Fuel Supply Disruptions Threaten Global Economy
Middle distillates and natural gas are the energy forms hit hardest by events stemming from the war in Ukraine. The two fuels have been largely siloed by market analysts and even emergency planners. This is a mistake given their central role in economies — even if this often gets buried in the fine print of broader debates over monetary policy and the global availability of crude oil. Middle distillates and natural gas are both used heavily by industry in ways that aren’t easily replaceable, particularly in Germany and other manufacturing centers in Central Europe. Shortages of either — much less both — will hit manufacturing much more quickly and directly than a shortage of gasoline or even electricity. Cost increases for these fuels will also filter through more quickly into the price of manufactured goods. Economic policymakers, including those at central banks, need to take this into account, especially as both fuels also have winter demand peaks that will likely intensify the squeeze on their supply as autumn approaches and the EU implements a partial ban on Russian oil imports agreed this week.
It's hard not to notice the headwinds facing worldwide economic growth at the moment, from a complex mesh of factors that includes not just war-related fuel shortages in Europe but also ongoing pandemic-related economic closures in China, residual kinks in global supply chains, unpredictable weather, and central bank monetary tightening in the US and elsewhere aimed at undoing the inflationary effects of the other factors. Fear of recession is evident in erratically plunging stock markets, as well as government debt and foreign exchange gyrations. A slowdown is beginning to register even in performance data that come out well after the event.
When will that economic slowdown arrive in full force? How long will it last? What are the best policies for governments and central banks to use in trying to moderate the impacts, particularly on the low-income people who seem always to be hit hardest? Better answers will result if the energy dynamics are understood — dynamics that are always complex and much more so in the midst of a transition to a new energy system.
Unnatural Natural Gas Situation
For the moment, natural gas supply appears less constrained than some had feared, and sky-high spot LNG prices have eased somewhat. But such softening is mainly a result of upheavals in the Chinese economy over the last couple of months of fluctuating Covid-19 lockdowns. China’s LNG imports plunged by 35% year on year in April, while imports by normally more price-sensitive India dipped by just 5.4%, and LNG intake by Southeast Asian countries continued to rise, thanks to their relatively heavy reliance on oil-indexed LNG supply contracts.
While Europe has managed to rebuild gas inventories somewhat as a result, US stockbuilding is lagging and domestic gas prices are surging even as the country’s liquefaction capacity runs at full-tilt in response to European prices that are still at abnormal highs. Given gas’ central role in heating homes and larger buildings in both the US and Europe, both typically see a big winter peak in gas demand.
With inventories still low, this means US and European spot gas prices and spot LNG quotes worldwide are likely to rebound strongly by late summer or early autumn, once forward supply trading is for months that see heating demand.
Whether China will succeed in getting the Omicron variant of Covid-19 back in the bottle or will give up on its Zero-Covid policy after the Communist Party conference in October is impossible to say. But even if its LNG demand remains tepid, appetites will grow seasonally in Japan, South Korea and Taiwan as the weather cools, and there has not been adequate time to build up Europe’s importing infrastructure, much less global LNG supply. So a pinch seems certain to come. And national authorities in Germany and elsewhere have stated the obvious: households will get gas for heating as a priority, ahead of industry.
Distilling the Distillate Issue
Middle distillate markets had also calmed somewhat while Hungary delayed an EU decision to halt imports of Russian products and crude, with some diesel and other distillates making it to Europe from Russian refineries. How much that will change now that the EU has agreed to sanction Russian oil imports remains to be seen and will depend in large measure on how quickly purchasing of Russian products is reduced.
Mideast Gulf refiners have already stepped into the supply breach, as well, and US refiners are exporting at record rates. Nonetheless, inventories of diesel and similar products are at their lowest levels in well over a decade across Europe, the US, Singapore and other important trading and consuming hubs. This leaves diesel markets highly vulnerable to upsets like the EU's partial ban on Russian oil imports, as well as other factors, including hurricanes in the Gulf of Mexico, unexpected refinery outages anywhere outside Russia and resurgent demand in China if Covid-19 constraints continue to ease.
Soaring natural gas prices exacerbate the danger for diesel. What the potential is for fuel switching between gas and diesel globally is hard to quantify, but it certainly exists. Much of it is on the power generation side, where individual users may turn to diesel generators if electricity from the grid has to be rationed, but industry can also do some amount of substitution. If both fuels are in short supply, the results could be highly damaging, mainly to Western economies but also in developing countries that reach a point where they simply cannot pay soaring prices. Economic activity could fall sharply, taking distillate demand down with it.
Transition Impacts
Overlaying all this is the dampening effect the accelerating transition away from fossil fuels is having on energy industry investment in fossil fuel capacity. Oil has become a short- to medium-term economic proposition, and the tepid investment response to the war-related run-up in oil and gas prices — even from US shale oil and gas producers with their relatively short investment cycles — is a striking sign of how powerful that dampening effect is.
The rewards from the surging profits from oil and gas production and oil refining are going in disproportionate measure to investors in oil company shares, through whopping big jumps in dividends and share buybacks. More of it may be siphoned off by governments through windfall profit taxes, as is already happening in the UK. TotalEnergies and some other oil and gas firms are plowing some of the massive earnings into solar and other new energy projects.
Where the money does not seem to be going in large amounts is into producing and refining more oil and gas. Without assurances that Russian supply won’t come roaring back, and that the combination of recession and a ramp-up in renewables and EV utilization won’t curtail demand and send prices plunging in short order, the investment tap will only be open at a trickle.
And without Russian supply of middle distillates and natural gas to Western markets, the only way to cure the imbalances will be the economically painful destruction of a lot of demand for gas and diesel.
Sarah Miller is a former editor of Petroleum Intelligence Weekly, World Gas Intelligence and Energy Compass.