Diminishing returns

Published at 10:24 14 Dec 2018 by . Last edited 11:18 22 Aug 2019.

This time last year, the market was in a bullish mood as the strong demand of 2017 was expected to trigger further big draws in Atlantic basin diesel inventories. Today, the mood is very different, as demand across Europe, the Middle East and Southeast Asia has generally been disappointing. There is no better indication of the shift in sentiment than the path of the spread between Dec-19 gasoil futures and the Dec-20 contract, as the $30 per tonne premium that Dec-19 held over Dec-20 well into October collapsed by late November into a shallow contango. But while there are good reasons to be cautious, the bottom is not about to fall out of this market.

The West of Suez diesel market has underperformed this year in large part due to the weakness in European diesel demand, amid a stifling drought and slow consumer heating oil restocking. For the most part, these were viewed as one-off problems, but now there are bigger concerns brewing. German GDP contracted in Q3 18, the first q/q decline in economic output since 2015, while French demand was also likely hurt by anti-government protests that forced President Emmanuel Macron to scale back reform initiatives. The bottom line is, European diesel demand is on track to be flat to slightly lower this year, which would be the first contraction since 2014.

Atlantic basin supply is clearly on the rise at a time when demand fundamentals in the region have stumbled. Indeed, with USGC refinery runs rising sharply this month, the arbitrage to ship diesel to Northwest Europe has been opened by falling USGC diesel prices, setting the scene for stocks to build in Europe. On the other hand, low PADD 1 diesel stocks ahead of the heating season leave the market vulnerable to a spike in demand if the weather turns averse, attracting cargoes from the Baltic into New York, and keeping Europe shielded from Russian supply.

The key to the market is going to be East-West flows. Faced with weakening domestic demand and armed with a fresh batch of export quotas that are sufficient to permit exports of over 1.8 Mt in December, Chinese refiners could boost diesel exports this month to levels unseen since May. East-West flows are set to be significantly higher than in October and November as the Asian spot market for diesel has collapsed amid a deluge of supply.

Given the slump in Asian diesel prices, the swing of Indian cargoes to the west should come as no surprise, unlike the latest weakness in Indian diesel demand. Much may depend, therefore, on the extensive maintenance planned by Indian refiners in H1 19, as outages at state-owned firms could reduce exports, supported by the rumoured shutdown of one of Reliance’s 0.33 mb/d CDUs at Jamnagar in Q1 19. Moreover, there is probably downside risk to diesel supply in general in H1 19 as well as we expect few refineries will be willing to undertake maintenance during H2 19 amid anticipation of strong markets ahead of IMO 2020.

The upshot is that ICE gasoil cracks should decline as the supply situation at ARA normalises and demand comes off seasonally in Europe. Already timespreads are pricing in modest builds in Europe, which looks appropriate. The most interesting space may be HOGO given the tight supplies in PADD 1 and the fact that RINs values, which have been a thorn in the side of anyone trying to trade HOGO in recent years, look set to remain stable given the Trump administration’s willingness to neuter US biofuels legislation.

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