Diesel set to be the ‘runt of the litter’ among oil markets

Diesel markets in the U.S. are starting to lag the rest of the oil barrel, with a surge in output in recent weeks sending inventories higher.

While the ultimate price of diesel will still be based mostly on what happens to the price of crude oil, all signs are pointing to a diesel market that is weakening under a market-driven decision by refiners through much of April to shift as much of their production as possible away from gasoline and jet fuel and toward diesel. While all markets have suffered a drop in demand, the impact on diesel was less than that in gasoline and jet.

The size of the decline in diesel demand in recent weeks has been far less than that of gasoline. According to Energy Information Administration (EIA) data, the drop in U.S. diesel demand between the week ended March 6 and the low point in the week ended April 10 was 37.3%. But the drop in gasoline demand during that time was 46%. 

But things are starting to normalize. With the rebound in reported demand since then, the decline in the most recent EIA report since March 6 is about even between gasoline and diesel when measured as a percentage, in the 37%-38% range.

But with that earlier collapse in gasoline demand, refiners shifted away from gasoline production significantly. In the most recent weekly EIA report, taking total output of gasoline, jet fuel and distillate (which includes diesel) shows that of those three, gasoline accounted for 55% of the mix, distillate was 40.7% and jet was 4.1%.

In the final week of 2019, in numbers more representative of the way refineries usually operate, gasoline output was 58.7%, distillate was 30.6% and jet fuel was 10.6%.

Refiners in the U.S. have cut way back on their operations. For the past two weeks, refinery utilization in the U.S. has been less than 70%. In the history of EIA data going back to 1990, it had been sub-70% only once, for one week after Hurricane Katrina.

The market equation runs like this: Refiners have cut their operations but shifted more of those activities toward diesel. Diesel demand has fallen sharply, not as much as gasoline but still with a significant decline. The increased diesel coming out of those refineries is therefore going into inventories in quantities not seen for several years. 

In Valero’s recent earnings conference call with analysts, Gary Simmons, executive vice president and chief commercial officer, said the refinery reductions did allow the industry to balance the gasoline market, which is now turning higher. But the collapse in the jet fuel market has been so enormous that refineries could compensate only one way: making more diesel, which like jet fuel is a distillate.

“The jet demand disruption was just so severe, and when everyone started blending jet into diesel, it caused the diesel yield from refineries to be really at record levels,” Simmons said on the conference call, according to a transcript supplied by SeekingAlpha. “And even despite the lower refinery utilization, we’ve seen diesel production outpacing demand, causing the inventory build.”

The result has been that U.S. distillate inventory as measured by “days supplied,” which includes diesel but not jet, is up to 44.2 days worth of consumption. That’s the highest since the January-February 2017 period, a relatively warm winter, when they were also above 40, presumably lifted by excessive heating oil supplies. But the five-year average for the final week of April is 33.8 days.

“Diesel markets are no longer able to avoid the carnage that has ravaged fuel markets,” the consulting firm of Energy Aspects said in a recent report on the middle distillate market. “If pushing kerosene into the diesel pool is the only tool refiners have to deal with the continued weakness in global jet demand, then any upward pressure on refinery runs from gasoline demand will be the catalyst for a sharp fall in diesel cracks.” 

While that latter part may be hard to understand for a layman, it comes from the idea that the steep fall in gasoline demand is probably going to be reversing itself soon as parts of the economy come back online. If refineries respond to that by increasing their already historically low runs, they’re also going to make more diesel for a market that already has plenty of it in inventory.

Valero’s Simmons said he expected adjustments in diesel operations to deal with that. “I think we are seeing, at least this week, some indications in the market that people in the industry including ourselves are making some adjustments to their operations to bring the diesel yields down, which should be supportive to the diesel fundamentals moving forward,” he said. 

Crude prices have been extremely volatile for the past two weeks, with its unprecedented negative prices followed by an upturn. But the only conclusion one can draw from looking at diesel prices relative to that volatile price of crude is one of distinct weakness.

The price of ULSD barges in New York Harbor, relative to the world crude benchmark of dated Brent, stood at $20.47 a barrel on April 16, according to data from S&P Global Platts. In just six trading days after that, it plunged to $10.84 a barrel before rebounding slightly this week to $12.80. On Friday, it dropped again, to $11.56.

By contrast, for much of the end of March and into mid-April, it was more than $20 per barrel almost every day.

On the CME commodity exchange, a similar movement is taking place. The simple spread between front month Brent and the ultra low sulfur diesel contract was at $12.08 a barrel on April 17 and fell back to $8.14 at the end of the month, when the May ULSD contract expired.

“Although the world is entering a deep economic recession, global gasoline demand is going to rise quite strongly relative to the current lows in the next few weeks as lockdown measures are eased, while in many places diesel is going to run into more economic headwinds,” the Energy Aspects report said in spelling out the market for refined petroleum products.

What’s going to happen to the excess diesel that’s being produced? Just like crude flowed into storage, it will also, according to Brian Mandell, executive vice president for marketing & commercial at Phillips 66.

“I think you’ll also see some gasoline come out of storage now and you’ll see some distillate go into storage,” he said on the Phillips66 earnings call. Referring to the “contango,” the spread between current prices and prices further out on the calendar, the big difference in them means that “there’s an incentive to store distillate as well.”