The oil price rally has really cooled down over the past three weeks, with oil prices declining to levels last seen prior to Russia’s invasion of Ukraine. A massive increase in interest rates by the Fed, pandemic-related lockdowns in Shanghai, slowing U.S. oil demand growth, and a historic strategic petroleum reserve release have all contributed to the selloff.
That said, whereas it’s crude markets that have been hogging the limelight, the most dramatic action in global oil markets has been happening in a more hidden corner of the market: distillate fuels.
The price of diesel and jet fuel in Europe has hit record highs amid unusually tight supplies. Both commodities have since pared some of their gains, but refiners are still making a killing.
Indeed, in another sign of impending distillate fuel shortages, jet fuel traded as high as $7.80/gallon in New York in May, a massive ~$200+ premium to crude feedstock prices. The jet fuel premium was~10x bigger than any premium seen in the past 30yrs.
Back in April, oil permabull Goldman Sachs predicted that distillate fuel demand and refining margins were likely to remain robust due to the fact that diesel and jet fuel stocks are at historic lows while jet fuel consumption is poised to accelerate into summer with a return to international travel. Just a few weeks back, GS predicted that Brent crude oil prices would average $140 a barrel between July and September, a level at which it’s likely to discourage consumption but also incentivize new production.
But it appears GS might have rushed their fences: Reuters market analyst John Kemp has now warned that U.S. diesel consumption is likely to decline by 200,000 to 600,000 barrels per day (5%-15%) over the next year as the economy slows in response to rising interest rates.
Distillate fuel oil is a category that includes diesel, gas oil, and heating oil. These are the petroleum products most sensitive to changes in the business cycle, and are therefore likely to be impacted most as the U.S. economy slows down.
According to Kemp, historical data shows that both recessions and mid-cycle slowdowns have tended to reduce consumption of distillates by between 5% and 15% Y/Y. The volume of distillates supplied to domestic customers in the United States is currently running at a little over 4 mb/d clip, meaning the expected decline is equivalent to between 200,000 and 600,000 bpd.
Kemp notes that whereas the Federal Reserve is not deliberately trying to induce a recession to bring inflation under control, the central bank is willing to risk pushing the envelope too far and plunging the economy into a recession as it struggles to lower inflation running at the fastest rate for 40 years.
That said, the Fed is hardly to blame for the current situation.
History shows that prolonged business cycle expansions tend to result in the progressive erosion of spare crude production and refinery capacity, which eventually puts strong upward pressure on crude prices and refining margins. Recessions, on the other hand, tend to restore a higher margin of capacity and inventories in both crude and refining but also result in downward pressure on prices and margins.
Currently, the world is rapidly running out of spare capacity to produce more crude and turn it into refined fuels, especially diesel, thanks to the rapid rebound in oil consumption in the aftermath of the pandemic. Russia’s invasion of Ukraine as well as subsequent sanctions by the U.S. and Europe, have only served to exacerbate the situation. Russia is a key source of distillate fuel for Europe and the world. Shortly after the war began, BP Plc (NYSE:BP) and Shell (NYSE:SHEL) stopped selling spot diesel in Germany. Shortly thereafter, Argentina’s YPF Sociedad Anónima (NYSE:YPF) warned of a diesel “scarcity” in the seaborne market. Jet fuel margins in New York harbor rocketed to $200/b shortly after the invasion, good for a ten-fold increase from historic averages.
The result has been an accelerating increase in crude prices and refining margins, which mirrors the end of earlier booms in 2008 and 2001.
Based on past experience, the only way this problem is going to be resolved is by a sharp slowdown in the business cycle so as to restore higher levels of spare capacity and reverse some of the run-ups in prices and margins.