This week's Global Market Analysis comes from Europe and what needs to be done in order for the continent to meet its looming deadlines for bans on Russian oil.
Europe needs to ‘pull an all-nighter’ to meet diesel D-Day over Russia oil ban
By David Elward
At school, did you start to work on your essays as soon as the assignment was set, weeks in advance of submission? Or, were you more of a pull-an-all-nighter type, scrambling at the last-minute to meet your deadline?
When it comes to the oil market, Europe has its own deadlines: by 5 February 2023, imports of petroleum products from Russia, including diesel, must come to an end. Crude imports from Russia will stop by 5 December 2022.
The embargo to “phase out Russian oil imports in an orderly fashion” was agreed by the European Union back in June and the UK has adopted similar sanctions in response to Russia’s invasion of Ukraine.
For diesel fuels, also known as distillates or gasoil, the transition away from Russian-origin supply is underway. Since hitting a 2022 monthly peak of 3.1mn tonnes in February, diesel/gasoil shipments to Europe from Russia have been slashed by almost one third, according to data from shipping company The Signal Group. Exports last month totaled 2.1mn tonnes, up from 1.8mn tonnes in September, according to a 4 November snapshot. It's too early to know from tanker tracking data what the November figure will be. While many oil companies and traders operating in Europe stopped handling Russian-origin barrels earlier this year, others committed to phasing it out in compliance with the embargo deadline.
High cost to replace Russian diesel
Diesel prices in Europe have surged in recent weeks. Higher, more competitive prices are needed to attract cargoes from non-Russian producers. ULSD CIF Northwest Europe Cargoes – the market expected to bear the brunt of the Russian-origin products ban – has been pricing in the low $70s/b on a crack spread basis vs Dated Brent, according to General Index. Its fortunes have diverged from the corresponding Mediterranean index, which is less reliant on Russian supply.
Bolstering NWE pricing, France has been contending with strikes by workers at its six oil refineries. Already the world’s largest diesel importer, the country has turned to the international markets to plug the supply gap resulting from the domestic disruption. Diesel/gasoil imports are seen at 2.8mn tonnes in October, up 23% on September to reach the highest monthly figure since before the pandemic began, according to Signal. Russian-origin imports rose 70% to 415,000 tonnes, Saudi barrels rose by 73% to 703,000 tonnes, and the Netherlands shipped 605,000 MT to France, up 95%.
Adding to the bullish environment, there was also an outage at Shell Pernis in the Netherlands, Europe’s largest refinery, as well as autumn maintenance planned at major refineries in Italy, Portugal and Spain.
When the diesel crack spreads shot above $85/MT in March in the wake of the UK and US first signaling embargoes on Russian oil, it was widely interpreted as a freak pricing event related to volatile trading on ICE LSGO futures. The market is on the cusp of returning to and possibly exceeding those levels as Europe is hit by the high cost of substituting 50% of its import needs. This key European diesel exchange price underpins other regional physical diesel benchmarks such as ULSD CIF NWE Cargoes. It will exclude delivery of Russian-origin product under the contract from January 2023.
Global squeeze on diesel supply
The looming ban also comes at a time when the global diesel market was already facing other supply challenges. Global inventories of gasoil/diesel have fallen precipitously to historic lows over the past two years. Across OECD Europe, North America and Singapore – homes to the world’s major trading hubs – stocks are down almost 27% to 506mn bl since August 2020, according to OilX (see chart below left).
In the US and Europe, as demand for diesel boomed during the recovery from the coronavirus pandemic, suppliers tapped vast stockpiles which had accumulated as a result of record oil demand destruction during the first wave of Covid-19. Overall refinery capacity has also not recovered to pre-pandemic levels due to permanent closures. Prolonged bullish spot pricing (backwardation) has underpinned the financial case to empty stocks in order to capitalize on higher prompt prices. In the US, diesel and distillates stocks fell to a 40-year low at the latest count, according to the EIA.
Amid a slate of bullish factors, in a bearish move, China has also begun exporting more diesel, having previously curtailed exports to cool prices in the domestic market.
How to solve a problem like Russian diesel?
When we posed this question in a paper earlier this year, we wrote:
The most likely replacement supply could come from locations where cargoes are typically loaded onto larger vessels, known as Long Range tankers…This would include the Middle East (the Gulf Cooperation Council states such as Saudi Arabia and the UAE), India and Far East Asia.
How is that prediction holding up? Diesel/gasoil exports from the Mideast Gulf, India, China, and South Korea to the EU, UK and Norway totaled 2.4mn tonnes in October up from 950,000 tonnes in January, according to Signal. More than 90% originated in the MEG and India. These regions have plenty of the fuels Europe needs. Large-scale refinery expansion is helping to buck the trend of depleted inventory in West. OilX data shows stocks above the five-year average (see chart above right).
Can the final stretch of Europe’s project to ditch Russian diesel be achieved in “an orderly fashion” as the EU set out? Another surge in exports on large tankers is needed from the Mideast Gulf and India destined for the major import hubs in NWE. But this won’t simply be a matter of swapping volumes. It will also involve a shift in logistics. Large cargoes of up to 120,000 tonnes will need splitting in the ARA hub or other large ports into more manageable sizes – a process known as breaking bulk – for onward delivery to import locations in the region previously serviced by smaller cargoes from Russia. Such optimisation will offer traders working the arbitrage and with storage in the hubs new margins, but it will also require efficient operations to avoid supply disruptions. After all, it's the traders acting as the intermediaries who are facilitating the shift away from Russian oil – mandated by governments, not the states or 'Europe' doing it by themselves.
The sailing time from the MEG and India to NWE via the Suez Canal at a speed of 10 knots is around 26 days. So, traders could, in theory, leave it until early January to lift additional substitute volumes. If they intend to bring cargoes from producers further afield, such as China or Korea, those cargoes could depart as late as mid-December. There will be money to be made (for those willing and able) by going right down to the wire.
Panic creeps in ahead of deadline
The oil market was set a compulsory piece of homework earlier this year: to substitute, in its entirety, 700,000 b/d of diesel usually delivered from Russia to Europe with supply from elsewhere. Progress has been made but a sense of panic is beginning to emerge.
The CEO of Spanish oil refiner Repsol said last week: “We are running out of middle distillates in some European countries.” And Bloomberg ran an article titled ‘Europe risks diesel supply shock as Russia oil sanctions near’ – a theme we’re riffing on in this piece. As the oil refinery strikes in France now begin to ease, prices will cool somewhat. But a cold winter boosting consumption of distillate fuels for heating will only exacerbate supply and price concerns once again, as the embargo on Russian diesel edges ever closer.
Imports from Russia have fallen from a monthly peak this year of 3.1mn tonnes to 2.1mn tonnes at the last count. Eight months to meet the embargo are now down to just three. Europe is (not quite) half way there, (and increasingly) livin’ on a prayer, to adapt a Bon Jovi classic.
It’s going to have to ‘pull an all-nighter’ if it's to hit the 5 February deadline.