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By Robert Gephardt
Diesel prices are likely to remain an economic headwind into 2023.
The Ukraine conflict and related Western sanctions on crude oil have been a focal point for investors, greatly affecting the global energy markets. However, we believe the more significant impacts have been to refined products, which are the finished goods of the oil industry, and specifically diesel.
Supply/demand dynamics for diesel have tightened and driven an extraordinary widening in the margin between prices for crude oil and refined diesel. Looking at the benchmark U.S. Gulf Coast diesel market, this difference has increased almost threefold when comparing average post-invasion pricing to the 2017 – 2019 period. This has added nearly $55 per barrel to diesel prices relative to crude prices, contributing to inflationary pressures, given that diesel is a critical component in commercial transportation and industry.
The seeds of the situation were planted during COVID-19. Refineries carry relatively high fixed costs and have difficulty operating at low utilization levels. Facing an unprecedented decline in demand during the pandemic, along with long-term uncertainty tied to the energy transition and potential future supply in the Middle East and Asia, operators elected to close significant amounts of older capacity. Most of this was permanent given the complexity of these facilities.
The Ukraine conflict exacerbated this tightening for four primary reasons: First, Russia has been a major exporter of not just crude but also refined product. Initial sanctions targeted refinery operations in the country and restricted exports, tightening supply. Second, these exports are disproportionally focused on diesel and intermediate goods that help Western refineries improve diesel output. Third, tight global natural gas supplies have also negatively impacted refinery yields, particularly in Europe, as the fuel is a critical component in the refinery process. Finally, high natural gas prices have incentivized substitution from natural gas to diesel.
Unfortunately, the diesel market faces the prospect of additional tightening with further sanctions on shipments of Russian refined products slated for February 2023. The market will likely have a difficult time adjusting given that India and China, the incremental buyers of Russian crude to date, are exporters of refined product. Additionally, capacity is limited in appropriate shipping vessels that are likely to not be subject to sanctions.
Absent a relaxation of sanctions and trade restrictions, global diesel prices are likely to present headwinds to economic growth and supply chain costs until new refining capacity comes online in late 2023.
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