Diesel consumers have enjoyed a several-week decline in retail prices, but there is a lot in the most recent International Energy Agency monthly report that should concern them.
The IEA is a multination organization of primarily large energy consumers, and its monthly report, which usually runs 75 pages or more of charts, tables and commentary, is closely followed.
Its release Thursday came as a slumping diesel market — falling faster than that of crude — has suddenly sprung into bullish mode this week, soaring for three consecutive days in futures markets.
After dropping to a settlement Monday of $3.1791 per gallon from a recent mid-June high of $3.7173 per gallon, a decline of almost 54 cents, ultra low sulfur diesel (ULSD) on the CME commodity exchange climbed back this week. It rose Tuesday by 15.47 cents per gallon, by 7.65 cents per gallon Wednesday and by another 7.37 cents per gallon Thursday to settle at 3.4840/g.
Although Tuesday’s rise didn’t have any apparent news behind it, by Wednesday the market was taking into account weekly Energy Information Administration statistics showing inventories of all U.S. distillates falling relative to consumption, and inventories of ULSD rising from a week before but still less than they were four weeks ago, at a time when they should be rising steadily.
The IEA report will likely add momentum to any bullish trend because its primary conclusions do not bode well for diesel consumers. And the main problem it identifies for those consumers can be found in the European natural gas market.
Natural gas in Europe has tightened because of consumer decisions to import less natural gas from Russia — and Moscow’s decision to send less of it to the West. As a result, according to the opening sentences of the IEA report: “Surging oil use for power generation and gas-to-oil switching in the wake of soaring European natural gas prices are lifting the growth trajectory for oil demand over the remainder of the year and into 2023.”
When a natural gas consumer moves away from that fuel and to an oil substitute, it can take several forms. For the production of electricity, fuel oil will be the substitute input. Fuel oil, also known as residual fuel or resid for short, is the heaviest, generally dirtiest oil product that comes out of the refining process. Its use as a fuel for generating electricity has been declining for years — the U.S. consumed about 3.3 million barrels per day of resid at the start of 1973 and consumption now is about a tenth of that — but utilities will turn to it when natural gas markets are squeezed.
Although substitution of fuel oil for natural gas is not a direct hit to the diesel market, it does create a new demand for a slice of the barrel and that can boost the entire complex of gasoline, distillates and fuel oil.
But there also is direct substitution of diesel for natural gas, as Bloomberg’s Javier Blas explained in a recent article.
“In Munich, the municipal utility has converted two gas-fired boilers to run on diesel,” Blas wrote. “[Farther] south, in the German Alps, the Berchtesgadener Land farming cooperative has sent two milk truck drivers to learn how to handle an oil delivery rig, just in case they need to buy. To the north, the Veltins beer brewery near Dusseldorf has stockpiled five weeks’ worth of diesel to prepare for an emergency shift away from gas.”
That microcosm of economic activity in the largest economy exposed to cutoffs or reductions in Russian gas supplies is a small part of the forces that may be slowing or stopping the decline in diesel prices that has been going on for weeks.
The IEA report noted that most residential consumers of natural gas cannot do anything except just suffer along with higher prices. “Nonetheless, industrial consumers, particularly refiners, can replace a great deal of gas use with oil,” the agency said. It estimated that substitution in Europe would be about 300,000 barrels per day for the next six quarters, and about half of it would be distillates, pressuring diesel markets.
Refiners generally run on natural gas to power their plants. But the reference to oil switching in refineries was mentioned elsewhere in the IEA report. “Several European refiners reported they have already started substituting higher priced natural gas in refinery processes, both in energy and hydrogen production, with oil products,” it said.
Switching is already going on, the agency said, though it cited oil products other than diesel. “Fuel oil and direct crude use for power generation soared in recent months, as the globe sweltered in unseasonable hot weather, boosting demand,” the IEA wrote. (Direct crude use is the burning of unrefined crude oil for power generation, without any processing.)
Substitution of oil for gas was the key reason the IEA increased its forecast for 2022 global oil demand by 380,000 barrels per day, bringing its projected increase in global demand to 2.1 million barrels per day, a relatively hefty amount by even pre-pandemic standards. (For example, IEA data from a few years ago shows demand rose 1.8 million barrels per day between 2016 and 2017, was up less than 1 million barrels per day between 2017 and 2018, and rose less than 1 million barrels per day between 2018 and 2019.)
The retail price of diesel in the U.S. as measured by the weekly average retail diesel price published by the EIA, the foundation for most fuel surcharges, peaked at $5.81 per gallon June 20. It opened the year at $3.613 per gallon and after a recent seven-week decline was just under $5 at $4.993 per gallon.
All petroleum prices have come down during that time, but diesel has fallen harder. For example, the spread between ULSD and RBOB gasoline, an unfinished gasoline blend stock that serves as the proxy for gasoline on the CME, was roughly $1.20 in mid-June, with ULSD priced that much above RBOB. On Monday, the last day before the recent diesel surge, that spread was just over 31 cents.
The spread between global crude benchmark Brent and ULSD also saw a dramatic decline. It got as high as $1.70 per gallon in mid-June. It declined to less than $1 in recent days before rebounding with the latest increase in diesel prices.
Switching of natural gas to oil was not the only part of the IEA report that could be seen as bullish for oil markets overall and diesel in particular.
Tight inventories have been a key driver of higher oil prices. The IEA said global inventories of crude and all petroleum products rose “a sharp” 87.3 million barrels in the second quarter, though the increase in June was minimal.
While the total increase is large, the IEA also gave preliminary numbers for July and said that middle distillate stocks — which includes diesel — “increased by a mere 0.4 million barrels.” And fuel oil stocks, which would be drawn on in any significant substitution of oil for natural gas, were down worldwide by 2.6 million barrels. This was occurring in July, when stocks traditionally build.
One piece of good news from both the IEA report and the weekly EIA numbers is that refineries continue to run at a strong level. Global refinery runs this month are expected to reach their highest level since January 2020, according to the IEA. But that won’t continue; as the IEA notes, the global refining industry is getting into September and October, when maintenance is undertaken to get ready for winter fuel production and operations decline.
In the U.S., refineries in the week ended Aug. 5 operated at 94.3% of capacity, reversing a two-week decline. The recent high-water mark was 94.9% for the week ended July 8. Refineries in the U.S. East Coast region, known in EIA lingo as PADD 1, operated at a stunning 100.4%, which is generally considered impossible. It can happen if refinery operations are at full blast and if various short-term shifts end up getting more yield out of a barrel than the nameplate capacity.
In the history of PADD 1 operating rates going back to 2010, it’s the first time the number exceeded 100% and drives home the point that capacity additions come more from improvements at existing facilities rather than the construction of new ones.