(PS, our friends in the shipping business say this is for real and not some sensationalist headline!)

Summary

  • According to MIT economist Philip Verleger, the oil market is months away from a catastrophic price rise.
  • The International Maritime Organization rule to require shippers to use only low sulfur fuel will shift 5% of global oil demand away from high sulfur and towards low sulfur.
  • For various reasons listed below, this would bring oil prices to 2008 peaks by 2020, just for starters.
  • If Verleger is right, here is how to prepare.

Thursday, January 2, 2020, is going to be a very interesting day in the energy markets. The day before that, January 1, the International Maritime Organization’s rule mandating only low-sulfur fuel be used for the maritime industry goes into effect globally. On that day, the demand for low-sulfur diesel fuel is going to skyrocket.

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The entire maritime shipping industry, which accounts for about 5% of global oil demand according to the IEA, is going to have to switch from cheap, viscous, poor quality high-sulfur fuel oil, to high quality low-sulfur diesel. Economist and energy analyst since the early 1970s, Philip Verleger, has written a paper on what he calls the “Armageddon” this could cause in the global economy, with ground zero being the energy markets.

I don’t wish to reinvent the wheel here so I’ll just mention the main points he makes in the paper, but I highly suggest you read it for yourself if you want to get a fuller picture of the impending disaster here. Then I will suggest some ideas on how to prepare, other than the obvious move to buy energy stocks.

First, it’s essential to understand the kind of fuel that trans-oceanic shippers use nowadays and why. When crude oil is processed, the more valuable, cleaner distillates like diesel are sold to suppliers, while the leftover dregs are used primarily by the shipping industry. The dregs are thick and dirty, unusable in cars and prohibited by environmental regulations to be used in most places on land. So the maritime industry uses the leftovers, as they are cheap and can’t be used for most other applications.

Here are what I consider to be the most important points that Verleger makes.

First, the problem isn’t just that 5% of demand is going to shift to low sulfur. That doesn’t sound so bad. The problem is also the plummeting price of high-sulfur fuel oil dregs. If they can’t be used for maritime shipping purposes, the demand for this type of fuel oil will fall through the floor, bringing its price down from what is now about 90% of the crude price to somewhere around 10%, according to Verleger. That means if the price of low-sulfur fuel does not rise to compensate, from around 120% of the crude price now to around 200%, then refineries that primarily sell these dregs to shippers could go bankrupt. Those refineries will have to close, further diminishing global refining capacity and pushing the high quality oil price even higher.

The most salient point he makes on the supply side though is this. First, he calculates the number of daily barrels of crude that would need to be produced by 2020 in order to compensate for the added demand of the shipping industry. His conclusion is 100 million barrels daily. From there, he concludes this:

Global crude production of one hundred million barrels per day in 2020 would require an eight-percent increase in output from 2017. The annual rate of increase would need to be three percent per year, three times the rate of increase for the last decade.

Basically, in order to meet this future demand, the global output growth rate needs to be triple what it has been since 2010. The chances of this happening are next to nothing. Venezuela’s output continues to collapse, Iran’s output will be squelched beginning later this year and Donald Trump will still be in office by January 2020 (and even if he is impeached, someone pro Iran sanctions will take his place). So Iran sanctions will probably still be in place and probably at their peak of enforcement by the US.

The chances that the regulation will be halted are also next to nothing. It’s coming. Verleger quotes Kitack Lim, the IMO secretary general, about the possibility of revising the law:

At this point, the regulation which brings into force the 0.5% limit in sulfur in fuel oil from January 1, 2020 cannot be changed from a legal perspective, so there is no possibility of delay.

Further, half of the world’s refineries cannot turn high-sulfur fuels into low-sulfur fuels according to Verleger, so we are about to hit a brick wall here. He believes that once the regulations kick in, price will spike to 2008 peak levels very quickly, at around $160 a barrel. Obviously it won’t come all in one day, but as D-day gets closer on the regulation, price is likely to climb higher leading up to that point.

The obvious move here is to buy energy companies, but there is a more refined (no pun intended) strategy than that. It’s the majors that should be bought because they have the best capacity to refine dregs into diesel. Invest in companies like Exxon (XOM) and Chevron (CVX) with the scale to be able to invest in technologies that can convert high sulfur to low sulfur fuel. The companies that do this in preparation for the new regulation will profit enormously, because they will be able to convert fuel that will only be worth about 10% of the crude price, to fuel that would be worth closer to 200% of the crude price. This will be a play on oil majors with this kind of capital and capacity, who will be able to turn crude-lead into crude-gold.

The other way to go, besides investing in oil ETFs like USO, is to go short automobile stocks like Ford (F) and General Motors (GM), and airline stocks like Delta (DAL) and American Airlines (AAL) and others, though this type of move would require more precise timing. Substantially higher gas and jet fuel prices will kill car and ticket sales in these industries just as they did in 2008.

Another play is to go long agricultural commodities, which will rise in price because fuel costs to farmers will increase. Agricultural companies themselves could go either way though, since sales will drop somewhat as prices rise.

MLPs would also benefit from the coming price spike, which generally rise with the price of oil. In the event that some ships switch to liquid natural gas, companies like Chesapeake (CHK) which mainly sells natural gas would benefit quite a bit as the price of natural gas rises.