Diesel price spikes may be the new norm

Wed Oct 17, 2012 9:45am EDT

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* Security of supply could become an issue

* U.S. and Europe both vulnerable to price spikes

* Longer supply chains could lead to volatility

By Simon Falush and Claire Milhench

LONDON, Oct 17 (Reuters) - Diesel and heating oil users in Europe and the United States may wonder why they are paying near record prices when recession has cut fuel demand and the price of crude is well below record highs.

But while the world has enough crude, shrinking refinery capacity in Europe and on the U.S. East Coast means consumers will need to get used to regular price spikes as increasing dependence on imports reduces supply security.

Europe is currently suffering a supply crunch in gasoil for heating and diesel due to pre-winter refinery maintenance, underpinning refined product prices even when crude prices fall, putting an additional cost on Europe's struggling economies.

The diesel price before taxes in the 27 European Union nations was at 0.795 euros per litre at Oct. 8th, compared to 0.704 euros for the same time last year according to figures from the European Commission.

Jet fuel -- like gasoil and diesel a middle distillate refined product -- is also vulnerable. A hitch at a Scottish refinery led to fuel rationing for planes at Edinburgh airport on Tuesday.

In the United States, a failure to build stocks of middle distillates ahead of the fourth quarter due to a catalogue of refining outages has already built one price spike and could lead to further jumps in heating bills for U.S. consumers this winter.

This level of volatility has been relatively rare before now, but the changing structure of the oil market will mean it is likely to become a regular feature in coming years.

Europe, where ageing refineries have to schedule lengthy maintenance outage periods, looks particularly vulnerable.

"Europe is going to be in trouble, so it's Europe that needs to make up its mind about products and refineries," Maria van der Hoeven, executive director of the International Energy Agency (IEA) said recently.

In a report released last week, the IEA cited several challenges besetting the industry, including diminishing demand, challenging environmental standards, constraints in feedstock access and an ageing refining fleet. As a result, it faces continued capacity attrition.

Sharply falling demand in many European countries this year due to high euro-denominated prices has done little to alleviate the supply crunch. Market backwardation LGO-1=R, where the prompt contract trades at a premium, blew out to around $20 a tonne as the October ICE gasoil contract approached expiry.

Backwardation describes a market structure where prices for more prompt delivery are higher than those for later delivery, meaning there is no incentive for storage.

In Europe gasoil stocks independently held at the Amsterdam-Rotterdam-Antwerp hub fell almost 4 percent week-on-week to their lowest level since January.

But some analysts see the U.S. situation as more critical, as Europe's refineries will start coming back from maintenance this month. Across the Atlantic unplanned outages due to fires, explosions and failed starts have tightened the market.

"In the U.S. they won't be able to recover as much ground as in Europe where there will be a large amount of capacity coming back as maintenance comes to an end, with much less coming back across the Atlantic," said Harry Tchilingurian, head of commodity strategy at BNP Paribas.

ENERGY SECURITY

Over the medium term Europe's problems are likely to be more acute, as U.S. refiners will reap the benefits of using cheap shale oil for feedstock.

Europe will become more dependent on imports as its ageing fleet is wrongly configured to meet demand, failing to keep pace with the growth of diesel as a larger proportion of the transport fuel mix as motorists switch from gasoline.

Although total road demand for diesel and gasoline is expected to shrink by 81 million tonnes between 2005 and 2030, according to a study by industry body CONCAWE, diesel imports will still be required to make up the shortfall.

A rise in cross-continental trading means that Europe will be increasingly dependent on independent trading companies, committed to their own margins and attuned to arbitrage plays that could distort domestic markets.

Europe will see refining capacity fall to 19.3 million barrels per day (bpd) in 2015 from 19.7 million in 2010, while Asia's will rise to 32.8 million bpd from 29.3 million over the same time period, according to Wood Mackenzie.

A price arbitrage allowing middle distillates to come from Asia to Europe has opened up for the first time in six months this week, a trader said, with cargoes coming from India and elsewhere in Asia.

"As sustained demand growth for middle distillates runs ahead of supply, consumers at peak demand times grow increasingly dependent on imports and various remote markets increasingly compete for limited supply," the IEA said.

"The implications for energy security ... may be significant."

These longer supply chains will introduce more volatility, said Alan Gelder, head of oils research at Wood Mackenzie.

"At the moment we are having a big spike in diesel/gasoil when there is a relative degree of calm. If there is a serious conflict, with more global movements, we could see much higher spikes."

He added that changes in domestic supply needs in Asia, and swings in freight prices could also have a big impact on the availability and price of products coming from overseas.

The Fukushima nuclear disaster in Japan saw a big spike in the price of fuel oil in the region, and the implications of similar supply shifts will be magnified elsewhere if more is exported between regions. (Additional reporting by Julia Payne, editing by William Hardy)

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