A glut of diesel is quietly undermining oil price resurgence

In all the hullabaloo of OPEC+ prolonging the deepest production cuts in history, it’s easy to overlook ominous signals for oil prices—and the wider economy—that are emanating from the diesel market.

The world’s largest crude oil producers agreed on Saturday that they would extend collective output curbs, effectively keeping 1/10th of supply off the market for another month. While the measures may be tightening the global crude market, potentially driving prices higher, they do almost nothing to address grim margins that refineries are earning when selling diesel, one of the most important petroleum products that the industry churns out.

“The world’s awash with diesel,” said Alan Gelder, vice president for refining, chemicals and oil markets at consulting firm Wood Mackenzie Ltd. “There’s just loads of it everywhere.”

Away from Europe, where diesel often powers cars, the fuel is also widely consumed by industry: things like freight to move goods around, as well as in construction and agriculture.

And while demand has recovered strongly in Asia—in particular China—since the coronavirus first broke out, markets in Europe and the U.S. are barely being propped up by increased online shopping and need for delivery. The economic recession means there’s been a much bigger hit to the amount of freight that’s being moved around.

The bigger problem right now, though, is supply. Refineries—particularly in Europe and the U.S.—are trying to make as little jet fuel as possible because demand from the aviation industry still remains far below where it was before the pandemic struck. And that means producing more diesel. Similarly, refineries cannot meet a recovery in gasoline consumption without boosting their overall processing rates—and that too brings more diesel.

In the U.S., where it’s a seasonally weak consumption period anyway, diesel supplied, the main measure of demand, last week hit the lowest weekly level in 21 years, tumbling to just 2.72 million barrels a day, according to the Energy Information Administration. At the same time, stockpiles have grown for nine straight weeks to sit at the highest since 2010.At the start of the pandemic, diesel was one of the few relative positives in oil markets as the world began going into coronavirus lockdowns. The trucking industry was still running at full speed to stock up supermarkets. Now, margins on making the fuel in the U.S. are hovering near a 10-year low.

“The bright spot has shifted from diesel to gasoline,” said Stephen Jew, director of global refining and marketing at IHS Markit. “The refiners are profit driven and can adapt quickly, and they will always try to find the bright spot. They will be chasing the gasoline.”

It’s not possible for refineries collectively to completely stop making diesel and jet fuel, especially if they increase runs to meet demand for gasoline. So a diesel glut will likely linger until there is a broad economic recovery, including a resumption in air travel.

“In our mind, the problem gets worse before it gets better,” Jew said.

That recovery is likely a long way off. Jet fuel demand may not return to pre-virus levels until 2026, according to Fitch Solutions. That means refiners might still need to make diesel at the expense of jet fuel, further adding to stockpiles of the former and thereby reducing its profitability.

While demand in Asia might be better, even that market will soon face challenges as refineries return from maintenance programs and ramp up operating rates.

The region’s diesel markets may head the way of the rest of the world if the recovery in demand isn’t as strong as expected, and if China increases exports on the back of stronger export markets, said Sandra Octavia, oil analyst at Energy Aspects.

Asian refineries may ramp up runs in July, as seen by their flurry of July-arrival crude purchases, she said. Stronger prices also mean the region will continue to attract supplies from India. “That’s a lot of pressure on demand recovery to perform,” said Octavia.

Increased supplies from Asia, which typically sends much of its excess to Europe, would further test a diesel market that’s already struggling.

With the International Monetary Fund anticipating a 3% shrink in the global economy this year, the deepest contraction in at least four decades, that doesn’t augur well for the diesel market, or the wider crude oil complex.

“Distillate represents the fuel of economic activity rather than social activity, which is represented by gasoline,” said Paul Sankey, a veteran oil analyst at Mizuho Bank.