Blowing Smoke About Diesel
There is a huge amount of hysteria going on about the diesel market. Tucker Carlson is prominent in flogging this as an impending disaster:
Like so much of Tucker these days, this is an exaggerated, bowdlerized, and politicized description of what is happening. There is a kernel of truth (more on this below) but it is obscured and distorted by the exaggerations.
First off, it is complete bollocks to say “in 25 days there will be no diesel.” Current inventories–stocks–are about equal to 25 days of consumption. But production continues, at a rate of about 4.8 million barrels per week. So, yes, if US refineries stopped producing right now, in 25 days the US would be out of diesel. But this isn’t France! US refineries will keep chugging along, operating close to capacity, supplying the diesel market.
Stocks v. flows, Tucker, stocks v. flows.
Yes, by historical standards, stocks are very low, although there have been other periods when inventories have been almost this low. But low stocks are not a sign of a broken market, or of impending doom.
Low stocks do happen and periodically should happen in a well-functioning market. That is, “stock outs” regularly occur in competitive markets, for good economic reasons.
Assume that stock outs never occurred. Well that would mean that something was produced but never consumed. That makes no economic sense.
The role of inventories is to buffer temporary (i.e., short term) supply and demand shocks. I emphasize temporary because as I show in my book on the economics of storage, storage is driven by scarcity today relative to expected scarcity in the future. A long term demand or supply shock affects current and expected future scarcity in the same way, and hence don’t trigger a storage response. In contrast, a temporary/transient shock (e.g., a refinery outage) affects current vs. future scarcity, and triggers a storage response.
For example, a refinery outage raises current scarcity relative to future scarcity. Drawing down on stocks mitigates this problem. For an opposite example, a temporary demand decline raises future scarcity relative to current scarcity. This can be mitigated by storage–reducing consumption some today in order to raise consumption in the future (when the good is relatively scarce).
To give some perspective on what “short term” means, in my book, I show that for the copper market inventory movements are driven by shocks with a half life of about a month.
Put differently, storage of a commodity (diesel, copper) is like saving for a rainy day. When it rains, you draw down on inventories. When it rains a lot for an extended period, you can draw inventories to very low levels.
And that’s basically what has happened in the diesel market.
Carlson is right about one thing: the Russian invasion in Ukraine precipitated the situation. This is best seen by looking at diesel crack spreads–the difference between the value of a barrel of diesel (measured by the Gulf Coast price) and the value of a barrel of oil (measured by WTI):
Although the crack was gradually increasing in 2021 (due to the rebound from COVID lockdowns) the spike up corresponds almost precisely with the Russian invasion. After reaching nosebleed levels in late-April, early-May, the crack declined to a still-historically high level and roughly plateaued over the summer, before beginning to widen again in September. This widening is in large part a seasonal phenomenon–heating oil (another middle distillate) demand picks up at that time.
In terms of storage, the initial market response made sense. The war was expected to be of relatively short duration. So draw down on inventories. However, the war has persisted longer than initial expectations, and the policy responses–notably restrictions on Russian exports, including refined products to Europe–have also taken on a semi-permanent cast. So the shock has endured far longer than expected, but the (rational) response of drawing down on stocks has left us in the current situation.
To extend the rainy day example, if you don’t expect it to rain 40 days and 40 nights (or for 9 months) you will draw down on inventories and you’ll go close to zero if the rain lasts longer than expected. That’s what we’ve seen in diesel.
As in any textbook stockout situation, price will adjust to match consumption with productive capacity. Inventories will not buffer subsequent supply and demand shocks, meaning that prices will be pretty volatile: storage dampens volatility.
I should note that low inventory levels can create opportunities for the exercise of market power–manipulations/corners/squeezes. So it is possible that some of the price and spread moves in benchmark prices may reflect more than these tight fundamentals.
Hopefully the hysteria will not trigger idiotic policy responses. The supply shock has been most acute in Europe (because it consumed a lot of Russian middle distillate). This has resulted in a substantial uptick in US exports (diesel and gasoline) to Europe, which has led to suggestions that the US restrict exports, or ban them altogether. This would be beggar–or bugger–thy neighbor, and would actually feed the recent narrative advanced by Manny Macron and others in Europe that the US is exploiting Europe’s energy distress.
Further, this would reduce the returns to refinery capital, reducing the incentive to invest in this sector–which would be a great way of perpetuating the current scarcity.
But this administration, and in particular its (empty) head, somehow think returns to capital are a bad thing:
Believe it or not, there are even worse proposals than export bans, windfall profits taxes, and restrictions on returning cash to investors bouncing around. In particular, supposedly serious people (who travel in the best of circles) like Columbia’s Jason Bordoff are suggesting nationalization of the US energy industry.
Yeah. That’ll fix things.
What we are seeing in diesel (and in other energy markets as well) is their efficient operation in the face of extreme supply and demand shocks. You may not like the message that prices and stocks are sending–that fundamental conditions are really tight–but suppressing those signals, or other types of intervention like export bans–will make the situation worse, not better.
And yes, energy market (and commodity market generally) conditions should definitely be considered when evaluating how to handle Russia and the war in Ukraine. But that evaluation is not advanced by hysterical statements about the nation grinding to a halt at Thanksgiving because we’ll be out of diesel.
Great stuff, why not just look at the diesel time spreads – not cracks – for a signal for inventories drawdowns? I would be curious to know if anybody can derive time spreads as a form of shadow prices of an inventory optimization problem.
Comment by Distyguy — October 29, 2022 @ 12:26 am
US produces ~4.8 million barrels daily, not weekly
Comment by The Brick — October 29, 2022 @ 6:37 am
I don’t want to be fair to Jason Bordoff, who seems to me to be a bit of a plonker. But here goes.
He makes the point that the transition to moonbeams from cucumbers will mean a lot of stranded assets. That is, oil or gas field investment based on a 20-30 production timescale, will become unviable if investors expect the government to shut them down prematurely. So the energy crunch is simply brought forward unless the government does something.
He thinks the solution is nationalisation. My preferred solution is a contract that says you can exploit your gas field legally as long as it produces gas.
It’s regulatory uncertainty that has crippled O&G investment, not costs or prices.
As for Europe, you would have to have balls of steel AND some very good lawyers to go into onshore exploration nowadays.
Comment by philip — October 29, 2022 @ 5:00 pm
Rather than nationalising Shell, or BP, or Exxon, why not sell countries to those companies? No doubt Shell could run Germany better than the Germans do, BP could run Britain, and Exxon the US.
The Robber Barons would cheer from their graves and the populations would have less to complain about. Soon revolutionary groups would be scouring the world for lesser oil companies to sell their countries to.
Comment by dearieme — October 29, 2022 @ 6:13 pm
@dearieme
Exchanging one vast and sclerotic bureaucracy for another. What would be the point of that? Shareholder democracy is even less effective than the ballot box.
Comment by philip — October 29, 2022 @ 6:18 pm
@Phil: culture. The bureaucrats in oil companies learnt their jobs in a firm that has to compete to survive, and competes partly by technological prowess. No civil service has that culture. (Even Singapore’s?)
True, after a couple of generations the culture would have died and another wheeze would have to be found.
Comment by dearieme — October 30, 2022 @ 5:42 am
Excellent analysis of market dynamics, Prof, as usual 🙂
Comment by Simple Simon — October 30, 2022 @ 11:52 am
You’re right. Weekly EIA data in bbl/day.
Comment by cpirrong — November 1, 2022 @ 11:55 am
@Distguy. Yes time spreads are an indicator of inventory drawdown, but the crack is a measure of the tightness in refining, which was what I was referring to: given the drawdown, it is refining capacity that will balance the market now.
And yes, I have (in my book) modeled time spreads as shadow prices in an inventory optimization problem. (Available on Amazon!) In essence, the non-negativity constraint on inventory gives rise to a Lagrangean/shadow price. (Others, notably Brian Wright and Jeffrey Williams in their book, have taken this approach. It is an alternative to convenience yield, which I detest.)
BTW, the XZ22 spread blew out in October: it went from under 10 cents/bbl to over 90. The movement in the spread doesn’t correspond with any noticeable tightening in inventories. PADD1B inventories actually went up slightly over the month.
Comment by cpirrong — November 1, 2022 @ 12:26 pm