October 2, 2023

Backwardation drives European Gasoil imports to 11-month low

European Gasoil imports have fallen to an 11-month low, despite this being the peak demand season. A mild winter in most of the region has combined with faltering demand recovery, meaning just 7.5 million tonnes were imported in January 2022. The backwardation in the Brent crude forward curve has also played a part, making arbitrage uneconomical, and stifling re-supply.

Despite a forward curve suggesting that there is significant strength in the European Gasoil market, imports to the region have fallen to 11-month lows even during the current peak winter heating oil demand season. The question of whether reduced flows have caused the strength in prices, however, is a complex one. Underlying all product curves, of course, is the crude oil forward curve. In the case of ICE Gasoil in Northwest Europe, the underlying curve is Brent crude.

Front-month spot Brent crude prices have been on a steep trajectory since the middle of 2021, reaching peaks in early 2022 that have not been seen in several years. The deferred months have struggled to keep pace with the physically-driven front of the curve, and steep backwardation has been the result. This strength and even shape of the curve are replicated in that of ICE Gasoil.

Daily Brent prompt (m) minus m+6 spread ($/bbl) - Source: NYMEX

Arbitrage flows from traditional supply centers have been stifled by poor economics for long haul voyages

Arbitrage barrels from the Mideast Gulf or even as far afield as East- and Southeast Asia would normally be expected to meet the apparent surge in demand in northwest Europe, bringing the structure down to more rangebound levels, but the backwardation in month 1 versus month 2 is so steep (22.50 usd/mt on Friday 4th February), that it is precluding traders from making the move. Cargoes loading in the Mideast Gulf in mid-February will mostly arrive after the expiry of the March contract, and will therefore be traded under a new, later, and lower-priced futures contract. At present, physical premiums are not compensating sufficiently for the backwardation.

This weakness in the prompt physical Gasoil market is causing traders to question the implied strength in the first time-spread on the forward curve. If the fundamentals of the market are strong, as the backwardation implies, then why is the premium for spot prompt physical ICE Gasoil barges relatively weak? The implication is that a mild winter may mean a reduced requirement for arbitrage barrels at an earlier time than in most years.

4Q21 flows were strong as traders pre-empted a strong demand season

Imports defied the backwardation to an extent during 4Q2021, averaging 9,316 kt, 10% higher than the whole year average of 8,491 kt per month, but subsequently crashed to just 7,455 kt in January 2022. This was the lowest monthly import total seen since March 2021 when 7,213 kt were imported. It is normal for totals to recede once the peak of the winter demand season has passed and the market expects surpluses to build, or if inventories are reported to be robust, but a fall in January imports is unusual.  

Imports in the last quarter of both 2020 and 2021 were higher than their full-year averages, bringing into question the notion of a “pre-season season”, as is often seen in the US gasoline market well before Memorial Day, the traditional start to the US driving season. In that scenario, traders anticipate a surge in gasoline demand in April and ensure that their tanks are full to either maximize profit in a rising market or to avoid being caught short of stock and being forced to pay elevated prices for prompt physical product. A similar phenomenon may now have developed in the European Gasoil market with traders stocking up well in advance of the peak winter heating oil season.

Monthly NWE gasoil/diesel imports by origin continent (kt) - Source: Kpler

Ongoing tepid clean products demand recovery seen in most parts of the world, including Europe to an extent, along with a mild winter in most places, have combined to create a scenario of relative prompt physical weakness, despite the shape of the forward curve. Just as expensive for the trader that imports Gasoil into a backwardated market are the losses incurred by holding the product in tank. So, not only is the trader at risk of importing product into a weaker futures contract month, even if a willing prompt buyer can be found, but the danger of holding the product for even longer than expected and falling foul of further backwardation is clear. Of course, if the current physical weakness persists, there is the potential for the first time-spread to weaken further and for contango to emerge, but with the shape of the underlying Brent curve, this appears unlikely.

Imports from the Mideast Gulf have seen the biggest decline

While imports from Russia and the former Soviet states have remained relatively stable, the hardest hit have been imports from the Mideast Gulf. European imports from Russia averaged 3,264 kt over the first three quarters of 2021 and held at 2,905 kt in 4Q. January imports were 3,064 kt. Imports from the Mideast Gulf, however, have fallen by 30% in January from the 4Q21 average of 830 kt to 584 kt, although this was in line with the whole year 2021 average of 561 kt. Imports during February are expected to climb from the currently predicted 329 kt, although the combined economics of arbitrage and backwardation are not favorable so the risk of low supply still remains while the backwardation is so steep.

Total Mideast Gulf exports fell to a 12-month low in January, managing just 2,452 kt against an average of 3,089 kt in 2021. Exports to Europe fell by 56% m/m from 671 kt to 296 kt, and exports to Africa also fell by 56%, a decline of over a million tonnes from 1,811 kt to 801 kt. Total Saudi Arabian exports fell from 1,306 kt in December to 916 kt in January, while exports from the UAE fell by 47% from 959 kt to 508 kt over the same period. Neither country experienced significant refinery maintenance over the two-month period, so the fall in exports may simply have been due to the poor economics of arbitrage forcing a reduction in refinery throughput.

With the potential for the weakening of backwardation with the imminent expiry of the February ICE Gasoil contract, however, imports into Europe are expected to rise, despite the peak demand season having already passed. This will be supportive of all suppliers to Europe, not least the giants of the Mideast Gulf.

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