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Alfonso: Hello, and welcome to "Driving Discussions Europe." In this series, we discuss the forces that affect road fuels globally, and specifically in Europe. "Driving Discussions" is brought to you by Argus Media, a leading independent provider of energy and commodity price information.

Today is six weeks exactly from the 5th of February when Russian diesel was banned from being imported into Europe. The market prepared too well for the phase-out of Russian products and started building stocks, which paired with a weak demand propelled in a fall in diesel prices and the diesel cracks, whereas backwardation weakened to a single-digit path. But it persisted signaling that a supply destruction event was to come. It seems that now the market is closer to that new reality where Europe's diesel demand must rely purely on its refining capacity, and the cargos coming from East of Suez and the U.S. 

My name is Alfonso Berrocal, European business development manager for oil products at Argus Media. And to help us to analyze the current situation of the diesel market in Europe, we have here today with us, Benedict George, European associate editor of oil products. 

Good afternoon, Benedict, and welcome back to the podcast.

Benedict: Hi, Alfonso. Thank you for having me.

Alfonso: Benedict, what is the situation of the diesel inventories in Europe today?

Benedict: The diesel inventories in Europe are now being drawn down. So, the volumes in storage are falling day by day. They're still high by the standards of last year, because late last year, diesel stock levels fell to multi-year lows. In some places the lowest in more than a decade. So, they're still high by those standards, but they're being drawn down. That's because the balance of demand, production, imports, and exports, simply means there's a significant gap that can only be being met by product coming out of storage. The prices are still well below the levels they were at for most of 2022, but drawing down stockpiles is obviously not a sustainable way to meet demand. So, on the current trend, the drawdown of those stocks likely means that supply will become tighter, which would push prices higher. The European diesel market has been pretty confusing over the last few months.

So, I think the easiest way to understand how we got to this point, is to break it down into three phases, of which we're now entering into the third phase. Phase One was when the EU first banned Russian diesel on the 5th of February. Six weeks ago, as you say. And the remarkable thing about Phase One, was that Europe remained well supplied with diesel, and stock levels were going up, even though it had banned imports from its largest supplier, Russia, where it would get 50% roughly of its diesel imports from in the past. The hard work here is to explain how we got into that situation in the first place, which we're now getting out of. So, this is a potted explanation of that. The reason was that the EU at that point when we banned Russian diesel, was receiving exceptionally large volumes of diesel from the east. So, that means primarily, Saudi Arabia, India, and China.

The reason that so much was arriving from the east, was because EU prices had been much higher than Asian prices in December and January. This created an arbitrage opportunity to load a lot of cargos in the east and deliver them to Europe. The reason EU prices were so much higher than Asian prices was because EU traders were so worried about the coming ban on Russian diesel, that they were willing to pay premiums just to secure, to be sure that they could get hold of product in the diesel business in the short term, just in case they were left short later on. Essentially, it was because of fear. And simultaneously, China at that point in December and January was exporting extraordinary volumes of diesel to all destinations. I mean, overall. The government export quotas that were imposed in China on refineries had prevented them from profiting from the exceptionally high global oil prices for most of last year.

And whether it was because the government in the end was persuaded by the potential profit, or for whatever reason, those export quotas in China were issued in dramatically larger volumes towards the final weeks of 2022. So, in December, China loaded about 3 million tons of diesel for export, which was around six times higher than it would normally do. Six times higher. And by the way, that difference of about two-and-a-half million tons of extra Chinese exports is equivalent to roughly half of Europe's import market. In other words, roughly equivalent to the volume that Europe was about to ban from Russia. So, just as the EU was preparing to lose all of this diesel, China was adding a comparable volume of diesel to the global market, but from the east. So, naturally, intuitively it makes sense that huge volumes of diesel began to load in the east for Europe.

And in January and then into February, these cargos began to arrive in Europe, because they take about three to four weeks to come from obviously less time from the Middle East, more time from China. But as a rule of thumb, about three to four weeks for an oil tanker to arrive from one of these origins in Northwest European, in Rotterdam for example. The strange part was that European diesel consumption was actually very low at this point. Even though European traders were willing to pay such high prices to make sure they got the supply they needed before Russian diesel got banned, consumers on the ground, which in many cases means companies, industrial companies, factories were consuming a lot less diesel than normal. German GDP contracted in the fourth quarter. Even places that avoided a contraction were more or less flat. And industrial activity was reportedly among the sectors that were most badly affected.

So, diesel consumption in Europe was very low, at the same time as European traders were still willing to pay very high prices, and were getting as a result, all of this extra diesel from the east. A trader recently told me diesel demand was around 3 to 5% down year-on-year over the winter, and remains around that level now. So, long story short, Europe was receiving exceptionally large amounts of diesel from the east, and not consuming it, but actually, putting it into storage tanks into inventory in January. And even when the ban on Russian diesel came into effect in early February, so much was still arriving that European diesel stockpiles actually continued to grow after that time. Which is quite extraordinary really, and definitely not what most people would've expected last year, I think. The market then very suddenly relaxed. And this brings us into what I'm describing as Phase One of the post-sanction situation, where the market suddenly relaxed. Traders were forced to accept that there was not going to be the crisis that some had worried about when Russian diesel was banned, because there was all this diesel building up in stockpiles, and the price of gasoil futures in Europe, which is a kind of benchmark for the market in Europe, came off very sharply at the start of February.

European diesel premiums against crude came off by around one-third in early February, came down to less than $30 per barrel. That's still very high by pre-war standards. And of course, very high by the standards of the pandemic period when prices were very low. But it's the lowest that the price has been since Russia invaded Ukraine last year. So, in the new environment that we live in, those diesel prices from February were relatively low. In a sort of stroke of irony, it was actually the first trading day that Russian diesel was actually banned from Europe. On that very day, European diesel premiums against crude came down to their lowest level since Russia had invaded Ukraine. And it was because of all of this diesel arriving from the east. And this was Phase One.

So, it was characterized by very relatively low diesel prices, a lot of diesel is still arriving in Europe, stockpiles are still going up. And then we come to March, and we enter Phase Two, which is when the stockpiles begin to come down again. This is what we've now seen for the last couple of weeks. The reason the stockpiles started to come down is because those low prices from February ruined the economics on diesel shipments from the east. So, less diesel was loading in the east for Europe at that point. And because of this three to four-week lag of journey time that I referred to, that means in March, much less diesel is arriving. And actually, not only less diesel compared to last month but less diesel by historical standards. Europe is now getting less diesel than it would do last year, the year before, the year before that. Europe is now not importing enough diesel to make up the volume it needs to consume. And this is even with consumption quite low as I said. So, the numbers just don't add up anymore, and stockpiles are being drawn down to make up that deficit.

Importantly, because so much got into the inventories in January and February, the actual volume in the inventories is still quite high, still a lot higher than it was for most of last year. Coming down, but still quite high. So, most traders are not in a position at the moment where they're under pressure to pay a lot to get new diesel in because they still have some in their tanks. And traders have said to me recently that a lot of traders inland, in Germany, Poland, for example, will probably not come back to the spot market until they've actually used up all of the diesel they have in their tanks. And for some of them, they have a lot of storage capacity. So, the first ones to come back will be the ones with the least storage capacity, and they'll trickle back into the spot market like this. But it will inevitably happen gradually that they'll come back in, and they'll need to pay whatever they have to pay to get the new diesel.

So, March is being characterized by much less arriving and stockpiles coming down. And we're now just in the middle of March getting into what I would call Phase Three, which is where the prices in the prompt spot market start to reflect the fact that the market is inevitably getting tighter. You could see this as a sort of delayed impact of the ban on Russian diesel. This is perhaps what people would've expected to happen when we banned Russian diesel. It's just been pushed back by six weeks or so because so much came out of China over the winter that it plastered over the gap for a while.

It's now being compounded by the fact that there are severe strikes in France, which are hugely restricting diesel production. Most of the French refining industry is now offline. Which comes to more than 5% of Europe's total refining capacity. And the last time this happened, although circumstances were different at that time, was last October. And diesel premiums over crude rose to the highest level on record ever in October last year. And that won't necessarily happen now, but it goes to show how severe an impact it can have when a number of refineries completely shut down for a while. And last week the confrontation between the French unions and the government only appeared to be escalating.

So, it does seem possible that these strikes will go on for weeks rather than days. To add to that, we're getting into the springtime when refineries schedule their maintenance work. So, several of Europe's largest refineries, even outside of France, are running at reduced rates, or completely offline at the same time. So, in summary, what I'm calling Phase Three now, is that Europe's diesel imports are still severely reduced because of the cheap prices that people were paying in February, which would not attract the imports that we now need. And domestic production is severely reduced at the same time. So, the two ways you can get hold of diesel in Europe are not really performing right now. Even though consumption is still low, stockpiles still are being used very rapidly now. And German traders actually tell me now that diesel consumption in that country at least is beginning to recover partly because of a season of horizon agricultural activity. But clearly, any extra diesel barrel being consumed, means another barrel has to be extracted from storage, and it means a high price.

Alfonso: Right. Thank you, Benedict. So, we can conclude that stocks are currently been depleted. Something remarkable is that the curve has been backward dated during the last month, what you call Phase One and Phase Two, despite the market being rather long. Do we see a change in the curve now that the market is shorter, and what this does mean for the liquidity of 30 kt cargos trading across Europe?

Benedict: Well, yes, we do see that the forward curve is becoming more steep backwardated now and quite rapidly. So, in the middle of last week, there was less than $20 per ton between the front two contracts on the curve. Now, there's more than $30 per ton between them. And that only looks likely to increase. So, in case any readers are not familiar, backwardation is when the prompt contracts, the futures contracts for early delivery, price at a premium over those with later delivery. And it generally indicates tight prompt supply because it shows that traders value early delivery even higher and higher relative to later delivery. And this makes sense because what we're seeing now is supply growing tighter in the short term as the stock levels come down. As you say, the forward curve was always backwardated, even when Europe was building stockpiles over the last month or two, which would usually be a feature of a well-supplied market where there was surplus to put into storage.

And that was indeed what we saw in the pandemic when stockpiles were building very rapidly when there was a huge surplus of supply, and you actually had early delivery pricing at a discount against later delivery. Which is called a contango market. But we never saw that this time. We always had the backwardated market. Which may be a signal that there were a lot of paper positions still essentially betting that there would be a shortage following the sanctions on Russian diesel. But for whatever reason, we have been stuck in this market structure for a while, and now it is growing much more severe. During the French strikes last year, we actually got to a point where the front contract, the earliest contract, was almost $150 per ton more expensive than the second one. Now, we're at about $30 per ton more expensive compared with the second one.

So, there's a lot more room for it to get steeper, but it is getting steeper. And in terms of the liquidity of 30,000-ton cargos, I think we can expect that there'll be more demand for them, but there'll be less supply of them. I think what will happen at some point, is that larger cargos are gonna have to come in to fill the gap. Which will mean 90 kt, 60 kt possibly, if the U.S. has more to sell than 40,000 tons that will start to appear in larger numbers in Europe. But the 30,000-ton cargos are really now limited to volumes that are discharged ship-to-ship from larger vessels, or that were taken into a port like Rotterdam, and then reloaded onto a smaller ship to be carried to a port that doesn't have the capacity to accept a large ship. So, these days, a much lower limit on the volume that 30,000-ton smaller cargos will be doing in Europe. Whereas in the past, 30,000 tons was the typical size of the cargo coming from Russia, which accounted for most of Europe's imports.

Alfonso: Thank you, Benedict. This is taking me to the next question. And it is, do we see an increase of LR2 cargos being scheduled or shipped from East of Suez, or MRs cargos being scheduled or shipped from the U.S. Gold Coast?

Benedict: In terms of arrivals at the moment, the volumes reaching Europe is still low. One of the big things here is that freight has become a lot more expensive over the last month. That's not only because of forces from the diesel market but from alternate oil product markets as well. Like the reopening of China has meant that naphtha demand in the east has increased. So, the demand for tankers to carry naphtha from Europe to the east has increased, which makes those tankers cost more. And these come from the same pool of tankings that would be carrying diesel. So, for a number of reasons, those tankers have become 50% more expensive than they were at the start of February now. And the result is that Europe is still not receiving the volumes from the east, or indeed at the moment from the U.S., that Europe was receiving in January and February, in terms of the loadings on those routes.

And these two things have to be separated because there is this three to four-week time spread between the loading and the delivery. But in terms of the loadings for Europe in these regions like Asia and the U.S., it's much more difficult to be specific because ships will not always signal their final destination until they get a lot closer to it. You know, when a ship from China is still near India, it probably won't be signaling Europe as a destination, even if that is where it's ultimately going to go. And because prices are so volatile these days, the traders don't even necessarily know that it is going to go to Europe, until it has done a lot more of the journey. It might go to Latin America or West Africa for example, instead of Europe. So, it's hard to predict these things, but the economics currently still don't appear to make sense for these ships to come into Europe. Not only because of freight, but because of the extreme selloff that we've seen in European oil futures over the last week or so, reflecting probably the implications of the banking crisis that's developing in the wider economy.

And there has been a selloff in Asian oil at the same time, and a drop in Asian prices, but there doesn't seem to be much chance of European prices moving up relative to Asia at the moment until the European stock levels come down to such an extent that traders are forced to pay whatever they have to pay to get cargos to move. Which is what happened during the French strikes last year when we saw this $150 per ton split between the front two contracts on the forward curve, as I was saying. When traders get into that position where their hands are tied and they just have to pay it, that's when I think we'll see the diesel price respond, and we'll see those cargos, those 90,000-ton cargos start moving again in serious volumes.

Alfonso: Thank you very much, Benedict, for your fantastic analysis and for your insight.

Benedict: Thank you

Alfonso: And thanks for listening to this podcast, in which we have focused in the European market. However, in the next episode, we will touch upon Russian diesel outflows as well, and figure out where Russian diesel is going. And if you enjoyed this podcast, please be sure to tune in for other episodes in our series "Driving Discussions Europe". And for more information on Argus global refined products coverage, please visit our Oil products commodity page. Stay safe and see you next time.