The Global Diesel Problem

Diesel is at the center of an international supply squeeze, with prices rising to historic highs. Andrew Sheets and Martijn Rats unpack why this industrial fuel matters far beyond the pump.

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Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Global Head of Fixed Income Research at Morgan Stanley.

Martijn Rats: And I'm Martijn Rats, Head of Commodity Research at Morgan Stanley.

Andrew Sheets: Today, the secret life of diesel and why there's so much attention on it.

It's Thursday, September 24th at 2pm in London.

Diesel is a fuel that I think a lot of investors may be aware of but not familiar with, so to speak. It's often the other price that you see when you're driving down the road.

But Martijn, it's incredibly important for the industrial side of the economy and unusually disrupted by current geopolitical events. And so, I'd like to really start at the top, or technically the middle of the barrel, so to speak.

What is diesel and what makes it so special?

Martijn Rats: Yeah. When people talk about diesel at the moment, they really talk about sort of three things combined. They talk about outright diesel, as well as jet fuel and also heating oil.

These are effectively part of the same pool of molecules coming out of the refinery. And so, when you look at that sort of pool of molecules, you talk about the things that fuel trucks, trains, ships, tractors in agriculture, excavators, generators, home heating. It is a molecule that has a tremendously broad range of applications.

It's really the fuel of the industrial economy.

One of the characteristics of diesel is that it has very high energy density. In contrast to, say, gasoline, electrifying the uses of diesel is harder because it carries so much punch.

Andrew Sheets: And why has there been so much on diesel recently, given the current energy disruption in these geopolitical events?

Martijn Rats: Yeah. So, the global refining system normally processes about 85 million barrels a day of crude oil and from that, it makes a range of products. Diesel is at the heart of it. But it's only one of many.

At the moment, we are short in terms of refinery runs, i.e., the amount of crude that refineries process to the extent of about somewhere between 4 to 5 million barrels a day. So, 4 to 5 million barrels a day on a base of 85, you're talking about 5 to 6 percent. That may not sound like a lot, but in the world of commodities, where prices really depend on relatively small changes, that is actually a very large amount.

That sort of 4 or 5 million barrels a day of refineries that are currently not running, they are fifty-fifty, either in the Middle East or in Russia. In the Middle East, it is a story of the Strait of Hormuz and refineries locked behind the strait, and they can't export their products. Some of them are also damaged, although information on that is hard to find.

And then the other half that is out is in Russia, where they are effectively taken out by Ukrainian drone attacks.

In total, that's sort of 4 to 5 million barrels a day of refining capacity that is not running. 40 percent of their output would typically be diesel, so we are missing something like 1.5 million barrels a day of global diesel supply, all into the seaborne market.

Now, I mentioned the seaborne market because the seaborne market is the traded market where traders buy and sell cargoes to each other. And that is where, from a physical market perspective, price formation takes place.

The global seaborne diesel market is an 8 million barrel a day market. And so given that all of the supply we're missing is also into the seaborne market, the comparison to make is to say that we're missing about, sort of, close to 1.5 million barrels out of an 8 million barrel a day traded…

Andrew Sheets: A pretty large percentage, yeah.

Martijn Rats: Absolutely. That is very, very large, and that is hard to offset. Every other refinery around the world that can run is running flat out. The margins are all-time highs. So, there's a lot of incentive to run very hard.

But nevertheless, it's left the market very, very tight.

Andrew Sheets: So, that tightness in the market shows up via price. And just talk us through a little bit about what has happened to the price of diesel and its related fuels. You know, I think a lot of listeners are probably more familiar with the price of gasoline. They're more familiar with the barrel of oil that's often the quoted benchmark in the market.

But what has been happening to these diesel prices?

Martijn Rats: Yeah. So, the way to really tell that story is to look at what we call the crack spread. So, making a barrel of refined product, including diesel, of course, you start with crude oil. So, the price of crude oil impacts the price of the refined product. So, quite often we focus more on the uplift from the price of crude to get to the price of the refined product, and we call that the crack spread.

Under normal conditions, say a year ago, crude was $70, and then the price of diesel was another $20 on top of that. And so, you got to diesel being 70 plus 20 is $90 per barrel. At the moment, crude is higher. Crude is about $100 per barrel. Crude has rallied. But the increment on top of it has spiked.

So, a couple of days ago we got to all-time high nominal term diesel prices over $200 per barrel. So, we're now having a situation that is [$]100 for crude plus another [$]100 to get to the diesel price. So, the crack spread is something that normally lives in a range of, like when the diesel market is weak, maybe sort of $8, $9, $10. When the market is normal, close to $20. If it's very strong, $25 to $30.

Now, that incremental crack spread is $100 per barrel, and that is something that we've not seen before. It is stronger than it was in 2022, when we also had a moment of a severe diesel crisis. Didn't last very long in 2022, but the crack spread got to sort of $60, $70 per barrel. So, that highlights the extent to which the price of diesel has rallied.

Andrew Sheets: So, Martijn, you mentioned this crack spread. You know, I think if we all go back to our organic chemistry, this is the refineries literally cracking a barrel of oil down into constituent distillates and other pieces.

But given those very high prices for diesel, why don't the refiners just refine more? Why aren't the incentives increasing production? What's getting in the way of that?

Martijn Rats: Yeah. That's just a matter of like the physical reality of the system.

So, when you build a refinery, you often quite think about two things. What crudes are available to me. So, if you're in the United States, you have U.S. shale crudes, or you have crude from Mexico, Canada. And based on those, you then also think about, you know, what is my consumption, where I am likely to be.

And based on that, you build a certain configuration – that converts the crudes that you can buy into the products that your specific customer set might need.

You fix the configuration of the refinery at the time you build it. And once it's built, there is a little bit of flexibility to say, "Oh, well, maybe at the moment I make a little bit more diesel and a little bit less gasoline," and change the – what we call the yield of these products. Like a little bit within, you know, a few percentage points range.

But that flexibility is small, so the only thing you can do to make more diesel is to run the refinery at 100 percent utilization. That is currently where we are. That has already happened. And then you put in the crude that you buy, you get the products for which your refinery is then designed, and that's it.

There are no other…

Andrew Sheets: You can’t just turn a big dial that says more diesel.

Martijn Rats: No. You can't say, "Oh, well, I don't like my naphtha output this week, so let's not make any naphtha for the chemical industry. Let's only make diesel." It's not contained in the barrel of crude and the kits that you have – takes many years to rebuild and probably very expensive.

So you're kind of then stuck. I mean, it is what it is.

Andrew Sheets: So Martijn, where is this leaving the global story? You know, if we think about just the relative price of this. Again, you mentioned it's an incredibly important fuel for agriculture, for industry… What's it looking like kind of across the major regions?

Martijn Rats: Yeah. Look, it leaves a very tight market at the moment. I mean, it's relatively straightforward.

The price of diesel depends very heavily on how the geopolitics of the Middle East and Russia sort of play out. So, in terms of the traded price that you see on the screen every day, it swings around very heavily with how the market foresees the future with regards to these two conflicts.

So, one week things flare up, the price of diesel rallies. The following week the market feels a bit more optimistic maybe around a deal, so then things sort of sell off. So, we have to live with that sort of geopolitical sort of reality. But other than that, those who can afford it pay a high price to effectively erode demand amongst sets of consumers who cannot afford these higher prices.

You see a substitution, for example, what I thought was very interesting last week. Some of the train companies in the United States were talking about a truck-to-train substitution of very high levels of cargo loads on trains because simply the diesel on trucks is too expensive.

So, you see those behavioral changes come through.

Andrew Sheets: But that point about demand destruction is really important because, you know, a point that you've made over many years is this idea that the solution to higher prices is higher prices. That that reduces the demand for the fuel, that helps these markets recorrect.

And yet, you know, we're hitting prices in diesel that are near all-time highs, and we've yet to see that demand really pull back a lot. A lot of economic indicators are still pretty good. What does that tell you maybe about where the demand destruction price really is?

Martijn Rats: Making estimates of the demand destruction price sort of bottom up in a sort of modeling sense, going sort of end use by end use, has turned out on many occasions to be very, very challenging analysis.

But we can sort of look at the market and say under certain conditions, prices have spiked and what were these conditions? And we can sort of try to learn something from that. We had a very severe diesel crisis in 2022 when the Russia-Ukraine conflict started, and effectively Russian diesel had to be significantly rerouted around the world. We got to $200 per barrel.

Andrew Sheets: Right about where we are now…

Martijn Rats: Right about where we are. That didn't last very long. Big spike to [$]200, and it sold off. In March-April, we got to [$]200, and it sold off. And now, a couple of days ago, we reached that again. And so, in the trading behavior of the market, it does look like what happens at [$]200 – there either is demand destruction. Or there may not be demand destruction in the fullness of time, but buyers just take a pause.

And this makes it quite difficult to kind of really unearth this issue in the sense that in the end, a lot of customers also have inventories of their own. Like airlines have tanks with jet fuel. In Europe, you have a lot of households that use heating oil for home heating if they're not connected to the gas grid. And they have tanks in their gardens.

And so, there are a lot of tertiary inventories, as we call them, where people can effectively afford to stop buying for a little bit and see how things pan out, and then they buy later. And so, the actual data points that we have on demand destruction, even at this price, they're actually not that convincing.

There seems to be some... There clearly is in China. In China, we have seen signs of demand destruction at these very high prices. But in the rest of the world, either there are subsidies in place, or people draw on their own inventories for a bit. Or they just absorb it because it's an indisplaceable fuel in the short run.

Actually, it's not all that convincing that there is a lot of demand destruction even at these prices.

Andrew Sheets: So, Martijn, the last thing I want to ask you about is – this is a fuel that is central to a lot of key industrial processes, as we've discussed, agriculture, trucking. What is the risk that the countries that have more of this refining capacity stop exporting it to the rest of the world. Try to keep more of it to themselves in order to cushion the domestic price impact?

Martijn Rats: That risk is very real. We've already seen some of this earlier on in the Hormuz crisis in March and April. For example, China at some point announced an export ban on all refined products. In retrospect, that wasn't quite as forcefully implemented as it was announced. But nevertheless, the Chinese government did announce that, and we saw a initially large decline.

The government of South Korea at some point banned refined product exports. In the United States, there are voices that say that this might be something that the government should consider. I would say, though, about the U.S. diesel export ban, there is a good reason why this has not happened yet.

Because the United States is broadly balanced in gasoline, domestic production of gasoline by the refiners. It broadly equals to domestic consumption. And there is a tiny little bit of exports. But in the overall scheme of things, it's not much.

In diesel, it has a very large surplus, which is exported. But if there were to be an export ban and that diesel cannot leave the country – for a little bit, you can store it. But you'd fill up those tanks very, very quickly. When those tanks are full, you then need to slow down the refineries because otherwise you simply have diesel that you cannot get rid of.

If you slow down the refineries, and this is how we come back to the start of the discussion, the mix of products that you produce is broadly fixed. So, if you slow down the refineries, you make less gasoline. And so, in the United States, you can get the counterintuitive outcome that a diesel export ban could lead to higher gasoline prices.

So, a lot of these things have unintended consequences, and there are good reasons why they haven't happened yet.

Andrew Sheets: I think that's a fascinating and counterintuitive way to think about it. Thank you, Martijn, as always, for taking the time.

Martijn Rats: My pleasure.

Andrew Sheets: And thank you for listening. If you find Thoughts on the Market useful, let us know by leaving a review wherever you hear us. And also tell a friend or colleague about us today.