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ANALYSIS: European diesel tightness widens backwardation to 3-year highs in January

European diesel market structure has rallied to a strong backwardation in January, widening further from December, as changing middle distillate yields and trade flows limit diesel supply.

Backwardation widens rapidly
Intermonth spreads in the ICE low sulfur gasoil futures — the key European futures benchmark for middle distillate markets, and indicator of market strength — have jumped since the beginning of 2022.

The outright value for the front month contract has also rallied to seven-year highs.

The prompt spread — February/March — was assessed at a three-year high at $13/mt backwardation Jan. 17, the highest since November 2018, having increased at a rapid pace from just 75 cents/mt on Dec. 31, 2021.

The balance-month to front month backwardation in CIF NWE ULSD cargo swaps reflected a daily backwardation of 39 cents/mt Jan. 18.

Despite the prompt structure of ICE low-sulfur gasoil futures weakening slightly on Jan. 18 with the February/March ICE LSGO backwardation reducing by 75 cents/mt to $12.25/mt and the March/April backwardation also narrowing by 75 cents/mt to $11.75/mt, traders remained bullish.

“[The strong backwardation] does reflect what is happening in the market; whether the exact value is correct is a tricky one,” a trader told S&P Global Platts Jan. 19. “On the supply side, it makes sense that the prompt is a bit pricey, due to lower production of diesel as a result of gas prices, and now high incentive to produce jet, while there are lower volumes arriving, and even small volumes departing Europe,” the trader said.

The trader added that the market did not expect this backwardation a month earlier.

Despite the weakening structure on Jan. 18, the outright value for the front month ICE LSGO contract continued to rise to a fresh seven-year high, assessed $3/mt higher on the day at $765.25/mt Jan. 18. This value is the highest since October 2014.

Tightening diesel supply
While demand for diesel across Europe remained reasonably steady, supply side fundamentals look set to tighten further in late January and moving into February. The import arbitrage flows are expected to dwindle and refiners were looking to adjust diesel production downwards, instead favoring the more profitable jet fuel.

The volume of ultra low sulfur diesel set to arrive in Europe from East of Suez markets in January totaled 859,300 mt as of Jan. 14, according to commodity firm Kpler data and shipping fixtures. This compared with just over 2 million mt that arrived in Europe in December.

Arrivals are expected to decrease further in early February, due to closing arbitrage economics, traders said.

In addition, imports arriving in Europe from the US Gulf Coast were minimal. The imports were expected at around 209,200 mt in January, according to Kpler data and shipping fixtures, with traders saying the arbitrage was closed.

Meanwhile, an open reverse arbitrage to send European diesel trans-Atlantic could reduce European supply further, with several tankers fixed on the route but total volumes set to move were unclear.

“At the moment we are seeing the market tight in Europe overall, cargoes headed trans-Atlantic and not much diesel production,” a second trader said.

Diesel production at European refineries has been hindered by poor cracking and desulfurization margins since the rally in natural gas and hydrogen prices from September. The two products are key components of the diesel production process.

However, the changing relationship between diesel and jet fuel crack spreads is set to lead to further diesel production cuts, as refiners are poised to swing output in favor of jet fuel.

This comes as physical cracks versus Brent hit two-year highs and jet fuel forward cracks settled above diesel cracks for the remainder of 2022, trading sources said.

The jet fuel physical FOB Rotterdam barge crack versus Dated Brent was assessed at $17.13/b Jan. 17, last assessed higher Nov. 6, 2019, before weakening to $16/b Jan. 18. The corresponding FOB ARA ULSD barge crack was assessed at $15.37/b Jan. 17, weakening to $15/b Jan. 18.

“There is less incentive to blend jet into the diesel pool, so it has totally changed the picture we were seeing the last few months… By the end of the month we will already see better jet supply, less diesel,” the first trader said.
Source: Platts

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