Seismic shift in demand patterns

The change in the spread between diesel and gasoline spelt a seismic shift in demand patterns, as Europe's balance, net long gasoline and net short distillate, was dramatically exacerbated by a slow down in US demand and burgeoning global demand for diesel and its distillate stable-mate, heating oil.

The additional length wore down gasoline's value in relation to crude and propels that of diesel's (see chart: Diesel 10 PPM FOB Rdam Brg, January 2 - August 14, 2008) to hitherto unforeseen levels--and it is this change that fundamentally re-writes the economic rules for European refiners.

A product's performance, its value to refiners and its relationship to crude prices, is determined by its crack. It is the crack that underpins all decisions, as a refiner balances the strong performers, traditionally gasoline, with that of the less-desirable products such as fuel oil.

That balancing act took on ever greater significance in crude's run up through the early part of 2008, and, as the expected strength of gasoline melted away, simple refineries-essentially those tied in to light crudes, operating a crude distillation unit and minimal post-processing units-were left facing disastrously unsustainable operating margins.

In 2007, the spring period was a lively one for gasoline, the crack surging to levels around plus $18/barrel based on 10 ppm barge values.

Diesel cracks meanwhile, drawing on stolid European motoring demand, trailed just behind at $16.45/b. The difference a year has made is starkly represented in the crack values. That $1.50/b spread in gasoline's favor at the end of the second quarter of 2007 was transformed into a monstrous diesel advantage that exceeded $30/b, while the gasoline crack itself fell to minus $1.44/b.

For gasoline, on the cusp of what should be a peak demand period, a negative crack was unprecedented, and vividly illustrated a change that traders had only pondered in passing.

Gasoline, the one-trick pony--a collection of varied blended components and barely a product in the strictest sense--was no longer the sum of its parts.

Demand for naphtha idled in the face of rampant flat prices, but retained enough bedrock interest from petrochemicals to lift the key gasoline blendstock's value above that of the finished product's value for a period in July 2007. But even here, naphtha's crack wilted to minus $13/b, piling further woes upon simple refiners.

The US decision to wean itself off foreign oil has resulted in greater blending of home-grown ethanol into their gasoline pool, excising almost instantly a significant portion of supply from overseas, and constricting by far the most significant export market for European gasoline.

The consequence for Europe was massive oversupply which undermined the gasoline crack (see chart: Gasoline Front Month Crack Spread, Jan - July 2007 / 2008), battering the star player for simple refiners. For many gasoline traders, the change was not unexpected, but the speed and completeness with which it was achieved stunned many.

"It is very, very hard to understand," one gasoline trader said, "Of 2008-2009, I think there was a feeling that it would be bad for gasoline, but to be so weak... I don't think anyone expected it to be as bad as this."

By contrast, traders have kept an eye on diesel's rise, acutely aware perhaps that, as a distillate, diesel has a life beyond road fuels. Its use as a heating oil, in power generation, in agricultural and heavy industry arguably lends diesel a far greater powerbase than gasoline.

Diesel's fortunes have risen as gasoline's have spectacularly declined. Globally demand has surged, with Europe's distillate production failing to keep pace with the burgeoning demand from European motorists.

Encouraged by European politicians, intent on utilizing diesel's cleaner and more efficient pedigree in order to meet stringent emissions targets, diesel has received tax incentives and encouragements from European Union governments that has steered the French car market, to take one example, to close to 70% diesel.

Along with unexpected heating oil demand from the southern hemisphere, distillates saw strong demand globally, leaving Europe to price higher to ensure that product kept flowing in.

The knock on effect saw the diesel crack balloon to unheard of levels, reaching as high as plus $50/barrel at the end of May--more than compensating for the weaker gasoline crack.

High flat prices inevitably attract arbitrage product from overseas and, in spite of a healthy flow arriving from the US from mid-May onwards, cracks have remained around the plus $25/b.

That arbitrage was expected to bring between 1 million and 1.5 million tons of diesel into Europe through August alone, crushing diesel premiums but only denting the crack.