IMO 2020 has arrived. Asian diesel markets are pricing to retain more supplies from Q4 19, and European markets have responded to force the east-west arb to reopen. Contrary to our expectation last month that the weakness in conventional European diesel demand would keep cracks under pressure, the market is focussing more on changing supply dynamics than mounting European inventories for now. This was a shift we thought would come later this year, but having arrived, the diesel market is likely to be biased to the upside for now.
European demand remains weak, and inventories likely built m/m in June for the first time since 2013, taking stocks to near 420 mb and probably 10 mb higher y/y. European refinery maintenance does not look particularly heavy in September and October compared to last year, either. But with MGO demand expected to rise by as much as 2 mb/d from 2018 levels due to IMO 2020 in our base case, the market is no longer focussing on short-term demand fundamentals. Global diesel demand is still poised to rise strongly after a period of stagnation, even if MGO demand comes in weaker than this estimate due to slower trade or greater adoption of VLSFO than anticipated.
East of Suez suppliers now supply a third of European diesel imports, up from 15% in 2014. Much of the gains have come from new refineries in the Middle East, while the share of imports from the Far East has remained small. The big variable has been India, which has to do with both Asian demand dynamics and the state of supply in India. Despite slower demand growth in India this year, supplies have been weaker thanks to a heavy programme of maintenance ahead of the switch to tighter fuel specifications next year, slowing Indian exports in Q2 19.
Asia is now seemingly starting to price to keep more of its diesel surplus at home ahead of IMO 2020. The question is whether it will also price to keep more of India’s surplus in the east.
With the market in backwardation, the incentive to accumulate stocks ahead of IMO 2020 has been wiped out, but unless Europe allows the east-west arb to close again, cargoes will flow westward. If Asia genuinely needs these barrels, then sustained European strength will be a catalyst for a further move higher in Asia. Now that diesel cracks have risen sharply, stimulating higher refinery runs as well as reopening the east-west arb, Europe risks a short-term return to oversupply.
Ship owners say that any large-scale buying of compliant fuel will not come until at least November. If so, European markets will be dealing with any mismatch between short-term arrivals and the ramp in MGO demand, which may only come in a few months. This means the backwardation at the front of the ICE gasoil curve may be vulnerable, unless turnarounds are greater than we expect.
The prospect of the IMO boom has allowed traders to ignore demand fundamentals for now, but a lot is still resting on big assumptions. High fuel prices and weak global trade will lead to changed behaviour from ship owners. Ships must burn disproportionally more fuel as speeds increase, and container ship speeds are already slowing. Until the market has a clearer picture of what IMO 2020 demand looks like, it will err on the side of caution and bid up supply. But at some point, the forces roiling the crude market must either recede or also assert themselves in diesel.