The strength in fuel oil has gone on for so long that it risks breeding complacency. Strong cracks have raised expectations that supplies will rise and snuff out the rally. We do think supplies will rise, and there are signs that some of the demand story’s most bullish elements are fading, but the market is a long way from taking a turn significantly lower. Crucially, there is little evidence that sky-high fuel oil cracks have delivered a major increase in Atlantic basin output.
A great deal of the tightness in the Atlantic basin stems from the snowballing of refinery problems in Latin America, where acute financial difficulties have led to crude shortages, insufficient maintenance, and an ever-growing list of unplanned outages. Runs in the region were a staggering 0.6 mb/d lower y/y in May and will likely be down all summer, with fuel oil production likely running lower y/y by around 0.2 mb/d as a result.
This will keep up the pressure on the Atlantic basin to sustain exports to Asia. Yet turnaround schedules and ongoing investment in upgrading units suggest any lasting resurgence in Russian fuel oil output is unlikely. At best, Russian fuel oil production will be flat y/y in August, even if refinery runs rise modestly y/y due to the cumulative effect of refinery upgrades.
With Latin American refineries in dire straits, the demand for Russian barrels will be intense, particularly if US refiners continue to run down stocks. US Gulf Coast fuel oil inventories have plunged over the last month to 18.7 mb, the lowest since January 2015. The pace of the decline is surprising, given the strength in US refinery runs, but we suspect that tightening sour crude markets may be encouraging refiners to lighten their slates and fill secondary units with fuel oil.
While the supply side remains resolutely bullish, some more bearish sounds have been heard on the demand side, particularly East of Suez. Singapore bunker demand fell y/y for the second month running in June, and anecdotal reports claim that sales in July have also been weak. Hong Kong continues to be a bright spot, but bunker demand must contend with shipping sector efficiencies amid ongoing consolidation. Fuel oil demand is also butting up against greater inter-fuel competition in the power sector. Saudi Arabian crude oil burn is surprising to the upside, displacing incremental fuel oil demand, perhaps due to production problems at the Manifa heavy oil field.
This retrenchment in demand has to be put in context, because massive drawdowns in Atlantic basin stocks have been required to keep matters in balance over H1 17. European inventories slumped by 6.5 mb over the first five months of 2017, and with arbitrage economics workable to Asia, outflows will continue even as supplies tick higher with peak refinery runs due to stellar worldwide refining margins.
The market may well pause as the autumn looms, a period when utility demand should decline further and supplies are released by Middle Eastern exporters as summer temperatures ease. Yet on our balances, the market is likely to be in deficit in Q3 17 and into Q4 17, even assuming some slowdown in demand in the bunker sector. If so, this represents a significant development for the market as stocks will need to continue drawing to meet demand.