Double envelopment

Published at 10:14 14 Jun 2019 by . Last edited 11:18 22 Aug 2019.

A month ago the market was readying itself for a bullish summer, but the collapse in the ICE gasoil structure amid what would otherwise be bullish supply constraints speaks volumes. Demand concerns have clearly tightened their grip on the market, and with April data starting to trickle in, fears of a global slowdown in demand are being reaffirmed. Traders are also starting to worry that IMO 2020 will prove no panacea either, as VLSFO supply looks set to rise faster than initially expected. Indeed, we think there is a good chance VLSFO demand exceeds our 1 mb/d base case for 2020, given the amount of supply announced by refiners.

Asian diesel demand was virtually unchanged over the January–April period amid weak Chinese data and a deceleration in Indian demand growth. Consumption in some smaller economies in the Asia Pacific was also lower, notably in Indonesia. Demand has been similarly anaemic in the Middle East, where the exodus of hundreds of thousands of expats from Saudi Arabia amid austerity measures has significantly contracted the Kingdom’s construction activities.

Latin American demand has fared better, though rapid expansion in Argentina’s shale gas output, on top of shrinking power generation requirements, is likely to displace diesel from its power stations. Similarly, while US demand has held up throughout Q1 19, recent heavy rainfalls have made Midwest corn crop planting impossible. While farmers have resumed planting, the prospect of weak diesel demand amid a disappointing harvest has increased.

But the slowdown has perhaps been most profound in Europe. Its weakness is directly responsible for the collapse of prompt gasoil futures into contango, despite the slate of refinery problems in Northwest Europe and weak exports from the Russian Baltic port of Primorsk. As if weak prompt pricing is not enough, the escalation of the US-China trade war has unnerved those who are bullish diesel going into IMO. A recession, after all, would make the transition to 0.5% sulphur fuels in the marine sector much easier.

Yet even without a recession, the case for a rampant diesel bull market in 2020 because of the new IMO rules has been rattled by evidence that VLSFO penetration in the marine fuel market will be greater than many had expected. VLSFO stands in direct competition with MGO, and given that VLSFO is expected to trade at a small discount to diesel, it will likely win market share as shipowner acceptance grows and compatibility and stability concerns are put to rest.

More importantly, boosting VLSFO output does not necessarily mean significantly higher refinery runs. Key blending components like LSFO and hydrocracked VGO are readily available, while boosting diesel output is harder without lifting runs, even if MGO does permit the introduction of a lot of heavy gasoil into the diesel pool.

The crux lies in whether refiners can secure customers for VLSFO. If so, then global diesel demand growth in 2020 will likely come in below our estimate of 1.8 mb/d y/y. With the large increase in refining capacity on the horizon next year, this could set the stage for a more challenging year for refining margins in 2020 than many expect. Between the slowdown in the global economy and the growth of VLSFO, diesel bulls must be feeling squeezed on both sides.

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