The Fuse

Diesel Market Contending With Short-Term Glut, Long-Term Image Problem

by Matt Piotrowski | October 30, 2015

The diesel market is dealing with two major issues, one of which is a short-term glut and the other which surrounds questions about its long-term outlook in the wake of Volkswagen cheating on emissions testing.

The diesel market is dealing with two major issues, one of which is a short-term glut and the other which surrounds questions about its long-term outlook in the wake of Volkswagen cheating on emissions testing. The current oversupply will take a while to work through given the number of wild cards on both the supply and demand sides. “A lot of additional diesel is coming onto the market at a time when demand is not doing so well,” John Auers of refining consultancy Turner, Mason & Co. told The Fuse.

Diesel’s outlook for the longer run, however, might not be as gloomy as one would think, despite shifting perceptions about the fuel in the aftermath of the VW scandal.

Diesel markets in all parts of the world have gotten hammered lately. Here are reasons why:

Diesel fundamentals are impacted more by macroeconomic factors than retail prices. Since diesel is closely linked to the economy, its health is dependent on factors such as industrial output, the transport of goods, and GDP. Any hiccups in the economy can have negative effects on diesel demand. The sharp drop in oil and refined product prices has not boosted demand for diesel the way it has in the gasoline market. It’s clear that gasoline demand in the U.S. has soared because of lower pump prices, but for diesel, it is having to deal with economic headwinds. For instance, in the U.S., the slowdown in crude oil production has undermined industrial use of diesel amid less activity with diesel-fired equipment such as generators, tank trucks, and rigs. Moreover, less crude output means lower volumes being transported on diesel-powered railroads, cutting demand. In China and other emerging markets, weaker economic indicators have also caused diesel demand to be lackluster.

“China’s diesel demand has taken a hit from slower economic growth,” Megan Wu of ESAI told The Fuse. “As the economy evolves into its new normal of being consumer-based, gasoline will be a stronger performer than diesel.”

Since diesel is closely linked to the economy, its health is dependent on factors such as industrial output, the transport of goods, and GDP.

The International Energy Agency (IEA) says China’s diesel demand will contract by 0.6 percent this year, while gasoline will rise by a robust 7.3 percent. For the entire non-OECD, the IEA says diesel demand was up by only 0.9 percent in the third quarter. Europe is the one market that has bucked the trend on the demand side. Demand has been relatively strong there, seeing surprise year-on-year growth. In Europe, lower retail prices have actually spurred demand because of diesel’s large use in the passenger fleet. The outlook for next year is of course up in the air, just like every other aspect of the global oil market. The International Monetary Fund’s recent downward revision for global growth in 2016 does not bode well for diesel demand, however.

IMF4

When refineries make a lot more gasoline, they also make a lot more diesel. In the U.S., refineries have run at a very high rate this year, with utilization consistently above 90 percent from April to mid-September. Amid high demand for gasoline, U.S. refineries produced record amounts of that product this summer, sometimes exceeding 10 million barrels per day. For the most part, every barrel of oil refined in the U.S. produces 19 gallons of gasoline and 12 gallons of diesel. U.S. gasoline demand has grown by about 4 percent, while diesel is up just 2 percent. Against this backdrop, excess diesel is coming out of U.S. refineries, putting inventories up an enormous 22 million barrels, or 18 percent year-on-year.

“New Middle East refineries have been sending a lot of refined products to Europe. Everyone in fact is trying to send diesel to Europe.”

High diesel stocks in Europe and stagnant Latin American demand limit export opportunities. For the past 10 years or so, U.S. refiners have sharply increased their exports as an outlet for their excess supply. U.S. distillate exports (which include both diesel and heating oil) have grown from about .1 mbd to over 1 mbd, but the gains have mostly stalled at that level. One major outlet has been the emerging Latin American market, but growth has slowed in those countries this year because of economic slowdowns. Another importer of U.S. diesel has been Europe, which is traditionally short of the fuel. But inventories there are also high, limiting the amount the U.S. can send. This situation is the result of a couple of factors. First, European refiners have enjoyed relatively strong margins this year, incentivizing higher output. Second, besides U.S. Gulf Coast refineries, others have also aggressively exported to Europe.

“New Middle East refineries have been sending a lot of refined products to Europe,” said ESAI’s Wu. “Everyone in fact is trying to send diesel to Europe.”

New downstream capacity in Saudi Arabia and the UAE was built particularly to export, with Europe as one outlet, while Russian refineries also send diesel to the EU. Even China has shipped some of its excess diesel to Europe. With high inventories in both the U.S. and European markets, the Atlantic basin imbalance should persist for some time.

“It will take a while to work off the excess diesel supply, perhaps as long as two years, depending on demand,” said Auers.

The long-term outlook is complicated

Diesel appears poised to pick up market share in the overall petroleum mix as gasoline falls.

The current oversupply will eventually slim down once demand picks back up and refineries delay investment plans or cut back utilization, but what about longer term? On the one hand, diesel appears poised to pick up market share in the overall petroleum mix as gasoline falls. The increase in “dieselization” of the transportation mix should boost global diesel demand by 9 mbd from 2015 to 2040, says OPEC. Meanwhile, gasoline is only expected to rise by 3.1 mbd during that timeframe (see graphic).

opecoutlook

Diesel’s share in passenger cars is forecast to rise from 14 percent to 21 percent by 2040, based on OPEC’s calculations, while there is also a shift from fuel oil to diesel in marine transportation. Diesel is attractive because of its greater fuel efficiency than gasoline and its versatility—besides being a transportation fuel, it can be used for industrial output and power generation.

Even if European consumers’ perceptions eventually shift and automakers adjust their focus to hybrids and plug-ins, it will take years or even decades for the economies there to turn over their vehicle fleets, meaning diesel will still dominate in Europe.

On the other hand, the VW emissions scandal has thrown a big wrench in diesel’s outlook. In Europe, where consumers and governments have a love affair with diesel-fueled cars, the issue has the potential for the biggest fallout: Some consumers’ views of diesel may change or governments could nix incentives to buy diesel-fueled cars, but action taken this week suggests otherwise. EU leaders are making it hard to shift away from diesel: To help the car industry, European countries voted on Wednesday, surprisingly, to give automakers flexibility in breaking emissions rules by granting more time to comply with targets.

Even if consumers’ perceptions eventually shift and automakers adjust their focus to hybrids and plug-ins, it will take years or even decades for the economies there to turn over their vehicle fleets, meaning diesel will still dominate in Europe. Data in the graphic below shows how entrenched diesel-fueled cars are in European countries.

diesel

Globally, diesel’s poor reputation could indeed slow its growth in passenger cars, but its use in long-haul trucking in the U.S. and its popularity in emerging markets will make it the highest grower in the transportation sector in the coming decades.