Last month, we asked if the oil market had a crude problem that was constraining diesel output. More evidence has emerged to support this theory. The crux of the ‘crude problem’ is that quite a bit of the oil coming out of the US is very thin in the middle. This has been evident on the US Gulf coast for some time and is now spreading to Europe. This suggests diesel output may continue to fall short of expectations. If so, diesel could go into IMO 2020 backwardated because prompt cracks will need to rally.
Not only do shale crudes have poor atmospheric diesel yeilds but they often have poor VGO yields, which worsens the problem by depriving upgrading units of feedstock. Furthermore, not all VGO barrels are the same. Even when the VGO yield is not significantly reduced, shale VGOs tend to be much more paraffinic. Under similar operating conditions, processing more paraffinic VGO yelds more gasoline and lower production of diesel-range molecules.
Nevertheless, refiners are not sentimental. If they can make a bit more money by making a little less diesel and a little more gasoline, they will do so until the price signals shift. With these facts in mind, it is significant to note that even at current product prices, European refiners still seem to be increasing their intake of US shale crudes—mainly at the expense of Iranian, Russian and Nigerian barrels. One of the sacrifices being made by European refineries under the current price scenario is the AGO content of these crudes. The other is VGO quality.
Getting diesel yields to increase will require the appropriate price signals, and this is something the market is groping towards today. Often this mechanism is viewed as the spread between gasoline and diesel values, though other factors are at play. Jet fuel, for instance, which stands between gasoline and diesel, is increasingly seen by refiners as a solution to their current pricing dilemma. It is for this reason that jet yields are soaring in the Atlantic basin. No refiner is going to overlook any opportunity to shift heavy naphtha barrels from the gasoline pool to the jet pool.
All of this suggests that the market consensus that a diesel contango into IMO 2020 at the end of the year should not be taken as a foregone conclusion. There is a widespread belief that heavy consumer buying of late 2019 and early 2020 diesel futures condemns the market to a contango structure as the demand for long-dated securities will overwhelm shorter-term financial flows.
But this point of view is highly dependent on Atlantic basin diesel stocks building over the next few months. European CDU maintenance has yet to peak, and with diesel imports looking weak for February, stockbuilds are likely to disappoint again. Indian refinery work this summer also looks significant. If so, stockbuilds in Europe could be small at best in H1 19. A modest drop in European refinery maintenance could therefore be of little consequence, especially if diesel yields continue to struggle.
Of course, a strong diesel market heading in 2020 should drive a more rapid adoption of VLSFO by the marine sector, reducing the call on MGO next year but to get to this point, price will need to do the work first to incentivise the marine sector to be more aggressive in testing new fuel blends.