The long awaited switch to ultra-low sulfur heating oil on the CME, owner of the New York Mercantile Exchange (NYMEX), has arrived! 35 years after inception, the world’s oldest energy futures contract has been given a facelift. For the last 35 years, the contract represented heating oil with a sulfur content of 2,000 parts per million (ppm), but will now feature heating oil with a sulfur content of 15 ppm. The specs must meet the following, “Colonial Pipeline’s Fungible Grade 62 for Ultra-Low Sulfur Diesel (ULSD) containing now renewable fuel content. “- taken from the CME’s website.
The move comes amid individual states, not the EPA, mandating the sale of 15 ppm ultra-low sulfur heating oil for residential and commercial use. New York has already made the transition, doing so in 2012. Connecticut (2014), Maine (2018), Massachusetts (2018), Pennsylvania and Vermont (2018) have either put laws into place or have propositions on the table. Ultimately, it has been long due and should have positive impacts on the heating oil industry. The transition follows the 2006 EPA mandate for on-road diesel to sell only ultra-low sulfur diesel.
The NYMEX switch will not be severely disruptive, but will certainly impact those hedging and reselling high-sulfur heating oil, as they will still use the NYMEX heating oil contract. In the past, dealers have used their historical rack basis (the difference between their rack price and the NYMEX), and added it to the futures curve to estimate future cost; those basis assumptions will no longer be accurate. Yes, even if you’re not reselling ultra-low sulfur heating oil it still impacts you. Based on New York harbor historical data, the spread between ULSD and high sulfur heating oil has averaged 7 cents per gallon, but has gone wider than 20 cents per gallon for brief periods of time. What impact do we believe this will have on your rack basis? While much is still uncertain, it is plausible to expect rack differentials to drop by 5 to 7 cents per gallon. For example, if a dealer was previously being charged 10 cents per gallon over the NYMEX at their local wholesaler rack, when it all shakes out, their rack differential could drop to between 3 and 5 cents. For those dealers in New York, it will be business as usual. Differentials across the state have already begun to fall- reflecting historical basis patterns. It should be noted, however, ULSD supply issues did surface last winter. It is still important to hedge basis risks via wet barrels or fixed differential contracts in troublesome months – January through April.
Based on the paragraph above, it is easy to ascertain that rack differentials should come down smoothly, but it is not that simple. With all the unknowns surrounding the recent switch, many suppliers have been reluctant to offer fixed basis deals and fixed price deals. While much of it can be attributed to the spec change, some can argue that as we decrease demand for high-sulfur heating oil it is becoming a boutique product. Back in the early 2000’s heating oil demand was 35% of distillate demand. Those figures have changed, and demand for high-sulfur heating oil has dropped to 10 percent of the total distillate pool, while inventory levels have simultaneously fallen. In many states, especially as those around them become saturated with ultra-low sulfur product, it could be difficult to secure high sulfur product.
Currently, most differential quotes around the industry are being seen similar to those in the past; but remember, these quotes are not comparable to the past- they are based off a higher grade product. There is still uncertainty as to where exactly the spread will land, and in the meantime dealers could be left stranded or be forced to pay up for basis. It would be ideal to hold off until basis offers reflect the change, but as program season is almost upon us, it is necessary for dealers to begin scale-in procedures to ensure competitive prices, and meet state price guarantee regulations. In that case you have a few different options: pay up for basis and secure wet barrels, ask for an unpriced fixed differential contract that you can convert to a fixed price wetbarrel later or utilize a mixed financial and wetbarrel strategy. If you’re making fixed price commitments, you don’t have much of a choice, you need to get your margin.
As far as the CME and the rest of the trading community are concerned this makes sense. For those of us still actively using/selling high-sulfur products, its poses risk management issues, but can easily be taken care of. In most cases, dealers will still be able to get their margins by adding previous differentials, but if you can save, or beat your competition, that’s typically a good thing. Be sure to communicate with your suppliers, and hedging advisor, to be certain you are protected and profitable.
The information provided in this article is general market commentary provided solely for educational and informational purposes. The information was obtained from sources believed to be reliable, but we do not guarantee its accuracy. No statement within this article should be construed as a recommendation, solicitation or offer to buy or sell any futures or options on futures or to otherwise provide investment advice. Any use of the information provided in this article is at your own risk.