Stocks of distillate fuel oil, which have been trending downwards all year, now look tight following disruption to major refineries caused by Hurricane Harvey.
The position is a marked turnaround from the start of the year, when distillate stocks were at record levels following the second warm winter in a row and a prolonged slowdown in freight movements since 2015.
Distillate fuel oil is used mostly for high-horsepower diesel engines in trucks, trains, barges and pipelines as well as some industrial engines, so demand is closely linked to manufacturing activity and freight movements.
Distillates are still used as heating oil for some homes, schools and commercial buildings, especially in the Northeast, though this source of seasonal demand has become less important in recent years.
By the second week of February 2017, distillate stocks stood at 170 million barrels, which was 8 million higher than at the same point in 2016 and 33 million above the 10-year seasonal average.
But a recovery in freight, coupled with a boom in oil and gas drilling, which relies heavily on diesel, and record exports to Latin America and other markets have steadily whittled away the surplus.
By the end of August, stocks had fallen almost 14 million barrels since the start of the year, were 5 million barrels below the corresponding point in 2016, and just 8 million above the long-term average.
Refinery outages in Texas and Louisiana following Hurricane Harvey have caused stocks to decline by another 10 million barrels since the start of September, leaving inventories looking tight with winter approaching.
Distillate stocks had fallen to just 139 million barrels by the end of last week, which was 25 million barrels below 2016 and 5 million barrels below the long-term seasonal average.
In response, futures prices for ultra-low sulfur diesel (ULSD) this winter have moved in a big backwardation since the end of August, reflecting concerns about scarcity.
The calendar spread between ULSD for delivery in November 2017 and April 2018 has swung from a contango of $1.40 per barrel in late June to a backwardation of $2.80.
Distillate prices have also moved to a significant premium over crude oil to encourage refiners to maximize crude processing and the yield to middle distillates rather than other products.
The refining margin for making distillate from US crude oil for November delivery has risen to $25 per barrel up from $19 in late August and $15 in late June.
The strengthening of both crack and calendar spreads was already well underway before Hurricane Harvey but accelerated significantly as a result of the disruption to refineries.
Hedge funds have amassed a net long position in heating oil futures and options equivalent to 46 million barrels, anticipating a further rise in prices. The current position contrasts with a net short of 32 million barrels in late June.
Portfolio managers have also accumulated a record net long position in European gasoil in the expectation that US diesel exports will be cut in the coming months.
US distillate prices are already rising to reduce exports and encourage refineries in the US and elsewhere to ramp up production.
The last two winters have been exceptionally mild in most of the US which has limited heating oil demand.
But if temperatures in the forthcoming winter are closer to the long-term average, distillate stocks could become very tight without very high refining runs.

Source: Arab News