Headline balances have deteriorated markedly but this obscures the divergent fortunes of different grades. ULSD markets continue to perform well and underlying fundamentals are strong. Higher sulphur grades, on the other hand, are coming under pressure. Rising supplies East of Suez are weighing on benchmark prices while the glaring weak spots for diesel demand are in many cases among higher sulphur diesel consumers like Saudi Arabia, where demand plummeted by 24% y/y in August.
Speculative length is considerable and the trajectory for refinery runs for the next two months is solidly higher. Thus, even though ULSD markets are far more balanced than higher sulphur grades, the pace of stock draws is going to slow next month and given the still chunky overhang of commercial stocks in Europe, fatigue may set in. Another warm winter could quickly turn stock draws into stock builds. Overall fundamentals are strong, but as the market exits turnaround season it will be up to demand to pick up the baton of leadership.
European inventories are tighter on some measures, but the market is not yet at the point where prices should be soaring. Total European stocks were equivalent to 66.4 days of demand in August, down from 70.3 days a year ago. Even with the current strength in European demand, inventories would need to fall by some 20 mb to get stocks in terms of days of cover down to the level that would support the most bullish scenarios for diesel. With refinery output set to rise, drawing down stocks this much by year-end looks unlikely despite strong demand.
The inventory picture is also more complicated than the headline numbers suggest. Stocks are tight in some countries, such as Germany, but are high in others, such as France or Italy, where inventories are more than 5 mb over the five-year average. However, of the more than 422 mb in diesel stocks held in EU countries in May according to Eurostat (where data is heavily lagged), 332.4 mb were classified as emergency stocks. Outside of the ARA countries, Germany and Italy, no EU states have sizeable surplus stocks relative to their reported emergency stock levels.
Chinese diesel demand contracted y/y by 0.3 mb/d in August, a massive swing versus the 0.2 mb/d y/y growth recorded in July, as a government crackdown on pollution bit into industrial activity. Indeed, if the authorities push ahead with set targets for pollution cuts in major cities, diesel demand across the balance of the year could disappoint further. Yet despite these restrictions, Chinese refinery runs soared by nearly 13% y/y in September and anecdotal reports suggest Chinese oil demand has picked up enough to keep stocks from building excessively.
Higher sulphur grades will bear the brunt of the growth in refinery runs and this could eventually weigh heavily on simple refining margins worldwide and perhaps even complex Asian refining margins. The Atlantic basin should be able to weather the rise in supplies in Q4 17. With speculative length at very high levels, any disappointment could trigger a selloff. Our base case remains that the strength of demand will ensure European stocks continue to draw, but at a slower pace, and that the main risk in the short run to the market is positioning.