LONDON, October 14 (Reuters) – Global shortages of middle distillates such as diesel, gas oil and heating oil are strengthening rather than abating – making it more likely that a relatively sharp slowdown in the economic cycle will be required to bring the market back into the picture to bring balance:
The global petroleum and refining system has proved unable to keep up with the rapid increase in fuel consumption resulting from the production and cargo-driven recovery from the coronavirus pandemic.
REFINERY LIMITS
The immediate bottleneck is the lack of sufficient distillation and catalytic cracking capacity to produce middle distillates from crude oil (“Oil Refining Industry Insights,” International Energy Forum, Sept. 2022).
The world’s two largest refinery systems are both producing less distillate fuel than before the pandemic broke out.
The shutdowns of US refineries caused by the pandemic, equipment outages and the planned switch to electric vehicles have left insufficient capacity to meet both domestic demand and increasing export demand.
U.S. refineries produced an average of 4.9 million barrels per day of distilled heating oil in the 12 months ended July 2022, up from 5.2 million in the same period ended July 2019.
China’s refineries have also scaled back crude oil processing as the country grapples with economic disruption caused by repeated city-level lockdowns to control the epidemic.
According to the National Bureau of Statistics, China produced 115 million tons of diesel in the first eight months of 2022, up from 119 million in the same period of 2018.
Chartbook: Distillate production in the USA and China
GREAT SHORTNESS
Some Western politicians have urged China to ease distillate shortages by boosting crude oil processing and resuming fuel exports. The country recently enacted new export quotas to allow more fuel to be sent abroad.
But diesel accounts for only 30% of China’s refineries’ production – the rest is gasoline (26%), naphtha (9%), fuel oil (9%), petroleum gases (9%), asphalt (7%), coke (5%) ) and kerosene (5%).
Processing significantly more crude oil to meet export demand for distillate would likely leave the refining system with excess inventories of other products.
In any case, accelerating refinery processing will simply shift the shortage from the upstream fuel market to the crude oil market.
Brent six-month calendar spread is trading with backwardation of more than $8 a barrel, at the 98th percentile for all trading days since 1990, a sign of just how tight the crude oil market is already.
US crude inventories, including the government’s strategic reserve, have fallen to their lowest levels since 2002, according to data from the US Energy Information Administration.
There is not enough crude oil available to meet the sharply rising demand from refiners in China without further destocking and driving up prices.
This is the context in which US officials told their Saudi counterparts ahead of last week’s OPEC+ meeting that there was “no market basis to cut production targets,” according to the US National Security Council.
RECESSION INEVITABLE
In the absence of major new crude oil production and refining capacity, the only way to restore market balance is to sharply reduce fuel consumption to stabilize and then rebuild distillate inventories.
Distillates are predominantly used in manufacturing, transportation, agriculture, mining, forestry, and oil and gas exploration, so consumption is primarily driven by the business cycle and not prices.
The need for a significant reduction in consumption compared to trend implies a relatively sharp downturn in the business cycle in North America, Europe and Asia.
The Federal Reserve cannot drill oil wells or build new refineries, but it can reduce fuel consumption by raising interest rates and causing a broader slowdown in the domestic economy and key trading partners.
US interest rate traders expect the Fed to raise its target for the interbank funds rate to 4.75-5.00% before the end of March 2023 from the current 3.00-3.25%.
If realized, the projected hikes would take US interest rates to their highest levels since October 2007, just ahead of the onset of a recession in December.
The US Treasury yield curve between 2 and 10 years is more inverted than at any time since March 2000 and before February 1982, both of which have been associated with the onset of recessions.
The World Bank, International Monetary Fund, World Trade Organization and United Nations Conference on Trade and Development (UNCTAD) have all been warning in recent days that a sharp slowdown is likely in 2023.
However, with spare capacity nearing exhaustion, a recession is the most likely route to rebalancing the distillate market in particular and the oil market in general.
Related columns:
– OPEC+ risks excessive tightening in the oil market (Reuters, Oct 12).
– Oil investors poised for recession (Reuters, Oct. 3)
– A recession will be needed to rebalance the oil market (Reuters 22 Sept)
– US diesel stocks at critically low levels after failing to recover over summer (Reuters 9 Sept)
John Kemp is a market analyst at Reuters. The views expressed are his own
Edited by Kirsten Donovan
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