LONDON (Reuters) - Middle distillates, including road diesel and marine gasoil, are the critical link between global growth and the oil market.
Distillates will be at the heart of three developments in the next two years that determine the direction of oil prices as well as the longevity of the current economic expansion:
It seems unlikely the global economy will still be growing strongly while oil prices remain at comfortable levels for consumers at the same time as the shipping regulations go into effect at the start of 2020.
Cyclical tightening of distillate markets plus new fuel regulations are inconsistent with moderate crude oil prices. Something will have to give.
Either global economic growth will slow of its own accord, easing the pressure on distillate supplies, or crude oil prices will rise enough to force an economic slowdown.
Mid-distillates accounted for 35 million barrels per day of global oil consumption in 2017, around one-third of the total, according to BP (“Statistical Review of World Energy”, 2018).
Freight transportation, including cargo moved by road, rail, pipelines, barges, shipping and aviation, is the biggest end-user of fuels derived from the middle part of the crude barrel.
Substantial quantities are also used by manufacturing firms, as well as miners and within the oil and gas industry itself, with much smaller volumes used for heating and cooking.
Distillate consumption is more closely geared to the level of business activity and the macroeconomic cycle than any other section of the oil market.
Distillate stocks are in turn closely correlated with changes in benchmark crude prices and the shape of the futures curve. Since mid-distillates are one of the most important refinery outputs, the link is not surprising.
As the distillate market alternates between over- and under-supply, Brent cycles between contango and backwardation.
Periods when distillate stocks were abnormally high (1998/99, 2001/02, 2006, 2009/10 and 2015/16), all linked to slower growth in economic activity, have been associated with a large contango in Brent.
Likewise, periods when distillate stocks became unusually tight (1999/2000, 2003/04, 2007/08 and 2012-2014), mostly linked with stronger economic growth, have all been associated with Brent backwardations.
Stock draws in distillates have been much more closely associated with the shift in Brent spreads than changes in gasoline stocks.
The same pattern has been evident during the most recent oil market slump and recovery, with distillate stocks surging in 2015 and 2016, before drawing equally strongly in 2017 and so far in 2018.
Strong growth in distillate consumption in 2017 and early 2018 coincided with a period of strong and synchronised growth in the major global economies and a marked acceleration in freight movements.
Distillate consumption is outstripping production in the United States, and in much of the rest of the world, resulting in a broad reduction in inventories.
U.S. distillate stocks, which were 36 million barrels above the five-year average in early 2017, have now fallen to 18 million barrels below in July 2018.
U.S. distillate consumption rose 5 percent year-on-year in the first half of 2018 but production was up by only 1 percent (“U.S. distillate inventories are low for this time of year”, EIA, July 27).
The same phenomenon is evident globally. OECD distillate stocks have fallen from 618 million barrels in May 2016 and 605 million in May 2017 to just 521 million in May 2018 (“Oil Market Report”, IEA, July 2018).
The drawdown in distillate stocks has corresponded closely with the shift in Brent calendar spreads from contango to backwardation and the rise in Brent spot prices.
Distillate markets are tightly coupled with the global economy - and the relationship likely runs in both directions.
Changes in the level of manufacturing activity and freight movements have a direct impact on the consumption and availability of transport fuels.
But changes in fuel prices also have a significant impact on input costs for a wide range of businesses as well as inflation.
The outlook for distillate prices (and by extension oil prices) therefore depends critically on what happens to the global economy over the next 18 months.
If the global economic expansion continues at its current rapid pace, distillate availability will become stretched, and oil prices will rise strongly.
The scheduled implementation of new International Maritime Organization fuel regulations at the start of 2020 will only exacerbate this tightness and could intensify upward pressure on oil prices even before they go into effect.
Eventually, the rise in fuel costs will act as a drag on global economic growth, and bring the cyclical expansion to an end.
Conversely, if the global expansion slackens on its own, perhaps as a result of trade tensions, distillate supplies will be more comfortable.
Plentiful distillates would curb or even reverse the upward trend in oil prices, and extend the current cyclical upswing for an additional period.
John Kemp is a Reuters market analyst. The views expressed are his own.
- World trade points to slowing economic expansion (Reuters, July 26)
- Global economic slowdown is likely and necessary later in 2018 or 2019 (Reuters, July 17)
- Rising oil prices put demand destruction back on the agenda (Reuters, May 2)
Editing by Dale Hudson