U.S. distillate fuel oil inventories are depleting to critically low levels; either an imminent recession reduces consumption or prices are likely to surge higher.

Distillate fuel oil is the lifeblood of industry and the worsening shortage shows the economy is hitting hard capacity constraints in the short term.

Stocks of diesel, heating oil and other distillate fuel oils fell by more than 2 million barrels to 109 million barrels last week, according to data from the U.S. Energy Information Administration (EIA).

Distillate inventories have declined in 66 of the last 109 weeks by a total of 65 million barrels since the start of July 2020 (“Weekly petroleum status report”, EIA, Aug. 3).

The drawdown has more than offset the 45 million barrels accumulated in the second quarter of 2020 when consumption was hit by the first wave of the coronavirus and widespread lockdowns.

Stocks are now in only the 8th percentile for all weeks since 2000, down from the 68th percentile at this point last year and a record at the end of July 2020.

Inventories are more than 21 million barrels below the corresponding point in 2008, when prices were just coming off a record high, and at the lowest level for the time of year since 1996.

EXPORT DEMAND
Distillate inventories usually increase during the third quarter as refineries boost crude processing to make more gasoline for the summer driving season.

But this year, inventories have failed to rise, and have actually fallen by 2-3 million barrels since the end of June, the largest seasonal drawdown since at least 1990.

Internal demand, measured by the volume of distillate supplied to the domestic market, is running 100,000-200,000 barrels per day below the corresponding point in 2021.

But external demand, measured by net exports, is running at very high levels as refiners export to Latin America, Europe and Asia in response to strong consumption and to compensate for the loss of distillate exports from Russia.

Net exports of distillate fuel oil averaged 1.4 million barrels per day in the most recent five weeks, one of the fastest rates in the last five years.

RECESSION AHEAD
Rebuilding distillate inventories will require a reduction in internal demand via a domestic business cycle downturn and a reduction in external demand via a global recession and/or easing of sanctions on Russia’s exports.

Interest rate increases by the U.S. central bank are already spreading around the world and are likely to induce the required slowdown in industrial activity at home and abroad.

In the United Kingdom, the governor of the Bank of England has forecast the economy will enter a recession before the end of year (“Bank of England raises rates by most since 1995 even as long recession looms”, Reuters, Aug. 4).

The other major European economies are likely to enter a recession on a similar timescale as surging inflation and energy prices dampen household and business spending.

China is struggling with its own worsening cyclical slowdown created by repeated lockdowns to control the spread of coronavirus.

Recessionary forces will also propagate through the middle-income countries that are major industrial suppliers to North America, Europe and China – including Brazil, Mexico, Turkey, Thailand, Indonesia and Vietnam.

ENERGY CONSTRAINT
U.S. interest rate traders now anticipate a recession is virtually certain, with the Treasury yield curve between two-year and ten-year maturities at its most inverted since before the dotcom crash in 2000.

Distillate prices are incorporating a high probability that recession will dampen consumption and rebuild inventories over the course of 2023.
The European gas oil futures calendar spread between December 2022 and December 2023 has softened to a backwardation of $15 per barrel from more than $32 in the middle of June.

Macroeconomists sometimes employ a KLEMS model to identify the contributions of capital (K), labour (L), energy (E), materials (M) and services (S) as well as multifactor productivity to economic growth.

Much of the recent discussion about growth and inflation has focused on the labour component (L) where economists and policymakers are divided on whether there is still unused spare capacity.

But the U.S. economy has already hit a binding constraint on energy (E) which is showing up in the shortage of distillate (and to some extent gas and electricity), rising inflation, and will force a slowdown in growth in the short term.
Source: Reuters (Editing by Kirsten Donovan)