Diesel stockpiles could derail crude's rally

neo_young

Diesel stockpiles could derail crude's rally

By Gregory Meyer in New York , Financial Times, 19 Oct 2009

For many months, crude has fluctuated between $65 and $75 a barrel even as other risky assets, from stocks to gold, have taken off.

But last week oil broke free, passing $75 for the first time in a year.

The rally continued on Monday, with the US crude contract for delivery in December, the most active, flirting with the $80 a barrel level after eight consecutive days of gains.

Analysts have taken note.

Barclays Capital, an oil bull, bid a "final farewell" to the "long, comfortable $65-$75 band and ... hello to the $70-$80 band".

Hopes that the worst of the economic crisis is over after better-than-expected third-quarter corporate profits in the US, the arrival of winter in the northern hemisphere when demand picks up, and a weaker US dollar have contributed to the surge.

Oil's nascent rally could, nonetheless, be washed out by rivers of diesel.

Demand for diesel, burned in trucks, locomotives and construction equipment, is an important reflection of economic activity. Yet while consumption should pick up as the economy recovers, big stockpiles of the fuel and others like it could keep the price of crude in check.

JPMorgan cautioned that "while we can justify the rally, we do not trust it".

In the US, stockpiles of middle distillates (which, alongside diesel, includes heating oil) are at their highest in decades. Europe faces a surplus of distillates so great that traders are booking tankers to store it offshore after running out of inland deposits.

The International Energy Agency, the industrialised countries' oil watchdog, says the volume of refined oil products in floating storage offshore Europe rose 25 per cent in September. In Asia, diesel stocks are rising fast, with inventories in the Singapore hub trebling since August to a record.

"The world has yet to come to terms with the massive middle distillate stock surplus," JBC Energy, the Vienna-based oil consultancy, says.

A quarterly statement from CSX, the US railway operator seen as a bellwether of the country's industrial and trade activity, points to weak distillates demand.

CSX locomotives used 18 per cent less fuel in the most recent quarter than in the same period a year ago.

Lower distillate consumption means less need for the crude from which it is derived and could translate into lower prices.

Chris Thorpe of Hudson Capital Energy, a New York options dealer that works with oil refiners, resellers and large manufacturers, says he has yet to hear of "any physical players seeing significant demand improvement".

Most analysts say oil demand will pick up in 2010 after two years of decline. US drivers are pumping 5 per cent more petrol – the other big oil product alongside distillate – than last year, according to official data.

But the diesel glut has forced refineries to shut down or scale back.

In the US, they were running at about 80 per cent of capacity, a rate that could fall to the 70 per cent range, Valero Energy, the largest independent US refiner, said last month.

The cutbacks will restrain the world's thirst for crude and cap surging prices.

"If you look at the fundamentals, we still have very high inventories. Refining margins are dire," says Sean Corrigan, chief investment strategist at Diapason Commodities Management, a $6bn asset manager in Lausanne, Switzerland.

"Demand seems to have stabilised. That's the best we can say," he adds.

Some analysts are confident oil prices are headed higher. A day before oil pierced $75 last week, Goldman Sachs said the market was "poised for a break-out", identifying goods shipped for Christmas from Asia to the west as the wild card that could rescue diesel demand and push oil prices higher.

"All indicators still point to a normal seasonal pick-up in shipping to retailers this year," the bank said.

Given Goldman's reputation as Wall Street's largest oil trader, some observers said the call was a self-fulfilling prophecy. The bank predicts $85-a-barrel crude by early next year and $95 by December 2010.

Deutsche Bank, which forecasts $75 crude for early 2010, says a steadily weakening dollar points to higher prices. Since oil is priced in dollars, a weaker US currency suggests a higher nominal price.

"It now looks like the dollar is driving oil prices once again," the bank said in a note. "The prospect of fresh lows in the US dollar will exacerbate this trend."

But even the most bullish analysts are not predicting a near-term price spike comparable to last year's run to almost $150 a barrel.

Opec's spare capacity is now more than 5m barrels a day, three times the amount estimated as crude spiked last year.

"As long as there's that much slack, there's no immediate need for oil prices to skyrocket in the spot market," says John Brynjolfsson, chief investment officer at Armored Wolf, a California-based global macro hedge fund.

The cartel has indicated it is satisfied with prices at around $80. Higher prices could encourage some members to flout official levels or even convince Saudi Arabia to push for a formal production increase at Opec's meeting in December.

Either of these moves would damp crude prices and derail the rally above $75 a barrel.