Atlantic basin cracks and spreads could remain under pressure until the summer despite heavy European turnarounds. Underlying demand trends are still intact—but it will take longer to work off the overhang that has built up than we had initially expected because supply is higher in some places.
Warm weather probably led to a 25 mb build in Atlantic basin diesel stocks in January, just as supplies from Europe, but also Russia, surprised to the upside. At first glance, it is not obvious that Russia has contributed to the stubborn overhang in the market. Refinery runs were slightly lower y/y in January but ULSD production rose by 92 thousand b/d (0.38 Mt) and most of these barrels found their way to international markets given Russia’s erratic economic recovery.
Recent oil market gatherings have been the scene of much commiseration among diesel traders still trying to understand just what went wrong earlier this year. Few are wholly satisfied by the explanation that warm weather sunk the rally, and a shortage of physical buyers due to many traders having given up tank leases also seems to be only a partial explanation.
European balances have not been particularly positive either. French demand declined by 3.5% in January-February and German heating oil demand may have contracted y/y by 0.1 mb/d in January given that HDDs hit at least a 10-year low in the month. Meanwhile, European supply has been much stronger, perhaps to the tune of 0.25 mb/d y/y. Thus, Europe has been hit by waves of middle distillate supply from its own refineries, Russia and the Middle East, where exports came in stronger than many (including us) expected in early 2018, partly because of continued weakness in the local construction industry.
But we still think global demand is on track to grow by 0.7 mb/d this year. Chinese coal output and imports are sharply higher, US building permits are strong and trucking is surging. Truck traffic on Brazilian toll roads is also up sharply and Indian demand is roaring back to life as pre-election government spending ramps up. So, dare we say it, the worst is probably behind us.
European diesel inventories built heavily between January and April last year but then plummeted, ending the year lower y/y by 26 mb. The warmth in January meant big builds, but inventories were still likely lower y/y by 20 mb. European refinery throughput gains flatten out from March onward and Latin American and Chinese runs are being constrained by local factors.
Moreover, in just a few quarters, the market will not want for demand. The IMO’s 2020 ban on high-sulphur ship fuel will trigger a sea change in refinery operations and oil demand patterns by H2 19. Given likely scrubber uptake and compliance levels, IMO-compliant fuels with less than 0.5% sulphur will be required in large volumes, perhaps up to 3 mb/d. But squeezing this much extra clean fuel out of the global refining system while reducing fuel oil output requires a big realignment in global oil product prices. Marine fuels will compete with other clean products such as gasoline. VGO hydrotreaters will effectively be able to become marine fuel hydrotreaters if the price is right. Ultimately, IMO 2020 will boost the value of all clean products relative to crude oil and fuel oil.