Depleted distillates threaten to reignite inflation

Global inventories of diesel and other distillate fuel oils are exceptionally low - meaning prices will surge higher again quickly if the economy avoids a recession in 2023.

Inventories have risen modestly from troughs in October and November 2022 as a result of increased exports from China and the worldwide slowdown in manufacturing and freight transport.

But stocks in most regions are still close to multi-decade lows and would deplete quickly in the event the manufacturing and freight cycle turns up again soon:

• US distillate inventories were -16 million barrels (-12% or -0.95 standard deviations) below the prior ten-year seasonal average on Feb 17.

• Europe’s distillate stocks were -41 million barrels (-10% or -1.43 standard deviations) below the ten-year average at the end of January.

• Singapore’s distillate inventories were -3 million barrels (-30% or -1.53 standard deviations) below the ten-year average on Feb 19.

• US jet fuel inventories (closely related to distillates) were -4.0 million barrels (-10% or -1.77 standard deviations) below the average on Feb 17, at the lowest seasonal level since 1996.

Middle distillates including jet fuel account for roughly a third of all global petroleum consumption (36 million barrels per day out of total global consumption of 98 million in 2019).

Distillate fuel oil is the workhorse of the industrial economy, providing the main fuel used in trucking, railroads, manufacturing, construction, mining and oil and gas drilling.

For the manufacturing and trade cycle to turn up without causing a rapid escalation of energy prices and reigniting inflation, there would need to be excess distillate inventories and spare capacity in the petroleum refining system.

Neither is currently the case. So far, the slowdown has been too short and too mild to result in significant inventory accumulation or leave much refining capacity idle.

At the end of the last three recessions, US distillate fuel oil inventories stood at 151 million barrels (April 2020), 163 million barrels (June 2009) and 139 million barrels (November 2001).

By contrast, inventories currently stand at just 122 million barrels, according to data from the US Energy Information Administration (EIA).

RENEWED PRICE SURGE

If the manufacturing cycle turns up in the next few months, fuel shortages and price increases are likely to emerge quickly, feeding through into renewed concerns about inflation.

China’s abandonment of its coronavirus suppression strategy and re-opening of domestic and international passenger aviation is likely to tighten supplies of jet fuel and distillates even further.

In 2007/08 and 2020/21, policymakers at the US Federal Reserve and other major central banks were prepared to ignore inflation driven by energy price rises by characterising it as transient.

But if energy prices drive inflation sharply higher later in 2023 or 2024, so soon after the worst inflation episode in 2022 for 40 years, it will be harder to ignore.

One inflation shock might be transient, a second starts to look permanent.

Policymakers seem to grasp this risk intuitively. Minutes from the last Federal Reserve monetary policy meeting held on Jan 31 and Feb 1 said: “A period of below-trend growth in real GDP would be needed to bring aggregate demand into better balance with aggregate supply and thereby reduce inflationary pressures.”

Interest rate traders expect the Fed to lift its target interest rate to 5.25% by December 2023, up from a forecast of a little over 4.50% a month ago and forecast of 4.25% at the end of the fourth quarter of 2022.

Rate rises and a period of sluggish growth if not an outright recession are the only way to create enough cyclical slack to avoid a resurgence of inflationary pressures later in 2023 and through 2024.

Part of that rebalancing will be a rise in distillate and other petroleum inventories, as well as the creation of enough slack in the refining system to permit margins to return closer to long-run levels.

So far, there has been only modest progress in rebuilding distillate stocks and defanging the inflation threat. Much more will be needed.

John Kemp is a Reuters market analyst. The views expressed are his own.