Risk management in the oil markets is challenging enough at the best of times; throw in a major new environmental regulation mandating shipping companies to use a lower-sulphur fuel, and the entire energy supply chain is tested to the limit.
From 2020, International Maritime Organization (IMO) rules will slash the amount of sulphur allowed in bunker fuel from the current 3.5% to no more than 0.5%, in a bid to reduce emissions of sulphur dioxide, which causes acid rain and smog.
“Shipping companies were hoping this was just going to go away,” says Iain Lawson, head of structured products, eastern hemisphere, at BP in Singapore. However, the IMO has made it clear the new rule will come into force on time, be strictly enforced and that it expects a high degree of compliance, he adds.
For shipping companies, the rule presents a major challenge; while they can fit scrubbers to capture sulphur emissions, these are expensive, and there is limited capacity to refit the tens of thousands of ships in time. Instead, they will be looking to refiners to rapidly ramp up production of low-sulphur fuel. “The question is whether the market is going to be able to deliver; will the refiners be able to produce enough … and will it be available where it’s needed? … This is a huge shock to the system,” Lawson says.
What’s more, hedging is almost impossible: a 0.5% market is not expected to begin trading until next year, with no specifications currently available against which to reference forward trades.
Step forward BP, this year’s oil house of the year. “We like to think we recognised fairly early that this was coming,” says Lawson, adding that BP’s presence along the entire marine fuels physical supply chain, including refineries, allows it to provide clients with bespoke risk management solutions. “In a situation like this, where you’ve got uncertainty right the way through the value chain, we’re in a nice position to help people get rid of some of it.”
Indeed, during the first half of 2018, BP worked with what Lawson describes as a “major Asian shipping company” to hedge its 2020 fuel costs and delivery against the risk of price spikes and potential gaps appearing in the supply chain.
“We were able to work with the company to guarantee to deliver IMO-compliant fuel, in the locations and volumes it needs, at a price that’s low enough for the customer to be happy to fix,” he says. The structuring, Lawson says, depended upon BP’s ability to take an educated guess on how the 0.5% grade will trade model the likely price across a combination of gasoil and different qualities of fuel, and absorb some of the remaining basis risk through its own physical refining profile.
We’re able to offer things that might not come naturally to other hedge providers, because there’s a lot we can do with the flexibility of the physical system that allows us to take on these types of risk
Iain Lawson, BP
Lawson adds that, as far as he is aware, the deal was unique. “We’re able to offer things that might not come naturally to other hedge providers, because there’s a lot we can do with the flexibility of the physical system that allows us to take on these types of risk,” he says. He adds that the end-user, which is now able to pass on pricing certainty to its customers, is reluctant to go public on the deal: “They are enjoying watching their competitors squirm.”
It is not only shippers who are exposed to the IMO 2020 rule; its effects are likely to be felt through the whole barrel, with the cost of diesel likely to rise, for example. As a result, some mining companies are now looking at locking in their input costs, says Lawson. Traditionally, these large users of diesel have tended to consider themselves naturally hedged given the historically close relationship between diesel costs and the price of products such as iron ore and coal. This may well change going forward.
Lawson cites a large mining customer, which BP helped with its first diesel hedge – a long-term collar option running into 2020, offering both downside and upside protection should the price of diesel trade outside the defined range. While the structure itself was relatively conventional, the transaction did involve working with the miner to help it understand the heightened risk of rising fuel costs to its business. This caused it to revisit its hedging policy, as well as managing a sizeable options trade in the Asian time zone, notes Tony Baker, commercial manager in BP structured products division.
That decision illustrates just how pervasive the impact of the IMO rules is likely to be, Lawson says. “When we began talking about this a couple of years ago, we assumed it was just a shipping thing. As we dug into it, we realised it will have a big impact on the refiners.”
Lawson now believes it will affect the entire market. “It will have an impact on crude and gas producers, refiners and distillate consumers. All in all, it will impact how people trade crude for the next couple of years.”
- People moves: SocGen adds in prime services, Deutsche fills new rates hole, HSBC makes model move, and more
- Quant Finance Master’s Guide 2019
- Credit risk quants are hitting the tech gap
- Princeton tops inaugural Risk.net quant master’s ranking
- Does credit risk need an expected shortfall-style revamp?