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Winter’s coming and that could have major impacts on already soaring diesel market

The various winter fuels outlooks that get published at this time of the year by analysts or government agencies have likely never been more important to truckers, railroads and shipping companies as they have been in 2022.

Diesel fuel is a distillate. Heating oil is a distillate. Natural gas is used for heating and in industrial applications, many of which can be substituted for by some sort of distillate fuel, whether it is finished diesel or an unfinished distillate product that is still built from distillate molecules, draining them from the pool used to make diesel.  

And with the soaring price of diesel relative to crude benchmarks, and a natural gas market that awaits a winter in which Russian supplies of natural gas into Europe will be at a still-unknown level but will certainly be lower than historic norms, the relationship among cold weather, natural gas and diesel has never been more fraught with risk for diesel consumers.

Here’s an example of fuel switching, as laid out by Rick Joswick, the head of global analytics for S&P Global Commodity Insights (NYSE: SPGI): Natural gas is the fuel of choice for many refiners to power their facilities. There are certain processes in a refinery that use natural gas, such as using it as the fuel to produce hydrogen. In turn, hydrogen is needed to desulfurize diesel fuel. 

“The refiners who have to buy natural gas are paying these extremely high prices,” Joswick said. Depending on the price of natural gas at the time, that could add refining costs of about $10 per barrel.

One choice then might be to power the refinery with diesel instead of natural gas. Multiply that through multiple industrial uses and the relationship between the high price of natural gas and diesel becomes clear. It was always there, but with natural gas for much of the last decade being at relatively low levels, switching out gas for diesel has not been a significant issue for the diesel market.

The inventory numbers in the U.S. for diesel inventories have been widely reported, enough that the Biden administration has become concerned. There are numerous ways to measure inventories, but one of the simplest is Days Cover. The measurement system takes inventories, divides that figure by daily consumption and what results is a number that reports how long inventories alone could meet demand. 

For four consecutive weeks through Oct. 21, that number for all non-jet distillates, which are probably 88% to 90% diesel, has been below 30. In the most recent two weeks, it has been below 26. For the third week of October over the last five years, excluding the pandemic-influenced numbers of 2020, it has been above 30 four out of five years and has been as high as 37 days.

(Although jet fuel is a distillate, inventory reporting by the EIA separates it from other distillates such as diesel.)

Given the relationship between natural gas and diesel, the news out of Europe may offset some of the tight inventories in the U.S. 

European natural gas stocks are at the third-highest level on record for this time of year, according to Reuters. There have been multiple reports using the word “glut,” as Europe has been on a buying spree to get its stocks full before a tough winter with questions regarding just how much Russian natural gas the continent can count on.

It is likely that inventories of heating fuels in Europe are rising on what is known as a “tertiary” level: in the hands of a consumer. Joswick noted that European heating oil buying habits differ from those in the U.S., where heating oil as a fuel to heat homes is less than 5% of the market, according to the EIA. 

The average home using heating oil in the U.S. has a tank that is about half the size of the European tank, Joswick said. That means that European buyers — who this year might be particularly worried about supplies and price — “buy the whole thing in one shot.” That may have contributed to a tightening of global distillate inventories.

Ties between European natural gas prices and diesel can be seen — partially — from data earlier this year.

The benchmark European natural gas price is the Dutch TTF price. At the end of August, it reached almost $100 per megawatt hour, the basis for the contract (translating gas consumption into the production of one megawatt hour of electricity). More recently, it has been down below $35.

During that slide, the price of ultra low sulfur diesel on the CME commodity exchange dropped from above $4 per gallon in late August to as low as $3.12. But since that time, it has moved back past $4 on several occasions and settled Wednesday at $4.1201 per gallon, the highest level since the end of June. 

So while a link between TTF and the price of diesel is observable for much of September, the relationship recently has broken down, as European natural gas inventories are at healthy levels and diesel stocks are at low levels that are increasingly being referred to as “historic.” 

Even at the now reduced levels, the TTF price is “three times higher than it used to be,” Joswick said. “It’s double the price of oil in terms of dollars per (British thermal unit), so it’s still supporting the price of diesel.” 

Natural gas in the U.S. is elevated but its climb and retreat has not been on the scale of that in Europe. Natural gas delivered at the Henry Hub in Louisiana, the basis for the natural gas contract on the CME commodity exchange, flirted with $10 per thousand cubic feet in August, while the European price was nearing $100. Since then, it has fallen back to a level this week closer to $5.60 per thousand cubic feet, while the European price is nearing $30.

But the ties between natural gas and diesel are not perfect. Even as European natural gas has plummeted in recent weeks, and U.S. gas has fallen though not at the same rate as the Dutch TTF number, diesel as measured by the ULSD price on CME has soared. When it settled Wednesday at that three-month high, $4.1201 per gallon, it was up almost $1 exactly since a recent low on Sept. 26. 

And that inevitably gets back to the inventory scenario: European natural gas inventories are flush; U.S. natural gas inventories run about 5.5% less than the five-year average for this time of year; and U.S. distillate inventories are down almost 20 percentage points from their five-year average.

Compounding the difficulty in forecasting such unprecedented times are the various sanctions that are going into place against Russian crude and product exports. As Russia is a minor supplier of gasoline, those restrictions on products are going to hit diesel and other distillate products, such as gasoil.

Specific to diesel, the sanctions will ban the delivery into EU countries of most petroleum products moved by ship out of Russia. That is as much as about a half-million barrels per day. (For comparison purposes, U.S. consumption of distillate products that aren’t jet fuel generally are either side of 4 million barrels per day.)

Ultimately, the price of diesel will be set mostly by what happens with the price of crude.
And as John Mayes, a vice president with the downstream analysis firm Turner Mason, said, predictions on that are all over the board.

“The last report we did we noticed there was a wider range of crude price forecasts than we’ve ever seen,” Mayes said. While previous forecasts generally all trend in the same direction, that is not the case with current outlooks “because there are so many variables out there impacting the markets.”

Turner Mason is “still bullish for the time being” and explained that making forecasts is particularly difficult “when the dominant variables are all political by nature.”

The perfect Economics 101 argument for the oil market is that because it is global in scope and practice, imports and exports ultimately smooth out variances in different key markets and the world eventually pays spot prices (not including local taxes) that are similar. 

That theory may get a workout this winter. U.S. exports of all non-jet distillates have been running well over historic norms, according to EIA data and could be a factor in the tight inventory levels the market faces going into winter. Exports of all non-jet distillates in 2021 averaged 987,000 barrels per day. For all of 2022, through the third week of October, that number had risen to 1.25 million barrels per day. But since July 1, the average has been more than 1.4 million barrels per day.

“The expectation is that the war will continue for some time, so there is a lot of diesel that is going to be diverted to Europe,” Mayes said.

Are there government steps that could ease a diesel squeeze? The general consensus is that after taking more than 15 years to fully implement IMO 2020, raising the sulfur limits in marine fuels is a nonstarter. 

One of the paths to making marine fuels compliant with IMO 2020 is to take an intermediate distillate product known as vacuum gasoil and blend it to make a product called very low sulfur fuel oil. But that process diverts VGO away from making diesel and into a market — marine fuel — where distillates before IMO 2020 had only a small presence.

If the issue were to be raised that IMO 2020 limits should be eased to cope with a diesel and heating oil squeeze in the coming months, there would also be a legitimate argument to be made by shipowners that installed scrubbers to burn high sulfur fuel oil and meet the IMO 2020 spec through capturing the sulfur emissions, or that converted their ships to run on LNG, that they made investments based on the new rules. The suddenly cheaper fuel oil that could be run under an easing of IMO 2020 rules wouldn’t benefit those companies with those investments.

But Mayes said there could be a presidential order that allowed the allowable sulfur level in the U.S. to rise to 500 parts per million (ppm) from 15 ppm, and that higher sulfur diesel that has no home anymore in the U.S. but is being exported could instead stay in the domestic market. 

“That could have an impact,” he said, adding that he does not see signs that the Biden administration would take such a step. 

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