Those meddling middle distillates

Deep Dive Summary:

• WTI/Brent trap, waiting on Washington
• European crude markets remain Tight esp DFLs
• Asian markets benefit from strong Hormuz flows

Another wild week in the oil markets where true volatility is borne by the whims of our political leaders and the tides of war.

If the market wasn’t tough enough to trade between ebbs and flows of vessel counts and the shifting sands of peace talks, traders around the world now need to worry about the loss of 1–2 mb/d of diesel exports, just as the northern hemisphere goes into winter.

The fallout of a diesel export ban does not stay in its lane; it spills out across the spectrum of oil markets.

Just the idea of an export ban is typically met with talk of run cuts and that is, directionally, the right way to think about the situation and maybe the first lever that gets pulled.

At a high level, it is safe to assume that a 90-day ban on even 1 mb/d of distillate exports would lead to an inventory build of 90 mb, which seems doable at a surface level but impossible if limited to PADD3 where nearly all the diesel exports come from.

Cutting runs is a lever, but a lever that may let your competition benefit from your drastic measures.

From a crude oil or refinery perspective, we think there are other levers that could be pulled to maximise refining margin while minimising diesel production.

One lever was already pulled last week as medium grades plummeted relative to WTI and against year-ago levels as well.

This implies refiners are already contemplating a lighter crude slate that would minimise straight-run distillate production while increasing gasoline and naphtha yields.

This slate change would also reduce residual fuel yields, causing heavy conversion units to run below nameplate capacity.

This leads to what we see as lever three. All the talk about export bans refers to finished diesel fuel while no one is talking about banning the exports of the precursors.

In June and July of this year, PADD3 refiners ran nearly 1.2 mb/d of VGO into hydrocrackers to make (mostly, circa 75% diesel yield by weight) diesel fuel. It is conceivable that the majors could slack or completely shut down their hydrocrackers in the USGC and export the VGO feedstock to their own plants in Europe or Asia.

The receiving plant could likewise run a lighter slate, knowing they could top off hydrocrackers with the imported VGO. By way of example, we could imagine a major like Exxon shipping VGO across the Atlantic to be run in an Exxon refinery in Europe.

Alternatively, if a USGC refiner does not have sister refineries abroad, they may elect to slack the vacuum distillation unit (VDU) and just sell straight-run fuel oil into the market. While spot VGO currently enjoys a $45/bbl margin in Houston, even spot LSFO brings a $22/bbl margin.

In this upside-down world of ours, this would let NWE refiners buy the cheaper light sweet barrel rather than pay up for medium sour barrels.

(A rare case of medium grades pricing at a premium to light grades)

The slate change lever is likely already causing a reduction in upgrader feedstock.

The strategy of exporting hydrocracker feedstock would make an already tight USGC dirty vessel market even tighter.

We believe typical flows of VGO and other intermediates to be in the 25 kb/d ballpark, or somewhere in the neighbourhood of one Afra/month, whereas our VDU or Hydrocracker slacking option would require loading 1–2 Aframaxes per day.

With roughly 20 mb of spare storage (working capacity) for fuel oil in PADD3, there is some room for setting aside feedstock for later use after the proposed ban is lifted.

With the lightening of the slate and less need for waterborne crude oil imports, refinery dock space could be easier to come by than in normal times. Ironically, given these workarounds, a diesel export ban meant to cool US domestic retail prices may actually not have much of the intended impact.

A lighter slate across the USGC coastal refiners would keep MEH values supported and the increased demand on dirty vessels would keep regional freight bid up.

As a result, the WTI/Brent spread would need to continue doing the heavy lifting to keep WTI export arbs open. Either way, it is worth keeping a close eye on TD25 values.

Flows from the Red Sea and AG have been quite robust in September. According to Signal, September crude oil flows from the region are about 84% of what was seen in January and at the highest level since February.

With nearly two-thirds of these flows thought to be medium grades, it is no wonder that the Brent/Dubai EFS has widened back out.

Notably, we also saw AG-adjacent barrels get lifted this past week, as well as 1.2 mb of Nile Blend secured at a discount to Dated.

Despite more AG-sourced oil headed to Asian markets, we continue to hear about Asian buyers securing volumes from WAF or the Americas as a diversification or supply security measure.

(Asian markets are looking better supplied while European markets have to scramble)

Of the large September AG/Red Sea loadings, Europe is not expected to be a large beneficiary. Signal shows forecasted arrivals in Europe for September, about half of what was seen in August.

As our previous deep dives indicated, CPC and BTC rank fairly near the top of the list for individual grades as do grades from the USGC. WAF imports also look strong and come in just above local North Sea streams.

Digging deeper into the Signal data, we can see quite clearly the impacts of Hormuz closure in the y/y change in the type of crudes imported into Europe.

When AG flows recovered in June, we saw a decisive uptick in medium barrels arriving in Europe in July, but as AG flows fell again in July, medium-grade imports fell in August, leaving the region to depend more on light and heavy grades.

Directionally, we think the increase in light crude imports, at the expense of medium grades, fits well with our call for the US increasing exports of VGO if a diesel export ban is announced.

(Restrictions on Hormuz flows manifest as significant changes in import qualities)

Headlines over the weekend revealed that US President Trump has officially rejected Iran’s peace terms. Perhaps with the increase in oil transiting Hormuz this month, President Trump thinks he has the stronger hand at the negotiating table.

We also saw reports of Houthi missiles being repelled by Saudi defence forces. Both updates put us back on a more bullish footing, especially for the Brent market.

We made a call early last week to sell Dec WTI/Brent, and it reached our target of -$9.25/bbl later in the week. With the wider WTI/Brent, US crude export arbs are looking quite workable again into Europe, but freight is still too large of a hurdle to get all the way to Asian markets.

We will stay on the sidelines of WTI/Brent for the next few days to see what the White House will do with the potential export ban. We continue to stay long the Oct DFL as we see NWE as the tightest crude market.

(October DFL may still have another $5/bbl upside)