Listen: Shifting flows: US diesel displaces Middle Eastern supply to Europe

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Joel Hanley: Hello and welcome to the Oil Markets Podcast from S&P Global Commodity Insights. I'm Joel Hanley. While European diesel markets have always had a helping hand from US exports, what's causing the sudden wave of middle distillates coming across the Atlantic?

Europe's diesel market has long relied on imports. For many years, Russia was the biggest supplier into Northwest Europe with countless 30,000 ton shipments coming down from the Baltics, but this, like so many other things changed when Vladimir Putin decided to invade Ukraine in 2022. Another major source of diesel has been the US with the typical trade flow of excess European gasoline heading to the States with the back haul of diesel coming into Europe in what was a nicely symbiotic relationship given the regional taste for the respective fuels. So what are we to make of the recent boom in European diesel imports from the US in the last couple of months or so? And what does it say about fundamentals in Europe and also which exporters is the US now competing with?

Well, I'm delighted to say that in this episode of the podcast, I'm joined by Robert Perkins, managing editor for Downstream Oil News, Rebeka Foley, who is a senior analyst for Near Term Oil Insights and Nadia Bliznikova who assesses and covers diesel markets for us here in London. Nadia set the scene for us. How are the European diesel markets looking right now?

Nadia Bliznikova: Yeah, thanks Joel. The diesel market has actually been remarkably weak in recent months. The ICE LSGO forward curve flipped into contango in mid-April and apart from a couple of weeks, it has been consistently assessed in contango since then. And the reason for this is twofold. First, diesel demand in Europe has been remarkably lackluster despite the summer season normally being a time when consumption increases. So construction, agriculture, industry have all been quite idle. Also, gasoline is displacing a lot of the diesel demand at the moment, but the growth in gasoline is not large enough to compensate for the reduction in diesel demand. And electrification is definitely playing a role in this as well because more and more people are incentivized to purchase electric cars.

And secondly, Europe has also been receiving extremely high volumes of diesel from the Middle East and the US and Middle Eastern refining capacity has increased massively as the new refineries like Al-Zour, Jazan and Duqm opened up there and then July the US diesel exports to Europe also reached record highs as the arbitrage opened up due to favorable freight economics and European demand has not been able to catch up fast enough to absorb all the additional volume. Diesel demand across the continent has notably been on the decline year-on-year, it is down at least 2% and the expectation is that this trend will continue going forward.

Joel Hanley: That's really interesting. I mean diesel, let's not forget, is basically gas oil or heating oil with the sulfur taken out. I mean in layman's terms, that's kind of what it is. So presumably that fuel can be used for something else if it is not desulfurized, but with the European diesel markets not looking so great and in contango as you say, which incentivizes storage and generally would speak of low cracks, is this more of a push from the US than it is a pull from Europe? Robert, what do you think about that? Why are you seeing that US flood into Europe?

Robert Perkins: Yeah, I think it's interesting point. It was like any sort of major global trade flow story. There are many moving parts and the demand and supply angles are very interesting. I mean, the numbers that we pulled show a big jump in US diesel exports to the wider Europe region this month by some margin, I mean we're up 200,000 barrels a day, just about 500,000 barrels a day of US diesel coming to Europe right now, which is significant. On the demand question, as you say, the contango structure speaks to weakness, but I mean the stocks say something else. I mean we've got ARA gas or diesel stock levels sort of hovering around six-month lows. So despite the observations and expectations really around weak manufacturing data in the European markets, there does seem to be a certain amount of diesel being pulled out of the region or consumed in the region at least, hence affecting the arbitrage economics.

And we can go into all these in more detail, but I think one of the big dynamics I'd pull out of this is also is the way the US diesel has effectively displaced the biggest marginal supply of the European diesel since the war, which is obviously Saudi Arabia being the biggest Middle Eastern producer. That's something we've seen a huge switch over the last year. It's gone now, US has overtaken Saudi Arabia as the biggest marginal supply to Europe. And maybe there's a number of reasons in the Middle East to do with that, refining maintenance, the Red Sea, the issue of Panama Canal limiting the flows of US diesel to Latin America. Again, so lots of moving parts we can talk in more detail. But yeah, it is a very interesting dynamic.

Joel Hanley: Well, yeah, let's break that down a bit because you said there's Red Sea delays, people are moving the oil further, it takes further, I suppose, therefore if it suits them, they might go for more local supply, maybe a slightly higher price, but it arrives on time and that flow, after a while can be maybe slightly hard to break I suppose. You have preferred suppliers who give you security of supply and therefore that relationship builds and cements itself a bit. So maybe we're seeing some of that. But let's not forget those large refineries in the Middle East that have been built over the years, I've said on this podcast repeatedly, I've called them diesel-making machines, right? They are huge and also in India as well. But if you look at Kuwait particularly, these large middle distillates refineries, have been pointed towards Europe, and granted there might be a bit of refinery maintenance, but where is that now going? I mean is that now going into Asia? Into Africa? Do we know?

Robert Perkins: It's an interesting point. I mean obviously Middle East is a key supplier in the winter and particularly we've seen a dynamic in the last winter where the limitations on German winter spec diesel have limited the amount of fuel coming from the Arab Gulf to Europe. That's been a limitation affecting crack spreads between the prompt prices in European diesel and US Gulf prices. And as we mentioned, the Red Sea obviously adds costs. It adds war premiums, insurance costs. So that feeds through to the dial back we've seen from flows from Saudi Arabia for sure towards Europe.

Rebeka Foley: I'd just jump in there. Another interesting dynamic if we look at these East-West spreads is that I think largely due to the diversions away from the Suez Canal, we had a big widening between Singapore diesel cracks and the Atlantic basin. But actually we've seen that spread narrow recently and Singapore has caught up with the rest of the pack. So that's sort of an interesting dynamic and that's happened even though Singapore distillate stocks just jumped up. We saw a pretty big stock build recently and to above the average and US and ARA, A-R-A stocks remain below average. So just another point that's sort of interesting.

Robert Perkins: Yeah, and then also I would charge economics right now, I'm just looking at the numbers from the Arab Gulf to Europe. I mean they've approved a little bit over the last month, but they're essentially still negative. But in May or June they were hitting minus $5 a barrel, which is quite negative. It speaks to those trade flow issues that we've touched on.

Joel Hanley: Yeah, and Rebeka, something you said there, and thanks for jumping in, the longer term, well, the near to medium term health of distillate markets in Europe must be somewhat under threat from this flood. I mean, there's only so long that you can sell oil into a market that doesn't really need it, right? I mean it has to go somewhere else. It goes into storage and of course contango kicks in properly and then eventually we see offshore storage on boats, but we're not there yet. But what does it say for European middle distillers, because, I know Europe is a big continent and maybe you can talk about the Med and the north separately I don't know, but there's only so long that this stuff can be forced into a continent before something has to give. So what's the outlook there do you think?

Rebeka Foley: Well, for one, if we look at right now, I think there is a lot of talk about, oh, the weakness in cracks but I think that we need to put that into context. So if we put our sort of pre COVID hat on, diesel cracks were trading in a range that was much weaker than they have been, not just in the past few years, but even now. So at the moment we have diesel cracks in Europe trading above the historical band, which is certainly saying something. And I think it seems weak compared to last year. And of course the astronomical highs we had in 2022. But actually they're pretty healthy not only by historical standards but for the season as well. I mean we usually see that seasonal boost in the fall, in autumn, and we actually had diesel cracks taking a counter seasonal lead recently during the summer, which is usually when gasoline takes the lead.

At the moment, gasoline has rallied in the Atlantic basin, but we certainly saw diesel have some counter seasonal strength. So I think that's also important to consider. But sure if we zoom out, diesel demand in Europe is expected to have peaked. We don't see it coming back to where it was years ago for a variety of reasons. Of course we have that sort of prompt weakness in the economy, very mild growth in Europe, US growth is a bit stronger, but structural reasons as well, we have that push away from diesel cars and also just uptake of hybrids and EVs. So structural demand declines but in that sort of short-term economic weakness as well, manufacturing has been in contraction mode for most of the past two years. It's at a seventh month low in July. Inflation has come down, but still we have these other pressures that are certainly pressuring demand from the economic side, but also structurally.

Joel Hanley: We're also in a US election year, right? As there's always pressure to keep gasoline prices, keep a bit of a lid on them in the US, I know we're talking about European diesel here, but you can't talk about gasoline in the US without talking about two things, one, how important it is the price per gallon, especially in election year and second, driving season in the US. Now as you say, the structural shifts have seen the gradual decline perhaps of the importance of driving season. We're certainly seeing that play out, I think. But anyway, let's return to European gasoline and Nadia, what are your sources telling you about the current state of the market then? You gave us a good overview at the top of the podcast, but looking ahead, we're looking at the next three months or so in terms of physical pricing. Are you seeing any or hearing of any sort of hope for higher prices for those who want them?

Nadia Bliznikova: Yes or no. Right now, the outlook is actually rather bleak. So as I already mentioned, and as Rebeka mentioned, diesel demand has been trending lower and market participants are saying that in the next two years, the tendency will remain about five to 6% decline year-on-year, on gaso in general. So the highest sulfur, which is what we call gaso, as well as the lower sulfur diesel and gasoline demand is expected to spike a little bit before coming down as well. So no one expects to see any backwardation in the market structure until the end of summer, but a lot of people are expecting to, the market to stay contango even going forward into the fourth quarter of the year. But September, October is normally the time when the diesel specification in Europe switches from summer to winter to account for the more stringent diesel coal properties required for lower temperatures. However, if there is still so much diesel coming from the US, then the quality in winter will not be an issue. So even going forward into winter, it might not become any stronger.

Joel Hanley: So potentially some strength maybe in Europe from the winter spec coming over. Rebeka, what are you hearing on the outlook six months out, for example?

Rebeka Foley: Sure, well, we have a variety of factors at play of course, and many we've discussed. Another one to consider is we have very high runs in Europe at the moment, a seasonal low for outages and refiners trying to capitalize on strong cracks. So we will have a little bit of excess supply. But looking forward, of course, we do expect that seasonal boost in the fall. As we said, we have low stocks, but also a period of contango. So from an inventory perspective, it's generally supportive to prices with stocks in the Atlantic basin in general on the low side, and with refiners focusing on gasoline output, that should also give a little bit of a boost. But structure remains weak and that implies that inventory levels are sufficient, right? So as Nadia said, we should see some structure pick up at the end of the summer as the market starts to look to fall buying for heating oil season.

And from a crack spread perspective, that means perhaps some mild uplift for Atlantic basin cracks in Europe and the US into the winter. So a couple key questions to finish on, I suppose. One, how much will distillate stocks build from August into October ahead of buying season? At the moment, we're assuming maybe a moderate build. So we have low-ish stocks and how much will they build, and that has an impact on prices. And the other wild card is weather, right? I grew up in the Northeast, we used to have four feet of snow outside. It's just not happening anymore. So if we have a mild winter, that could also weigh on cracks. So winter and stock builds are really risk to the downside.

Joel Hanley: Well, I'm from Southeast England and trust me, I think it always seemed to snow more when we were little. But Rebeka, that's a great point, thank you very much for that. And thank you Nadia, thank you Robert and thank you for listening as well. And something I should tell you is that we recently talked about our Nigeria forums coming up at the end of September, but new for this year, we have a Cairo Energy Forum on October the 8th, 2024. This is a new event and we're excited to invite you to this inaugural forum in collaboration with the Ministry of Petroleum and Mineral Resources in Egypt. The event will be held in person in Cairo on October the 8th, 2024 and for more details, you can click on the link in the show notes.

This episode of the Oil Markets Podcast was produced in London by Felix Fernandez.