Diesel's gloomy message for the global economy: Kemp

Global shortages of middle distillates such as diesel, gas oil and heating oil are intensifying rather than easing – making it more likely a relatively severe slowdown in the business cycle will be necessary to rebalance the market:

• US inventories of distillate fuel oil depleted to 106 million barrels on 7 October, the lowest seasonal level since the government began collecting weekly data in 1982.
• EU distillate inventories were just 360 million barrels at the end of September, the lowest seasonal level since 2004.
• Singapore mid-distillate inventories have fallen to just 8 million barrels, the lowest seasonal level since 2007.

The global petroleum and refining system has proved unable to keep up with rapid growth in fuel consumption as a result of the manufacturing and freight-led recovery after the coronavirus pandemic.

REFINERY LIMITS
The immediate bottleneck is the lack of enough distillation and catalytic cracking capacity to make middle distillates from crude ("Oil refining industry insights", International Energy Forum, September 2022).

The world's two largest refinery systems are both producing less distillate fuel than before the pandemic erupted.

US refinery closures brought on by the pandemic, equipment failures and the planned shift to electric vehicles have left insufficient capacity to meet both domestic and rising export demand.

US refineries produced an average of 4.9 million barrels per day of distillate fuel oil in 12 months ending July 2022, down from 5.2 million in the same period ending July 2019.

China's refineries have also scaled back crude processing as the country struggles with the economic disruption caused by repeated city-level lockdowns to control the epidemic.

China produced 115 million tonnes of diesel in the first eight months of 2022, down from 119 million in the same period of 2018, according to the National Bureau of Statistics.

CRUDE SHORTAGE

Some western policymakers have called on China to relieve the distillate shortage by boosting crude processing and resuming fuel exports. The country recently issued new export quotas to allow more fuel to be sent abroad.

But diesel accounts for only 30% of the output of China's refineries - the rest is gasoline (26%), naphtha (9%), fuel oil (9%), petroleum gases (9%), asphalt (7%), coke (5%) and kerosene (5%).

Processing significantly more crude to meet the export demand for distillate would likely leave the refinery system with excess inventories of other products.

In any event, accelerating refinery processing will simply push the shortage upstream from the fuel market to the crude market.

Brent's six-month calendar spread has been trading in a backwardation of more than $8 per barrel, in the 98th percentile for all trading days since 1990, a sign of how tight the crude market is already.

US crude stocks including the government's strategic reserve have fallen to the lowest level since 2002, according to data from the US Energy Information Administration.

There is not enough crude available to satisfy a big increase in demand from the refiners in China without depleting inventories further and sending prices higher.

This is the context in which US officials told their Saudi counterparts there was "no market basis to cut production targets" before last week's OPEC+ meeting, according to the US National Security Council.

RECESSION INEVITABLE
In the absence of major new additions of crude production and refinery capacity, the only path to market rebalancing is through a sharp deceleration in fuel consumption to stabilise then rebuild distillate inventories.

Distillates are overwhelmingly used in manufacturing, freight transport, farming, mining, forestry, and oil and gas extraction, so consumption is driven primarily by the economic cycle rather than prices.

The need for a major reduction in consumption from trend implies a relatively severe downturn in the business cycle across North America, Europe and Asia.

The US Federal Reserve cannot drill oil wells or build new refineries, but it can reduce fuel consumption by raising interest rates and inducing a broader slowdown in the domestic economy and major trading partners.

US interest rate traders anticipate the Fed will raise its target for the interbank federal funds rate to 4.75-5.00% before the end of March 2023, up from 3.00-3.25% at present.

If realised, the forecast increases would take US interest rates to the highest since October 2007, immediately prior to the onset of a recession that December.

The US Treasury yield curve between two- and ten-year securities is more inverted than at any time since March 2000 and before that February 1982, both of which were associated with the onset of recessions.

The World Bank, International Monetary Fund, World Trade Organisation and United Nations Conference on Trade and Development (UNCTAD) have all warned in recent days that a severe slowdown is likely in 2023.

But with spare capacity almost exhausted, a recession is the most likely route to rebalancing the distillate market in particular and the petroleum market in general.

Photo: Reuters

John Kemp is a senior market analyst specializing in oil and energy systems. Before joining Reuters in 2008, he was a trading analyst at Sempra Commodities, now part of JPMorgan, and an economic analyst at Oxford Analytica. His interests include all aspects of energy technology, history, diplomacy, derivative markets, risk management, policy and transitions.