The current backwardation in fuel oil is not a recent phenomenon and ramped up back in 2016 when the IMO made the decision to cut the sulphur content from 3.5% to 0.5%. Back-end fuel cracks (the value of fuel versus crude) collapsed whilst the front-end remained relatively unchanged. The result, in order to have the front cracks fit with the back, was increasingly strong backwardation in the fuel oil curves out to 2020 and beyond.
Backwardation – where nearby swaps contracts are more valuable than ones further into the future – is usually associated with prompt strength, typically due to supply tightness.
In the case of 2020, the backwardation is driven by the weakness on the back end.
Looking at the 3.5% Rotterdam barge and the Singapore 380cst curves, the strongest spread on the curve is Sept ’19 into Oct ’19. This tells us that the trade is selling down the October contracts ahead of 2020. This makes sense as the last VLCC of HSFO will leave Rotterdam at least two months ahead of the specification change: October is when the true weakness should start to bite.
But why are the Oct/Nov and Nov/Dec spreads weaker than Sept/Oct? It shouldn’t necessarily be: by rationale, the spreads should increasingly strengthen further out as HSFO is rejected. It appears that this is a function of liquidity. Industry feedback on the open interest (sum of outstanding contracts) is around 2.50m mt on the Sept/Oct barges, 2.40m mt on Oct/Nov and 1.20m mt for Nov/Dec.
Aside from the spreads backwardation, the price action of Singapore rejecting HSFO is also very apparent on the cross-arbs – the spread between the month of load in ARA and the tertiary month of arrival and pricing out in Singapore. This spread is usually the cost of freight and other costs and it significantly compresses as we back into 2020.
Any subsequent flow eastwards will have to be via partially-loaded VLCCs or on smaller vessel classes moving via the Suez Canal in order to get to the Singapore market as soon as possible and not incur the straddling between three pricing months.