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Energy: Running Out of Cheap Seats and Diesel Markets are in the Crosshairs

Author: Brynne Kelly 8/21/2022

The last 12 months have played havoc with supply/demand balances in the global energy space. One thing is for sure, the space is truly global now. One fallout in this strange new world is there doesn't seem to be reasonably priced alternatives to cover marginal demand this winter season. Put bluntly, there is no obvious cheap seat left in the current environment should demand outstrip stockpiled supply for US natural gas. Substitution and fuel switching might be extremely costly this winter if needed.

Energy 'cheap seats' aren't so cheap anymore - fuel switching construct is constructive this year.

The ability to easily replace one energy source for another in power generation is reaching operational capacity limits. When assessing peak seasonal heating (and cooling) demand the construct of fuel-switching is A KEY DRIVER FOR CALCULATING PRICES. Prices for this winter's heating and fuel-switching criteria come from two main components:

  1. BASELOAD CAPACITY COSTS The generating equipment normally operated to serve demand on an around-the-clock basis

  2. PEAKING CAPACITY COSTS: the incremental energy unit needed to fulfill ORDERS? during periods of high demand.

These are familiar terms in electricity AND, are universal.

When demand is more than normal supply (including inventory reserves), generators (of electricity, refined products, etc.) look to buy the next lowest cost input to meet that marginal demand.

Using the criteria above, we contextualize the cost of resources used traditionally for heating as the winter season is on deck.

The resulting graph is the heat-content adjusted comparison of futures markets traditionally associated with heating homes and businesses in the winter for Western-hemisphere locations (aka, Europe, Asia, North America).

Winter 2022 Natural Gas and Distillate price comparison in US$/Mmbtu...

The difference measured by #1 in the graph approximates the cost difference between US natural gas at Henry Hub and European natural gas. That difference can be narrowed via increased US exports of LNG into global markets but is also limited by US liquefaction capacity.

The difference measured by #2 represents roughly the difference between NYH ULSD (diesel, basically) and global natural gas markets. ULSD, as a finished product, is less limited by export capacity than raw US natural gas and can be used both for home heating and electricity generation. Meaning that if/when operators in EU, UK or Asia are looking for less pricey alternatives this winter, they will most likely look at diesel which looks attractive relative to their local natural gas prices.

This is another new unknown in the pantheon of new unknowns this year. This year, diesel prices have the small but real potential to spike significantly from non-US demand. That is not typical. Why?

2022: Not Typical Fuel-Switching Calculus

This year on a US dollar per BTU basis, European and Asian natural gas and liquefied natural gas futures have moved into scarcity pricing territory relative to US diesel or natural gas prices, both of which can be used to not only generate electricity to heat homes and businesses but also are directly used for heating in their raw form.

To get a better handle on the difference this year, let's look at the same comparison on this date a year prior.

Winter 2021 Natural Gas and Distillate price comparison in US$/Mmbtu...

Historically, during the winter heating season, US diesel futures tend to price relatively close to those of their European and Asian natural gas/LNG counterparts as diesel is an alternative fuel that can be used to generate both heat and electricity in cold winter months. As a result, diesel (or 'heating oil') tends to price competitively at the margin with it's European and Asian gas counterparts.

Said another way, the price for winter molecules used to generate heat is traditionally capped by diesel prices and vice versa.

This year, however is an entirely different animal. European and Asian gas/LNG are being gobbled up ahead of the winter season over fears of the loss of supply from Russia continue. This is understandable as fuel switching between gas and diesel is limited in a majority of the world. However, its fair to say that if that marginal unit of diesel IS needed, the upper limit that generators or refiners will be willing to pay will have already been significantly raised.

We are now dealing with an international shortage in resources used to generate electricity (an heat) this winter. Substitution costs are much more codependent. The ceiling is now being set by Europe and Asia. And as a result diesel prices have become the 'cheap seat'. Wow, what a world. A closer look at diesel is in order to round this out.

Diesel Consumption

Oil prices have been on the decline, which are also pulling down diesel markets. This is understandable due to the volatile economic climate and recession fears. However, if we look a little deeper at the shape of the US diesel consumption curve, there is cause for concern.

2022 monthly diesel consumption is represented by the bright green bars above. The 5-year average monthly consumption (excluding covid 2020) is depicted by the black line. Notable is October's consistent increase in consumption. Why is this? Harvesting season is why.

U.S. distillate demand typically increases during the fall, when diesel-powered agricultural equipment is used to harvest crops. Fall harvest season in the region usually runs from late September through early November.

Notable in the above demand chart is the fact that diesel demand in October is fairly inelastic. Even in 2020 (light brown bars above), with the pandemic impact witnessed throughout the year diesel demand still showed up in October.

Yet when you look at inventory levels in the US, balances are running significantly behind those of prior years.

No one is yet rushing to re-stock given the current sell-off in prices. They are likely waiting for a price respite in the fall. Yet, as we have stated, some fall diesel demand has proven to be inelastic.

For those holding off on rebuilding inventories, be wary of the fall demand trend. Not only has diesel become the last cheap seat relative to natural gas and LNG, it also faces low inventory levels heading into the season. You may not be able to bank on diesel weakness in October.

That being said, so much of this is still weather dependent as we stated in last week's report:

...we are approaching the peak Known-Unknown season. Meaning, the market has defined the problems that loom, but it's too soon to tell how they will play out. On the Supply-side: We know consumers are at risk this winter if Mother Nature delivers an unusually cold one, but we don't know if she will yet.

IF we don't have a cold winter, the first prices to collapse will be natural gas and LNG. IF mother nature delivers frigid temperatures, the tails and the asymmetric risk to diesel prices are skewed to the upside.

Bottom Line

In the US, diesel handles much of the marginal needs for power generation in winter time. It is more expensive but not prohibitive. This year, due to protracted complications between Europe, Russia, and the US; global demand for NatGas outside the US prices trade at much higher prices than normal compared to prior years. If the winter is bad in Europe, those that can may switch over to diesel there. If that were to happen, US costs for marginal diesel fuel could skyrocket.

Right now with energy in a deep selloff, operators are holding back as much as they can on restocking and that may be smart. But October's demand for diesel is largely inelastic and therefore not really affected by slowing economies. Which brings us back to weather once again. The bears have a lot riding on this winter being a mild one here and possibly more importantly in the EU.


EIA Inventory Recap - Week Ending 8/12/2022

Weekly Changes

The EIA reported a total petroleum inventory DRAW of (14.30) for the week ending August 12, 2022. Commercial inventories however, posted a weekly DRAW of 7.10.

YTD Changes

YTD total petroleum EIA inventory changes show a DRAW of 157.00 through the week ending August 12, 2022.

Inventory Levels

Commercial Inventory levels of Crude Oil (ex-SPR) compared to prior years are have gone from way above historical levels to surprisingly below historical levels and should continue to flounder while backwardation in the market persists. The real 'worrisome' figure is distillate inventory levels.


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