A shortfall of middle distillates — especially diesel — lies behind
the latest oil price surge. Without more Opec crude, refiners cannot keep up
with strong diesel demand growth.
High oil prices signal a shortfall — but Opec remains in denial. The latest surge in crude prices past $110/bl prompted renewed claims that oil prices are not related to market fundamentals. But blaming speculators and turbulent financial markets for record oil prices is only an excuse for postponing increases in supply. Opec maintained deep output cuts for much longer than was necessary last year, starving the market of crude and laying the foundations for the present price surge. The organisation risks making the same mistake this year — at a time when the global economy desperately needs relief from the relentless rise in commodity prices.
Rapidly rising demand for diesel around the world is fuelling the oil price surge. Demand for diesel in the 14 largest oil consuming countries monitored by Argus rose by nearly 6pc last year, stretching the capacity of the refinery system. By comparison, demand for other transport fuels — gasoline and jet fuel — grew by only 1pc, while demand for burning fuels — heating oil and residual fuel oil — fell by 10pc. Refiners therefore face a growing mismatch between the mix of products they can make and the mix of products that consumers want to buy.
Diesel engines are the workhorse of the global economy. And they are more efficient and reliable than gasoline engines in cars, with sales of diesel models booming as consumers switch. Much tighter product quality specifications — especially lower-sulphur content — mean that diesel is no longer interchangeable with heating oil, greatly reducing supply flexibility. So refiners are now struggling to make enough diesel and are investing in new upgrading and hydrotreating plant to boost output yields.
But refinery investment has not kept pace with growing demand and diesel margins are at record highs. Without more upgrading capacity, the only way for refiners to boost diesel output is to run more crude. But this creates a surplus of other refinery products — gasoline, naphtha, heating oil and residual fuel oil — for which demand is growing much more slowly. This has been happening since Opec boosted crude supply late last year, undermining crack spreads for most other products. But Opec is still not supplying enough crude to keep pace with rapidly rising diesel demand, so prices continue to rise in order to limit diesel consumption to available supply.
Downstream refinery capacity constraints remain the key bottleneck. With demand for products such as diesel growing much faster than total oil demand, refiners face simultaneous shortfalls and surpluses for the different products they make. Refiners solved their yield problem last year by upgrading surplus fuel oil into gasoline. But this left a growing shortfall of middle distillates that emerged this winter, as colder weather and rising diesel demand soaked up supply and drained depleted inventories.
Opec faces a dilemma. Boosting crude supply will help ease the diesel shortfall, but risks precipitating a crude price drop as surpluses of other products accumulate — as in late 2006. But restricting crude supply will keep diesel tight, forcing prices up to slow demand growth. Diesel demand is intimately linked to the global economy, so Opec restraint means oil prices will continue to rise unless the world economy goes into a slowdown.
