Diesel markets worldwide are exhibiting considerable physical strength, but futures markets are burdened with worry that the market is about to hurtle off a cliff due to rising supply. With some 5.5 mb/d of refining capacity due back online between May and July after a hefty spring turnaround season, there are some good reasons for this view, but positioning for disaster ultimately requires a firm belief that the crude market will not tighten.
On the contrary, we expect a significant acceleration in the tightening of the global oil market in Q3 17, with draws of crude and products accelerating to 1 mb/d from 0.7 mb/d in Q2 17. However, there will be a noticeable shift in the market as the bulk of draws will start coming from crude rather than products in Q3 17. This should result in tighter refining margins that will help clean up the diesel market even if stocks build seasonally in the summer months first.
Stockdraws have already been considerable. Excluding data from Sweden that has been tainted by a methodological shift not yet applied to historical stocks, European diesel inventories were over 4 mb lower y/y in March and lower in terms of days of supply at 67.4, compared with 68.3 days in March 2016. Getting stocks down to 63 days of supply, the level inventories were at in March 2015, would require running down European inventories by 30-35 mb. But some of these draws will have happened in April and May.
The draws are not only occurring in Europe either. US diesel inventories have fallen by 24 mb since early February and were lower y/y by nearly 6 mb in the week ending 12 May. The draws in the US are all the more impressive given that US Gulf Coast refinery runs have soared to record highs of over 9 mb/d. It is hard to describe a USGC market that is running at over 96% of installed refining capacity yet still drawing stocks as anything but bullish.
Backward-looking data is masking some of the strength in demand. Bears can point to weak growth in the US, Europe, India and Saudi Arabia in Q1 17 as a basis for their scepticism. In our view, much of this weakness is attributable to warm weather in the US and destocking by consumers in Europe. For instance, German heating oil demand plummeted by 0.13 mb/d y/y in February, despite a 4% y/y increase in heating requirements that month, but on-road diesel consumption leapt by 4% to 0.76 mb/d. Indian demand is also recovering, and imports with it.
But even with demand growth set to accelerate after disappointing headline numbers in Q1 17, diesel production is set to seasonally rise and stocks always build in Q3. The bears fret that the return of refining capacity from seasonal maintenance on top of the start-up of new refinery expansions will tip the diesel market back into a devastating surplus. With refining margins at strong levels around the world, this is not an idle concern.
But right here, right now, demand is strong, helped by both the dire state of Latin American runs and the plethora of refinery works still ongoing. Positioning for tomorrow’s disaster risks catching the market off its guard. Later in the summer, much will depend on the tightening in crude markets. Will it arrive fast enough to damp down diesel supplies?