Viewpoint: Europe diesel supply set to outshrink demand

Europe enters 2023 with demand for diesel waning as high energy prices and rampant inflation take their toll on the region's economic growth prospects. But the drop in consumption is likely to be outpaced by constraints on supply as Russian imports dry up, supporting European diesel margins in the first quarter of the year.

The EU's ban on Russian oil product imports takes effect on 5 February. More than half of the diesel and gasoil arriving in Europe by sea in 2022 has come from Russia, according to Vortexa. That means around a tenth of regional demand has been met with Russian product. Although the upcoming ban was announced in the summer, there has been no gradual phase-out. In fact, Europe took more diesel and gasoil from Russia in November 2022 than it did a year earlier.

Europe got a taste of a diesel supply shock in October when strike action shut down all but one of France's refineries, accounting for around 5pc of the region's total refining capacity. Argus estimates the closures took roughly 30,000 t/d of diesel supply out of the European market. Traders responded by importing more from locations east of Suez. But they had to pay premiums of more than $200/t over Singapore diesel prices for these imports at one point, pushing European diesel prices to a record $77/bl premium over crude in mid-October.

Europe's diesel market is vulnerable to supply shocks because stocks are at historic lows. Refining costs have soared since late 2021 as natural gas prices rose, emissions allowances grew more expensive, capacity was cut from the European refining system and high inflation led workers to demand bigger pay increases. This has incentivised traders to use stored diesel to meet marginal demand. But that is not sustainable. In September Dutch diesel inventories were at their lowest in at least eight years.

When Europe stops importing diesel from Russia, the region will lose around 60,000 t/d. All things being equal, the restriction on supply will be considerably more severe than it was during the French strikes in October. And while the industrial action was resolved in a matter of weeks, the ban on Russian diesel looks set to stay in place for much longer than that, barring an end to the conflict in Ukraine.

Of course, all things will not be exactly equal. Europe is edging steadily into recession, with manufacturing purchasing managers' indices pointing to contraction since the summer. Inflation has been running at more than 10pc annually, prompting central banks to ratchet up interest rates to try to cool economic activity. All of this will depress diesel demand and already seems to be doing so, at least in the UK and Germany.

During the Great Recession of 2008-09, diesel demand fell by around 10pc in some European countries, equivalent to the proportion of European diesel supply that currently comes from Russia. But in the unlikely case of such an economic downturn, demand for other oil products would also drop and refineries would be forced into heavy run cuts. That would mean a reduction in local diesel production at the same time as the halt to Russian imports, so supply could still fall short of demand even in the case of a severe recession.

Diesel premiums over crude have come down a long way since their peak during the French strikes. They spent most of November around $45/bl before dipping briefly below $40/bl. But two factors are pushing diesel margins higher again as 2022 draws to a close. Natural gas prices are on the rise as temperatures drop. And European gasoline prices are flirting with discounts against crude because of seasonally low demand, effectively adding losses on gasoline to the costs of producing diesel. These factors will support regional diesel prices in January, even before the embargo on Russian products comes into play. Any effort to rebuild stocks will be costly and will itself put upward pressure on diesel prices in the short term.

By George Maher-Bonnett and Benedict George