the over-the-road and maritime sectors. Over the past year, the price spread between low sulfur marine gas oil and high sulfur fuel oil has already widened. ExxonMobil executives, for instance, are on record saying they expect that global demand for high-sulfur fuel oil to drop by 25% through 2025 due to the IMO 2020 restrictions -- but no one really knows for sure. More than 80% of global demand for high-sulfur fuel oil comes from the maritime sector. Due to the availability of different classes of crude oil in various regions, refineries in the U.S. may be better placed to keep supplying ultra-low sulfur diesel than other countries, and that's before we start brainstorming potential new protectionist measures to distort domestic prices in the event this fuel market really does get wild in 2020.

For farmers, or for any business owners who will need to purchase significant quantities of diesel fuel in 2020 and beyond, the upshot is this: There is a likelihood that if all of this goes according to plan, the global demand of low-sulfur fuel products, including diesel, will be increased starting January 2020. This means there's a chance to see higher prices than what you could lock in today. There is also some chance that all of this will get worked around, delayed or sidestepped by the fuel refiners and/or the maritime shipping industry in a way that doesn't affect prices as much as analysts might otherwise predict. So a long position in fuel isn't a sure bet -- like all commodity trades, it involves substantial risk.

In any case, expect volatility in agricultural input prices, specifically diesel prices, as we get closer to 2020 -- but we're used to that.

Elaine Kub is the author of "Mastering the Grain Markets: How Profits Are Really Made" and can be reached at elaine@masteringthegrainmarkets.com or on Twitter @elainekub.

(BE/BAS)

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