Driving Discussions: Diesel Draught Turns into Floods

Alfonso: Hello and welcome to "Driving Discussions Europe." 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. The diesel crack in Europe has been trading below $20 a barrel since pretty much April this year. Fifteen dollars a barrel was considered as normal a few years ago, but it is way below the levels since the war started in Ukraine back in February 22, with a crack that has been trading at about $40 a barrel since. The macroeconomic performance of Europe is weak, but what are the drivers of these low margins and what is the impact in the refinery landscape?

My name is Alfonso Berrocal, VP for middle distillates and sustainable aviation fuels at Argus Media. And to analyze this topic, we have here today with us my colleague, Benedict George, European associate editor for oil products. Hello, Benedict, and welcome to the podcast.

Benedict: Hi, Alfonso, thank you for having me.

Alfonso: Benedict, let's start looking at the European refineries. Why are the diesel refining margins so much weaker today than what they were one year ago?

Benedict: The big problem is on the demand side, really. European diesel demand has declined really significantly over the last five, seven years maybe, particularly in Northwest Europe. Not uniformly in every country in Europe by any means. In Eastern Europe, demand is actually still growing year on year, but in the countries where diesel demand is centered in Europe, the countries that consume the most, which are Germany, France, Spain, and so on, demand is declining in those countries.

So, in the early summer of 2024, domestic diesel deliveries in Germany and France and Spain were down by between 5% and 10% against 2019. So that's over the last 5 years, 5% to 10% decline in demand. Italian diesel deliveries were roughly flat against the 2019 level, so there's less of a clear trend there. But by contrast, in the Netherlands, Belgium, Denmark, Norway, the decline over the last 5 years is more like 15%, 20%, 25%. So there's a lot of variation. As I say, Eastern Europe is quite different. In Poland and Romania, diesel deliveries are much higher than they were in 2019, but the average is being pulled down really heavily by Germany and France, really, above all.

And in combination with the weak demand side, the diesel, there's very easy import supply to Europe at the moment. So for the last two months, Europe has actually received regular VLCC, very large crude carrier, tankers filled with diesel, which is very rare. Usually, tankers of that size, which are too big to transit the Suez Canal, they're the largest class of oil tankers in regular use around the world. And they generally only carry dirty products, so they carry crude or dirtier refined products. But they've actually...several of these, I think more than five of these now, have been cleaned and loaded with diesel, which is a huge expense for the trader. It's been estimated to me that their cleanup costs $800,000 each time it's done. So this doesn't usually happen, but this has been regularly happening over the last few months, over the summer. There are 3 of these very large crude carriers on the way to Europe today with more than 800,000 tons of diesel on board between them, which is equivalent to 5% of all the diesel that Europe consumes each month just on 3 tankers.

The import picture is complicated. There's the exclusion of Russian diesel in the background is still providing some support. I mean, there's no doubt that European diesel market would be even weaker than it is now. Prices would be even lower than they are now if the EU and the UK had not excluded Russian diesel in the way that it did from early 2023. But the reallocation of the Russian diesel into new markets and the reallocation of other diesel like Turkish diesel or U.S. diesel from those other markets into Europe has been relatively smooth. And that process has been really completed by this year.

So, Russia now supplies almost all of Brazil's diesel imports, for example, and as a result, the U.S. supplies very little diesel to Brazil and has a lot more diesel to sell to Europe as a result. So the volume of U.S. diesel entering Europe now is much higher than in the last few years. And, actually, the August volume of U.S. diesel reaching Europe was around three times the monthly average from last year and four times the monthly average from 2019 before COVID. So the reallocation of Russian and other diesel around the world has meant Europe has successfully replaced the missing Russian diesel, and there's more diesel available from East of Suez at the same time. So there are easy imports and a weak demand picture at the same time.

Alfonso: Okay, you have mentioned that demand has dropped in a number of European countries. Some of them historically they are big diesel consumers. Is this diesel demand just suffering from the current weak macro-environment, or is this loss of the structural, you think?

Benedict: I think the loss is structural. It's chronic. It's long-term. So back in 2022 maybe, 2023, a lot of people were uncertain whether the decline, particularly of German diesel demand, I think, which has been the most pronounced out of the large economies in Europe, whether that decline of diesel demand was tied to recession in German GDP. Germany's been in and out of GDP recession for the last couple of years. They've been...I think I'm right when I say more than one period of technical recession, but Germany has kind of temporarily recovered, temporarily dipped back into recession, and so on. The thing is that the decline of diesel demand in Germany is steady and severe, whereas GDP, as I say, has been rising a little bit, declining a little bit, rising a little bit, declining a little bit. The correlation just doesn't seem to check out.

Total EU GDP in 2023 last year was around 4% higher than it was in 2019. So even after a huge contraction during COVID and then a recovery, the net result was 4% higher GDP in real terms in 2023 than in 2019, according to EU data. But total EU domestic diesel deliveries were 4% lower over the same period. So, despite a net gain in GDP, there was a significant net loss of diesel demand. The disparity in Germany is even more pronounced. So German GDP was just 1% higher in 2023 than in 2019, but German diesel deliveries were 12% lower in 2023 than in 2019. So the trajectory of diesel demand just doesn't seem to...for the last five years or so, at least, doesn't seem to have anything to do with the trajectory of GDP. Now, I have no doubt that if there is stronger GDP growth in the EU and in Germany, in particular in the future, that will tend to support diesel consumption volumes because trucks and industrial machinery, industrial vehicles run almost exclusively on diesel fuel, and GDP growth tends to mean more usage of those kind of vehicles, more activity in those sorts of areas.

So GDP growth supports diesel consumption, but there's been a significant dislocation between the two things. The main problem being, the main structural long-term problem being that there's less manufacturing happening in Western and Northern European economies now than there was even 5 years ago and certainly 10 years ago. I think sometimes we have an impression in Western Europe that this transition in our economies away from manufacturing and towards services is kind of complete and has already happened, but it is very much still ongoing. Manufacturing is still contracting as a percentage of GDP in Western Europe, and services are still growing. So the result will be that GDP is performing much better than manufacturing output in particular, and manufacturing output tends to be very diesel-intensive because there's a lot of trucking around of intermediate parts, intermediate products and because a lot of the machinery used in manufacturing facilities is fueled with diesel.

So as economies are shifting away from manufacturing and towards services, each dollar of GDP that they produce is tending to require less diesel to produce it. German manufacturing in particular has contracted especially hard over the last few years because of the exclusion of Russian energy because Germany was such a large user of Russian energy before 2022. I mean, it attracted a lot of media attention when BASF, the huge German chemicals company, announced it was going to close several chemicals factories in Ludwigshafen. They haven't actually closed them yet, but just the announcement they were going to close them, I think, struck a lot of people as a landmark blow for German manufacturing. And, actually, just last week VW, another huge industrial champion, the Germany, announced that it could not rule out closing factories in Germany, which would be the first time in the company's history that it's ever done that. And the CEO of VW actually said Germany in particular as a manufacturing location is falling further behind in terms of competitiveness.

This loss of competitiveness in terms of energy costs and, obviously, a range of others and other respect as well, not least of which is environmental regulation and so on, this loss of competitiveness for manufacturing in Europe against China, but in particular, but lots of settings in Asia, this is a huge chronic pressure on European diesel consumption. And in addition to that, in parallel with that, European consumers, they own fewer diesel cars than they did five years ago or seven years ago. In fact, I mean, some of the clearest...the data, unfortunately, is not up to date, not up to date for this year or from the EU, but we can see that in a period of time as short as between 2019 and 2022, the number of diesel passenger vehicles on the register in France fell by 9%. So we're not talking about the proportion of new vehicle sales that are diesel versus electric. We see a lot of data about that in the news. But, of course, what really matters is the number of diesel vehicles and other types of vehicles that are actually on the roads in total, and that number for diesel vehicles is falling very rapidly. It's 9% lower, as I say, in the three years to 2022 in France. In Germany, it was lower by 4%. In Italy, it was lower by 3%. In Spain, 2%.

So it's falling with different velocities in these different countries, but it's falling in all of those countries. And that's partly because electric vehicles are becoming more popular, but also because gasoline, petrol vehicles are becoming more popular as well. Possibly, I think the Dieselgate scandal in 2015, that was a blow for the consumer perception of diesel as a fuel. In some countries, there are higher taxes on diesel cars. There are some respects in which diesel engines are less environmentally friendly, so that has motivated...less environmentally friendly than gasoline. I mean, the diesel engines tend to emit more nitrous oxides. And that has motivated, in some cases, higher taxation on diesel cars, which naturally discourages consumers from owning them.

And then the third thing, along with the decline in manufacturing and the decline of diesel-intensive manufacturing and the decline of diesel car ownership, the third problem for European diesel demand is the gradual increase of biofuel mandates. So every year or every two years, most of the large economies in Europe increase their mandated biofuel blend by 1 or 2 percentage points. And that naturally...all else being equal, that will significantly detract from fossil diesel demand. And we shouldn't underestimate the impact that is cumulatively having over the years.

Alfonso: Amazing analysis, Benedict. Thank you for that. If we consider nevertheless that the supply chain is more fragile now, why, for instance, the diesel market has adjust so well to the disruption caused by, for instance, the Houthis attacks in the Red Sea? Effectively, this has added weeks to the delivery of diesel cargoes coming from East of Suez.

Benedict: I think it's a really interesting question. Earlier in the year, in January and February, when the attacks had been going on for...well, the attacks really started in December. So when they had only been going on for a few weeks, everybody was asking themselves whether this was going to go on for another week, another two weeks. And, of course, what's actually happened is they've gone on for another nine months or so, and they don't show any sign of stopping. I mean, two large oil tankers have been hit by missiles in just the last three weeks or so. So it's a surprise in a way that the European diesel market is not more distressed by this. There are some reasons I think we can actually identify. Like, obviously, the weak state of European diesel demand makes the Yemen problem much easier to cope with.

And this is easiest to see in the forward curve. So in the relative prices of diesel futures in Europe, the most liquid diesel futures in Europe are the ICE Exchange Gasoil Futures. And for the last few months, the futures for the earliest delivery have been pricing cheaper than futures for later delivery, which we call a contango structure in the forward curve. But what it implies is that buyers of diesel will actually pay more to avoid needing to store the product effectively. People saw the prompt diesel market so well supplied that they would actually pay a premium to receive the product later, which that in itself, I think, illustrates how the market is very comfortable with the import supply line taking two or three extra weeks. Buyers in Europe are in no rush to get diesel delivered as quickly as possible, quite the reverse, in fact.

Additionally, it's important that we bear in mind, although since the exclusion of Russian diesel suppliers to the east of Yemen, so the Mideast Gulf suppliers like the UAE and Kuwait and the Saudi Gulf refineries and India, these are all much more important for the European diesel market today than they were back when Russia was supplying half of Europe's diesel imports. These are all much more important suppliers for Europe today, but it's not as if they're the only suppliers Europe has. Europe gets a lot of diesel from Turkey. Yemen is not an issue for imports from Turkey, of course. Increasing volume of diesel from the U.S., as I mentioned before. Of course, Yemen isn't a problem for that either. And Yemen isn't even an issue for all of the diesel that Europe imports from the Middle East because two of Saudi Arabia's largest refineries are on the Red Sea coast of Saudi Arabia, so the YASREF refinery at Yanbu and the relatively new Jazan refinery. And both of those are supplying regular diesel cargoes every month into Europe. The cargoes don't...they don't need to pass Yemen.

Additionally, the MIDOR refinery in Egypt, which is near Alexandria, has just this year started producing European-standard diesel and regularly supplying European-standard diesel into Europe. So there are a lot of suppliers Europe can turn to without worrying about the disruption around Yemen as well. I think it's interesting how there have been some curious side effects of the disruption around Yemen. And I mentioned before how there are now regular very large crude carriers cleaning up in order to load diesel to bring it to Europe. And I don't think that would be happening if it weren't for the disruption around Yemen, because one of the key disadvantages of that tanker class in the diesel trade is that that tanker class can't fit through the Suez Canal, so will always have to go around the Cape of Good Hope in order to get to Europe. But, of course, now almost every tanker is going around the Cape of Good Hope anyway, so that has disappeared as a distinguishing factor between the tanker classes.

And the usage of the very large crude carriers also, I think, points to how the Asian market for diesel is simultaneously very weak. It happens to be very weak at the same time as the European market is weak. The weakness of the Chinese real estate investment sector is a big driver, we think, behind low consumption of diesel in China. But one way or another, China and Asia in general are consuming less diesel year on year this year, and that frees up more tankers, more diesel from the Middle East and from India to head to Europe. Despite the longer journey, sellers in those countries are almost in a position where they will set their price at a level that makes their product move, because with a weak market in Asia and a weak market in Europe, their alternative would be not to sell their diesel to anybody. So the ball really seems to be in the court of the refiners, and the refiners are having to cut their prices or else fail to sell the product.

Alfonso: Okay, thank you very much, Benedict, for your insights and for coming to the podcast.

Benedict: Thank you very much.

Alfonso: Thanks. And maybe something to add to Benedict's analysis is that if you're interested in tracking the impact of the global diesel flows, you can follow the Argus cif deliver pricing to Europe, which assess the value of large cargoes of diesel coming actually from the East of Suez or from the U.S. and the value of the diesel being re-exported afterwards. Those cargoes land in Europe from the hub of ARA into smaller clips of 15,000 to 30,000 metric tons to other European destinations. So if you're enjoying this podcast, please be sure to tune in for the other episodes in our series, "Driving Discussions Europe," and for more information on Argus global refined products coverage, please visit argusmedia.com/oil-products. Stay safe, and see you the next time.