Driving Discussions: The bumpy road ahead for European diesel prices

Author Argus

The European distillates market, in particular the diesel market, has been going through challenging times due to loss of some refining capacity.

At the same time the market has seen demand return, finding high production and hydrotreating cost, historic backwardation levels, and lower stocks, which are complicating the supply of diesel in Europe.

Listen in as Alfonso Berrocal, European business development manager, Benedict George, senior European market reporter, and Alina Rapoport, senior markets reporter in Germany, as they break down the diesel picture in Europe and one of its main markets, Germany.

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Alfonso Berrocal: Hello, and welcome to "Driving Discussions." In this series, we discuss the forces that affect road fuels globally. "Driving Discussions" is brought to you by Argus Media, a leading independent provider of energy and commodity pricing information. This podcast today is focused on the distillates market in Europe and, in particular, in the diesel market, which supply-demand fundamentals are going through a quite challenging time after the loss of some refining capacity, during the last two years, the market's demand came back, finding high production and hydrotreating cost, historic backwardation levels, and lower stocks, which are complicating the supply of diesel in Europe. My name is Alfonso Berrocal, European business development manager for oil products at Argus Media. And to better understand the diesel picture in Europe as well as in one of its main markets, Germany, we have here today with us Benedict George, senior European market reporter, and Alina Rapoport, senior markets reporter in Germany. Good afternoon, Alina and Benedict.

Benedict George: Good afternoon.

Alina Rapoport: Hi, Alfonso.

Alfonso: Hi, Alina. Let's start with Benedict. It is now two years since the pandemic hit Europe. How the current refining capacity and stock levels look like compare with the pre-pandemic era? And what are the fundamentals driving the diesel market in Europe today?

Benedict: Well, since diesel demand began to recover from the lockdowns of 2020, Europe has actually seen demand outpace refinery output quite significantly. This is actually a global trend. It's happening all over the world. And the IEA actually says it's been happening all over the world since mid-2020. So, demand outpacing production means a draw on stocks, on inventories. Data on middle distillate inventories for 16 of the biggest countries in Europe show that stock levels in December of 2021 fell to their lowest level since January of 2019. So, long before the pandemic struck. And that figure is including more than just diesel in the middle distillate pool, but diesel is the biggest component of that. The IEA has been pointing out, as I say, for a while now, global refinery output has been recovering a lot more slowly than demand has been recovering and Europe is the key example of it.

The refinery sector in Europe is still only operating at less than 80% of its capacity. It spent most of 2019, between about 80% and 85% for comparison. So, utilization is substantially below the pre-pandemic normal levels still. In 2020, it went down into the mid-60s, so this is a big recovery from that, but it's still not back at pre-pandemic levels yet. On top of that, the refinery utilization figure is actually exaggerating refinery output, in a sense, because several refineries have actually closed down permanently since 2020. And in fact, around 4% of Europe's 2019 capacity has already been lost completely permanently, and another 2% of it has been scheduled for closure in the coming years, and those figures are likely to keep growing. Oddly, the closures don't actually have much to do with the pandemic, although the pandemic probably accelerated them. In the long-term, Europe is just gradually losing its share in the global refining market to regions like the Middle East and Asia, because costs in those regions can be kept far lower than in Europe, either in terms of the crude costs in somewhere like Saudi Arabia, or the refinery operating costs in Asia. For example, while Europe's closing down refineries, Kuwait is building a new refinery, which will be 50% bigger than Europe's biggest refinery when it's finished. So, that's the opposite story in different parts of the world.

In terms of fundamentals in the diesel market now, in some ways, the biggest story, I think, in the diesel market in Europe, is still the high natural gas price. The natural gas price has come down since its peak, and the story has kind of faded from the news cycle over the last couple of months, but natural gas is still much more expensive than it was before the pandemic. And that is not only making electricity more expensive for refineries, but most importantly, it's making hydrogen very expensive for refineries. Most refineries need some hydrogen extracted from natural gas to crack diesel and desulfurize diesel. At one point last year, the IEA reported that hydrogen was costing refineries as much as $6 per barrel of crude that they processed, and that was 10 times more than it had cost them in 2019. And it'll be costing less than that now, but it'll still be a lot more than it was costing in 2019. So, you can compare that $6 per barrel number to a diesel margin to crude at about $14 or $15 a barrel, and regular refinery operating costs of about $5 or $6 a barrel as well, and the actual margin that they're making on this diesel product is a lot smaller than it might look on paper. In the auction, there were question marks over the economics of some of these cracking units, and at least two refineries did temporarily shut down their hydrocrackers because the hydrogen was just too expensive and it wasn't economical to run them, and that was limiting diesel production at the time.

But the bigger impact of the hydrogen cost is a little more obscure and is now being felt actually more strongly, which is that refiners have tried to process as much light sweet crude as possible in order to reduce their need to crack and desulfurize the diesel using hydrogen. So, cracking makes the product lighter, and desulfurizing it makes it sweeter, essentially. So, if they get light sweet crude, in the first place, they don't need to use as much hydrogen to process the product in those ways. So, refiners have rushed into the market for light sweet crude, at the same time as there have been various supply constraints for light sweet crude, and that's made the light sweet crude market extremely tight. And this has all come in the context of the IMO 2020 regulation, which came in just before the pandemic and kind of got swept away in the panic over the pandemic, but at the time, it was very big news. The IMO 2020 regulation limited the sulfur content of marine fuels, which, again, made refineries want sweeter crude, in the first place. And the upshot of it is that now light sweet crude is in very, very tight supply.

And Brent Crude Futures, which are the kind of headline crude price that a lot of people in the world are looking at, the Brent Crude Futures are based on light sweet crude, and that market has gone into a very steep backwardation for this reason, because of the tight supply in the prompt end of the curve, meaning that the prompt futures contracts, the front-month of futures contracts for that crude, is trading far higher than the second and the third month. And so this has had a knock-on effect on gasoil futures, which we call them gasoil, they're technically called gasoil futures, but they are diesel futures. They're based on diesel barges. And we now have, as a result, this is kind of the punchline of the story, we have the steepest backwardation in gasoil futures. Since 2008, the March gasoil or diesel futures are trading about $25 a ton more expensive than the April futures. It's very extreme, and it's leading to all kinds of unusual dynamics in the diesel market.

Like, for example, we now have diesel barges in Northwest Europe trading a lot more expensive than cargoes in the same region, which you essentially never see. And the reason for that is simply the barges are loading earlier than the cargo is gonna be delivered, and that difference of just a week or two is making a huge difference to the price that's been charged for these products. The barges are at their highest premium to the gasoil futures since 2018 as well. And the backwardation is also making it unprofitable to import diesel from the Middle East and India, which are two of the largest suppliers of diesel to Northwest Europe, usually. Those flows are now uneconomical because the sellers in the Middle East and India would do better to sell that product closer to home, rather than put it on a tanker for two to three weeks, during which time the futures market says that it's going to lose a lot of value, I mean, as much as $10 or $20 a ton in value just on that journey. So, that, meaning, NorthWest Europe is receiving much less diesel by sea than it would usually, which is tightening diesel supply even further and is actually a contribution to keeping that backwardation as deep as it is, in a kind of feedback loop, keeping those front-month diesel futures extremely expensive at the moment.

Alfonso: Okay. Well, thank you, Benedict, for this fantastic analysis of what the situation is now in Europe if [inaudible 00:10:33] to assuming into the different regions. And if we look at Northwest Europe, Northwest Europe is the main outlet for Russian diesel exports. How these fundamentals that are now in place are affecting the flow of Russian diesel into Europe? And do you think that the current geopolitical uncertainty is having as well an impact on the structure of the market?

Benedict: Well, Russia is by far the dominant supplier of diesel to Northwest Europe. I know, I just mentioned Saudi Arabia and India, and they are the second and third biggest suppliers, but Russia is by far the biggest. It's the closest geographically, meaning it can supply diesel most cheaply to Northwest Europe. And that basically means it can offload as much of its domestic diesel surplus as it wants into Northwest Europe. And Russia is currently working on expanding its port and pipeline capacity around its Baltic ports, like Ust-Luga and Novorossiysk. And that means I expect it will increase its exports to Northwest Europe in the future and that will tend to make NorthWest Europe even more heavily dependent on Russian diesel. Often, Russia is already accounting for as much as 75% of Northwest Europe's diesel imports in some months.

But what this means is that Russian diesel flows into Northwest Europe, the volumes that move on that route each month are not actually very sensitive to European fundamentals. The demand always exceeds the supply basically, on that front. Whether European demand is high or low, or whether European refineries are running high levels or not, Europe always wants more diesel than Russia can sell to it. So, Europe always buys all of the diesel that Russia wants to sell to it. So, the marginal volumes coming from Saudi Arabia and India, those are much more responsive to European fundamentals. Sometimes Europe will need a lot from the east, sometimes less, but it will always buy everything Russia wants to sell, basically. Looking at the geopolitical situation, it's very difficult to be precise about these things, and I think there's a lot of uncertainty, particularly at the moment. And I don't want to stray into a political territory, but several of the diesel traders that I know have attributed the strength in the press of the gasoil futures, partly, among other factors, to the rest of U.S. sanctions on Russian energy. That doesn't mean that it's likely the U.S. will sanction Russian energy, or even that it's likely that the situation will escalate on the ground. It doesn't even mean that these traders think that any of these things will happen. It's just that the impact of sanctions on Russian energy would be so severe for European oil markets, in general, let alone the diesel market, in particular, that just a tiny risk of it could very well have lifted these futures prices even more than they already or have been.

Russia accounts for more than 50% of all of Europe's diesel, and let alone just Northwestern, but it accounts for most of all of Europe's diesel imports every month. And Europe imports around 15% to 20% of its diesel consumption every month. So, in some months, Russia is contributing as much as 10% of all of the diesel consumed in Europe. And if that were taken away, it's very hard to see how it could be replaced. Like I was saying, stocks are already at a relatively low level. The refining industry is struggling with the high costs of electricity and hydrogen, and the refining industry is contracting in capacity anyway, in Europe. On paper, Europe could make up for the loss of Russian diesel in that worst-case scenario by increasing refinery utilization by 10 percentage points. That would mean running our refineries in Europe as hard as they have ever been run in this century so far, about 90% utilization. It never really goes higher than that. Even at the best time with the strongest product margins to crude, utilization just doesn't get higher than that.

And as I say, as capacity gets closed, since that wouldn't even be enough, so the response would have to be some kind of combination of that with something else. And that's not even to mention the fact that in the energy sanctions scenario, Russian crude oil would also be lost, making crude much more expensive for European refineries, making the feedstocks like vacuum gasoil much more expensive. So, refining diesel, domestically, would become much more expensive, even before you got to trying to replace the inputs. Europe could, theoretically, import more diesel from Saudi Arabia and India in order to make up for it. But like I said, Russia is so much larger in terms of volumes than Saudi Arabia and India. Europe would actually have to triple its imports from both of those countries in order to make up for the Russian volumes. And even if that were feasible, which I doubt, to be honest, Europe would have to pay much higher prices for that product in order to make it economical for those sellers to sell to Europe, instead of into Singapore and Australia, for example, which are their other markets. So, all in all, any sanctions on Russian energy, even if they're unlikely, at this point, they would lift European diesel prices very dramatically. And it is likely, I think, that futures markets have been pricing in the risk of those sanctions, however small that risk might be.

Alfonso: Thank you, Benedict. We've been primarily looking at Northwest Europe, and let's maybe...if we zoom into the Med. As you mentioned earlier, there is a decrease in refining capacity, and at the same time as well, Europe is going through an energy transition where biofuels are emerging. And this obviously may have an impact in inflows coming from east of Suez. You've been already elaborating inflows from Saudi Arabia and India, and obviously, this has a strong impact in the Med region. How do you see the Med in terms of supply-demand? How do you see the supply-demand of diesel [inaudible 00:17:11] into the Med?

Benedict: Well, the Med is almost an inverse story from Northwest Europe in terms of dependence on Russia versus Saudi Arabia. The big story in the Med is that it's becoming much more heavily dependent on Saudi product, and less dependent on Russia. I mentioned that Saudi is supplying much less diesel to Northwest Europe. And this is actually part of a longer-term trend, not only reflecting the very steep backwardation that I mentioned but also, this has been happening over the last two to three years. Saudi Arabia has steadily taken a bigger market share in the Mediterranean, which is obviously geographically a lot closer to Saudi Arabia. And it's been reducing its market share in Northwest Europe. Saudi Arabia is now challenging to provide as much as half of all the Mediterranean's diesel imports now, whereas 2 or 3 years ago, it used to be less than 20% coming from Saudi Arabia. And at the same time, it's now providing Saudi Arabia less than 10% of Northwest Europe's diesel imports, whereas it used to provide 25% or 30%. So, the inverse dynamic is happening in these two regions.

Traders in the Mediterranean tell me that they're being offered Saudi Arabian diesel at very good prices relative to Russian suppliers in the back seat, which is the alternative source for them to go to. The traders tell me that the Saudi Arabian suppliers are cultivating stronger relationships with buyers in the Mediterranean, and that it's generally easier to work with Saudi Arabia, they say, than with Black Sea suppliers. It almost looks as though there's a kind of tacit agreement between Russia and Saudi Arabia that they're going to split Europe in this way rather than both of them competing in Northwest Europe and in the Mediterranean. And I think that that investment that we're seeing in the Baltic, that I mentioned in the Russian pipelines and Russian port capacity, I think that could be seen as part of Russia aiming strategically to focus on its exports to Northwest Europe, which will mean exporting less into the Mediterranean, all else being equal. And that is what we're seeing, we're seeing less diesel come out of the Black Sea overall, year on year, each year, and Saudi Arabia seems to be perfectly happy with this arrangement so far. That seems to be the way we're going.

Like Northwest Europe, as you mentioned, Alfonso, the Med is losing refinery capacity. So, we now know that Eni's Livorno refinery in Italy is going to shut down permanently, probably this year. Although the date does not seem to have been decided yet, but it does seem clear it's going to shut down permanently. They're going to convert that site to process sustainable aviation fuel, which is following a pattern. As you mentioned, all over Europe, we're seeing refineries pivot to produce biofuels, different types of biofuels instead of conventional fossil oil. There are rumors now of another Italian refinery as well possibly closing down and converting to process biofuels. I can't yet say which one that is. We're trying to get stronger sourcing on that, but there are rumors in many departments. So, the Med altogether is heading towards a greater dependency on diesel imports, and particularly on Saudi Arabian product.

Alfonso: Thank you, Benedict. We're gonna open a window now and zoom into Germany. Huge importer of distillates, but where demand has been relatively weak in the last months. Alina, recently, in the last weeks, we have seen that Hamburg became the most expensive region in the country with problems at one of the largest distillates storage facilities. What are the factors behind those high prices within the Northern Germany region?

Alina: Yes. So, the situation in North Germany was really unique in the first half of February. The price in Hamburg, as you said, rose pretty quickly in only a few days. And Hamburg became actually the most expensive region for diesel and gasoline on truck loading prices in Germany. Normally, Hamburg is actually one of the cheapest regions because there is a very big competition in the location. So, why did this happen? This was a result of a loading stop at the oil tanking terminals in the country due to a cyberattack, which was only resolved in the middle of the month. And the terminal in Hamburg is actually the biggest one in Germany. It comprises 870,000 cubic meters and therefore, Hamburg was especially affected. Also, the Hamburg oil tanking terminal is the most important outlet for Russian diesel in North Germany, with roughly 30% of all diesel intakes in the country being unloaded in this affected terminal.

A disruption of more than two weeks as it happened, therefore prevented the Argus of Hamburg quotation from dropping in spite of excess supply from Russia. But still, the inland prices rose faster than those of Hamburg, therefore increasing the input margin to Hamburg by more than $30 per ton until mid-February from the beginning of the month. But even the attractive input margins could not increase German diesel intakes since overall distillate demand is very low in Germany since the beginning of the year due to high prices. The steep liquidation is also a reason why importing companies are not importing extra diesel volumes into Germany. So, we can see that even the disruption in the storage facility in Hamburg and the higher product margins we're not able to increase German import demand, therefore we cannot really expect imports to North Germany to rise until the demand in the country comes back, or, for example, product shortage affects other parts of Germany as well.

Alfonso: Thanks, Alina, for this explanation. There is another obvious diesel gateway into Germany, which is the ARA barges market of the Rhine. There have been disruptions in the last months in the Rhine due to several factors, water levels, or even the cyberattacks that you mentioned, which has affected, not only this region but the whole country. What is the current status on the distillates flows up the Rhine? And is there any alternative to these flows when disruptions happen?

Alina: So, yes, this cyberattack is, I think, one of the biggest disruptions, not only in Hamburg but also in the other parts of Germany, as it affected, all in all, 11 oil tanking terminals, of which 2 terminals are directly located in the Rhine regions. But still what's really interesting is that this disruption had a minor impact on supply in West Germany and in the Rhine destinations than in Hamburg, for example. Companies in the Rhine regions were just able to reroute to other facilities and prices, therefore, were almost not affected. The import demand to other terminals in the regions also did not really rise, it actually is really low still. The water levels on the Rhine which can prevent full batch and takes, if they are too low or too high, for example, were actually ideal for imports, so fine in February, but the freight rates for digital transport to the Rhine destinations did not go up since the beginning of the disruption. And this is actually a sign of really low demand since the freight rates actually fell. Normally, when distillate supply is tight in West Germany due to inland disruptions, imports from ARA over the Rhine become more important to balance supply. Late last year, for example, imports increased due to high demand in Germany in autumn, but the low water levels limited intakes over the Rhine. Import costs increased so much due to high freight rates that it became attractive to import more diesel to North Germany and to transport it by train to the south of the country.

Alfonso: Thanks, thanks, Alina, for this excellent view of the German diesel market. Thank you very much both, Benedict and Alina, for sharing your knowledge. And if you enjoyed this podcast, please be sure to tune in for other episodes in our series, "Driving Discussions." And for more information on Argus global refined products coverage, please visit argusmedia.com/oil-products. Stay safe, and see you next time.

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