No stone left unturned

_{The looming European ULSD problem is set to spark some creative refining, with an unexpected winner emerging}.

What can European refiners do to address the looming physical shortage of gasoil as Europe prepares to ban Russian product imports? Although European diesel demand softened across the board over Q4-22, according to incoming data from JODI and national statistics, we remain far from demand destruction territory. Meanwhile, December and January have seen some of the largest volumes of ULSD departures to Europe on record, with both Russian and European majors going for a last hurray on product trade, a pick-up in flows that has also intermittently helped ARA inventories add almost 4 Mbbls since the end of November (see chart).

_{ARA Gasoil stocks in independent storage (Mbbls)}

While tepid demand and high imports has helped inventories recover, we are still talking about the halt of a flow in the region of 700 kbd of ULSD between Russia and Europe, undoubtedly set to cause ripples in product markets soon. There has been a lot of talk about the launch of Al-Zour's and Jizan’s secondary units, with a general redirection of Middle Eastern ULSD molecules towards Europe slated as a potential solution to the European gasoil conundrum. The start of the year, however, has proven challenging for both setups to produce on-spec diesel. Whilst the US managed to ramp up ULSD exports to Europe in December, a sustained solution is still out of sight, with US product balances tilting towards tight territory (see here and here). Nonetheless, there might be a partial alleviation on the cards.

Namely, we have more recently seen a pick-up in gasoil (not ULSD) exports to Europe, with high-sulfur gasoil (HSGO) reaching a multi-year high in December. While distinguishing product grades on vessels is admittedly a Herculean task, we also suspect that the amount of off-spec diesel flowing to Europe might be currently underestimated. Indeed, since discounted Russian barrels are increasingly finding their way into Middle East’s traditional export market for gasoil/diesel there will be increasingly more off-spec (for EU standards) gasoil barrels searching for a home over the weeks ahead, a potential feast for Europe’s refiners. Moreover, we should point out that as the new capacities in the Middle East are struggling to produce on-spec diesel, there will be an uptick in off-spec diesel exports.  

This means that some European refiners can snatch the off-spec gasoil barrels and further hydrotreat them to ramp up on-spec diesel production, something which data suggests has started to take place already (see above). Indeed, with total middle distillate hydrotreating capacity of around 6 Mbd in EU-27 and UK and assuming typical utilization rates of around 80% (even assuming a bit higher rates recently), there is still the technical capability for a lot of setups to ramp up utilization rates by some 5-10pp and capitalize on the looming (further) widening of gasoil sulfur spreads. In turn, this can solve part of the looming ULSD problem, potentially helping to shave off around 100-200 kbd of European ULSD import requirements.

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