Diesel Demand Boosted Crude, But May Now Hurt It

Robust demand for diesel has helped fuel the oil rally since the end of August -- but the fuel's popularity could now hinder crude's further ascent.

The booming global economy has been driving demand for diesel and other so-called middle-distillate oil products, including fuel for trucks, jets and ships. More recently, arctic temperatures in the U.S. boosted the need for heating oil, another middle-distillate like diesel.

World demand for diesel rose to more than 28 million barrels a day in 2017, up from 27.5 million barrels a day in 2016, according to the International Energy Agency.

The price of diesel has soared by close to 30% since August, when hurricane damage to U.S. Gulf ports kicked off the fuel's comeback.

Meanwhile, the price of Brent crude -- the global benchmark -- has gained by a similar percentage and is now hovering near a three-year high of $70 a barrel.

But as the price of diesel has increased, refiners have rushed out more product and speculative investors have jumped in. That has raised concerns that diesel's price could weaken, putting pressure on crude, which it is refined from.

The oil rally can "by and large be traced back to the distillate markets, " according to Sabine Schels, head of commodities research at Bank of America Merrill Lynch.

"With refiners in max distillate mode and net speculative length at record highs, prompt prices could face near-term downside," meaning crude prices "would certainly struggle to move higher," she said.

Oil refiners responded to price gains by betting big on the fuel, churning out more diesel at the expense of other products. Distillate prices are more than $10 a barrel higher than gasoline, for which demand has weakened following the peak summer driving season in the U.S.

In the U.S., weekly net production of distillate fuel oil hit 5.5 million barrels a day in the last week of 2017, compared with 4.5 million barrels at the start of September, according to the Energy Information Administration.

Net long positions in diesel on the New York Mercantile Exchange rose more than 7,000 lots to 109,000 in the past week, the most bullish they have been since June 2006, according to Giovanni Staunovo, a commodities analyst at UBS Wealth Management. Speculative investors in any asset or security will typically move out much quicker than other buyers when its price begins falling.

"If diesel comes off the boil, crude would also come off the boil," said Stephen George, chief economist at KBC Advanced Technologies.

Oil-market observers mainly agree that falling diesel prices will at least halt crude's upward march in the short- to mid-term. But many other factors have contributed to crude price gains, and could temper a diesel-led reversal.

Oil has been boosted by a deal by the Organization of the Petroleum Exporting Countries and 10 other big oil producers, including Russia, to hold back crude production by nearly 2%. First struck in late 2016, the deal will carry through the end of this year.

Worries that geopolitical tensions in Iran and Saudi Arabia could eventually disrupt supply have also supported the price.

While refined products initially "led the rebalancing" of oil markets, crude is now "marching to its own tune," said James McCullagh, an oil products analyst at consultancy Energy Aspects, citing growing investor appetite for oil on the back of the OPEC cuts and geopolitics.

Until this summer, the price of diesel had languished for several years, even as oil was starting to climb. The price of Brent and West Texas Intermediate, the U.S. benchmark, have doubled since the height of the oil glut in early 2016.

Diesel was out of favor for much of that time. Relatively warm winters consigned many barrels to storage while Volkswagen AG's 2015 admission that it had rigged millions of diesel cars to cheat environmental regulators hit the fuel's popularity in Europe. The case ultimately revealed diesel engines as far bigger polluters than originally thought.

But increasing industrial activity spurred greater appetite for diesel, helping to drain inventories in the U.S. and Europe throughout 2017 -- and tying crude's fortunes with the fuel, according to KBC's Mr. George.

Write to Christopher Alessi at christopher.alessi@wsj.com

(END) Dow Jones Newswires

January 18, 2018 01:44 ET (06:44 GMT)