Deeper dive into VGO, diesel and base oil dynamics

Gabriella: Hi, everybody. Good morning. My name is Gabriella Twining. I'm the Global Editor of the Base Oils report, and we'll be discussing and exploring the relationship between certain oil products at the refinery level and how recent developments have impacted supply, demand, and, in turn, pricing. So, we often look at certain commodities and silos, and we sometimes forget how interconnected they actually all are, and we need to look at all the factors that impact the wider refining process.

So, today, we have Isabella Reimi, our reporter for vacuum gas oil or VGO, and the main feedstock for the oil products of which we are talking about today, including base oils, where we have Christian Hotten, our European producer, and Josh Michalowski, our diesel reporter. So, Isabella, why don't you kick us off and explain a little bit about what is happening right now in the VGO market in terms of supply, demand, and pricing?

Isabella: Okay. Thank you so much, Gabriella, for having me here. Yes, so on vacuum gas oil, which I might further refer to it as VGO, VGO prices since the start of the month of April have been coming down a bit. This has been an immense relief to the market because refiners have seen these prices rising since the start of the year. So, modestly, the price of VGO has come down. Still, it's really high in comparison to what it used to be. But you were asking me also about supply and demand, and the thing is that VGO and refinery feedstocks, really, they're very sensitive to refinery operations. So, if refineries are on maintenance periods or things like that, then they don't produce, depending on which units are down, enough feedstocks, or they might just not need enough feedstocks.

Gabriella: So, that's interesting because you were saying that VGO pricing is finally coming down, but still is at a higher level or a higher baseline level, we could say, compared to the previous year. Now, why is that? Do you mind delving a little bit deeper into those factors? Have there been structural changes to this?

Isabella: Yes. So, we really have to go back to the situation with Russia and the sanctions that were imposed because, really, Russia used to be the biggest supply in the global market of vacuum gas oil, VGO. That is because, as they had this enormous capacity, then they didn't care to refine or run and overrun their feedstock into, let's say, more profitable or finished products, and instead they exported that. So, they were responsible for nearly half of the global supply. And, of course, Europe, as being the neighboring continent, it was one of the biggest buyers along with the U.S. as well.

So, ever since that has been off the table. Most of the supply from Russia has been going to Asia at a very, very low price. But refiners in Europe have been in a competition for feedstock, and that is what really has made prices increase that much. Of course, then this second thought that I was telling you about in the introduction, if that is the base of our problems, then imagine that a lot of refineries just happen to be in turnarounds. Then, if crude distillation units, which are the primary units in the refining process are down, that's going to mean less PTO as a surplus for refineries to buy, and that's going to make prices increase a bit.

Gabriella: Okay. So, you're basically saying that the European VGO prices are now especially sensitive to any changes in supply, whether it be a refinery maintenance or outage. But you mentioned that prices have recently been decreasing slightly. Now, why is that?

Isabella: So, we have our regular and seasonal maintenance throughout the year. So, for instance, there is the spring maintenance, and a lot of refinery units might be right now just restarting. So that is one reason. And actually, when we see at base oil trackers, the supply of VGO in the month of April has doubled the supply in the month of March. VGO supply, which is just like internally traded from Europe to Europe, because of this lack of external providers or suppliers was very, very, very tight in the month of March. Now it is a bit less so.

Gabriella: Interesting. So, we've talked a bit about the supply of the feedstock. Moving on to a little bit further down in the refining process. How has this affected or has it at all the diesel market and pricing now that there's an influx or greater availability of the feedstock? Josh?

Josh: So, with the enough VGO supply, there are no constraints on the feedstock at the moment. So, there's no constraints from VGO output passing through to diesel output at the moment. But we have actually seen diesel values come down a considerable amount since the start of this month, mainly driven by market sentiment after President Trump's tariffs. Diesel values are actually very reliant on manufacturing output, and the general expectation is that uncertainty and higher cost directly from the tariffs themselves are gonna bring manufacturing output down, which are gonna bring demand down from industry, which in turn will bring demand for diesel down from trucking.

Over the last two years, we've also seen diesel demand generally just decrease, which has brought values down from what they once were. This is a structural change in the market. Generally, consumers are not wanting as much diesel as they used to. They're moving away from diesel cars towards hybrid cars and gasoline cars. And not only has Trump's tariffs brought the manufacturing market down, the manufacturing market in Europe itself is in a long-standing decline. You're seeing industry move abroad, and manufacturing output in Europe has been declining every month for a number of years now.

I think the third biggest factor on diesel prices in the last few years is the switch from imports of Russian product to product from other locations. Before the Russia-Ukraine conflict, Europe could source diesel from Russia very quickly and with a lot of ease, and now they're much more reliant on imports from the States and from the Mideast Gulf. We've actually seen in the last two or three months imports from the States decrease massively, like almost half from their monthly levels last year. Whether that will continue this year is disputed within the market. Some people think that U.S. flows will only return to the level that we once saw last year over a million tons a month. If there's a slowdown in the states, again, that's very speculative.

Gabriella: So, would you say that Europe is heavily dependent on U.S. diesel imports since the sanctions have been imposed on Russian diesel? How much as a percentage-wise would you say that Europe was dependent on Russian diesel? Was it similar levels to the VGO?

Josh: Europe got about 40% to 50% of its diesel from Russia. Now, some of that has been made up because Turkey now imports a lot of Russian diesel and exports their own product, but it's not near the same amount that it used to be.

Gabriella: So, VGO is extremely sensitive, as I've mentioned previously, to fluctuations and changes in output either from domestic European refineries or from imports. You were saying, if I get this correctly, that because of the drop in demand, and even we could even say retraction on European manufacturing, I believe the latest PMI numbers show that it's been consistently under 50, which implies contraction since July 2022. The demand for diesel means that because it's so low, the price will not fluctuate as much as with imports like VGO.

Josh: I think that's right. I think that the decline of demand is happening, but it's a more gradual thing, and that changes in demand aren't gonna be massive from month to month. You do see seasonal uptick with more people using the roads in summer. But because there's this big gap that's been created by the lack of Russian product now, if imports drop from like, say, the U.S. and the Mideast Gulf, that's really seen in the diesel market. We actually saw values firm quite a lot in February when U.S. imports and Indian imports were very low.

Gabriella: But you would say currently, right now diesel pricing is falling, or at least weakening because of the lack of demand?

Josh: Yes.

Gabriella: So that is very interesting. From the base oil side, we see diesel as a competing fuel. Christian, please elaborate a little bit more on what is happening in the base oil market in terms of pricing because I do believe we are seeing completely opposite trends.

Christian: Yes, you're exactly right, Gabriella. It's a different picture when we look at the base oil prices. So, first, if we look at what Isabella mentioned for the VGO prices, at the beginning of the year, we did start to see that base oil prices were increasing. Now this would inevitably be a knock-on effect from the higher feedstock costs, but also when we look at Europe, we see a tighter supply pool of Group 1 material because Europe is predominantly a Group 1 base oil player in terms of its nameplate capacity. For some point of reference, the nameplate capacity has been contracting over the last decade by about 55%, and multiple fires, some strike action, and the closure of a major refinery in the Mediterranean region reduced output by about 50% of its total nameplate capacity.

And moving into this year with the higher feedstock costs and a tighter supply pool, we have seen prices strengthen month on month. And when we look at diesel as well, there is a strong incentive to prioritize this base oil output, as I believe the premium of the SN150 Group 1 base oil holds at about $300 over diesel, and it's been this way for a few months, which has really incentivized refineries to look at this and say, "We're going to produce this base oil to capitalize on the demand that is there that is growing but also to be able to target higher margins as well."

Gabriella: That is because refiners have to look obviously at the refining economics to then decide which commodity that they will prioritize the output of because I believe historically diesel and base oils are produced when there is a certain margin that is reached, correct?

Christian: Yes, that is correct. It is at around the $100 a ton mark, and a refiner would look at this, the spread between diesel and base oils, and decide month-on-month on what to prioritize. And you would see that if diesel were to increase, then this would obviously narrow the price spread, and maybe they would look towards prioritizing diesel over base oil. But with what Josh has mentioned with this weakening demand that's taking place, and perhaps with some downwards pressure on the price as well, you will see this trend of a good incentive to prioritize base oil continuing. And with what Josh has mentioned with the weakening demand taking place in diesel and perhaps some downwards pressure on prices, it would just strengthen this incentive for the refiners to prioritize the base oil output.

Gabriella: Most recently, several European governments, most notably Germany, also the UK, have announced increased spending on defense but also infrastructure. Josh, do you see that maybe having a factor in terms of increasing diesel demand in the near future and reversing this trend?

Josh: I would say that was the expectation before the U.S. implemented its wide-reaching tariffs. As I mentioned before, diesel derives its demand from manufacturing output. Defense is obviously a huge portion of manufacturing. People would have expected a slight uptick in demand. But now because of the tariffs, the majority of the market thinks that any boost in manufacturing, and therefore diesel demand is gonna be entirely offset by essentially decreased firm confidence and a lack of confidence because they don't know the policy environment, they don't know whether the president is gonna implement more tariffs, is gonna remove the tariffs. They simply don't want to invest, and investment is what boosts manufacturing output, essentially. So, people expect any boost to be totally offset.

Gabriella: Yes, and also it would seem a little bit ironic, given that refined products are exempt from the tariffs but it is all knock-on and associated industries and sectors that are being affected. For example, imports of automotive parts and cars are being hit quite drastically with these tariffs, which could also further weigh on, would you say, diesel demand, but also base oils as they are the basis for all finished lubricants?

Josh: Certainly. I think the fewer cars are made, the less diesel is needed to fuel those cars, and obviously also less manufacturer of cars is gonna bring diesel demand down. I think another point that should definitely be considered is that Trump has kept these huge tariffs on pretty much every good from China. China is gonna have to look towards other markets to export its own goods, which are gonna come in very cheaply, and are only going to depress domestic manufacturing in the regions in which it exports to.

Gabriella: Exactly. And there has also been an impact on these harsh tariffs and reciprocal tariffs with China on base oils recently, would you not say, Christian?

Christian: Yes, and the main impact's been on the polyalphaolefin, otherwise known as PAO. And the main reason that this has been impacted is because the PAO market is fairly illiquid compared to the base oils market in terms of the actual volume that's in Europe. What we've seen as a result of these tariffs is Chinese buyers to get their hands on this material have looked towards the European market and adding further demand to soak up these already fairly limited supplies. And this has created tighter supplies of PAO in the European market and leading to European buyers also more wary to secure supplies as well, adding a bit more drama in this market, especially. And also another knock-on effect is that, because of this tightening PAO market in Europe, due to this demand coming from China, we're also seeing a tightening of the Group 3 and Group 3 Plus markets also because what can happen as a blender with the introduction of some additives to this base oil as well, you can use that as an alternative to PAOs. And as a result, we are seeing a little bit more contraction on the Group 3 due to this new demand coming from China.

Gabriella: Very interesting, especially as I believe the U.S. makes up 30% of PAO global production. So that essentially has exited to the market, and why Chinese producers are looking for more European-origin product. Focusing a little bit more on Europe, most recently we have seen that there's been a major power outage affecting southern Europe, especially Spain. And as we've talked about in great detail how sensitive the VGO market is to sudden shocks and factors that affect production, has there been an impact, if at all, or that you can see on the market, Isabella?

Isabella: Well, right now, on the first day of the outage, or the day in which the outage lasted, it was not a direct effect also because of this lack of supply. Sometimes you have to give it the market a little bit of more time to absorb the news in order to do your proper price discovery. Actually, what we know as background information from the experience that we have had with other power outages is that, once the refinery is put on a safety mode, their units, then it takes from two to three days to restart. So, certainly some of the offers that had been done in the VGO markets that were very prompt offers are surely going to be affected by this in terms of probably some things being delayed if refineries struggle to get their barrels out of the refinery and take it to the ports.

Gabriella: Josh, the same question, has there been an immediate impact that you can tell so far with these outages or not?

Josh: I think it's probably too soon to say. I mean, there almost certainly will be an impact, but it's too soon to say exactly what that impact has been. But decreased refining output is only gonna tighten the diesel market. I know Spain sends around 300,000 tons a month of diesel and other gas sold to the rest of Europe. So, even if that's missing for just a few days, the market will definitely see an effect from it.

Gabriella: Interesting. And, Christian?

Christian: Yes, we've certainly seen an impact on base oils as well. So, the two main base oil producers in Spain have been affected. And as I mentioned earlier with tighter Group 1 supplies in the European market, this outage is somewhat amplified because, with buyers already looking around to see where they can source supplies, this also is another region that would be somewhat cut off from them being able to get their hands on volumes. Although this outage has affected Group 1, 2, and 3, predominantly Group 1, again, in Europe, but it's another dynamic that's taking place that's making it quite difficult to really get your hands on Group 1 material in Europe.

Josh: Just to add that the power outages has caused every refinery in Spain to halt operations. And like Isabella said, that there will be at least a two or three-day startup time because of this halt.

Gabriella: So, quite a major outage affecting one of the main producers in all three markets here.

Isabella: Yes, Josh, that is right. There are seven refineries in Spain. Spain is a major producer, five of which are owned by Spanish Repsol, and the other major two are owned by Cepsa and Moeve. And as we're speaking, I'm reading on Argus Direct that Spain's well-based refinery is going to start their hydrocracker maintenance. So, that's something to keep in mind, right? Like these unplanned things happen, but then the planned turnarounds are still on a schedule. And these refining companies, they pay a lot of money to keep on their operations as planned.

Gabriella: So, in all, it's looking like supply is set to tighten quite considerably with these unplanned outages, planned maintenances, and might have an impact on prices reversing somewhat the downward trend in VGO and diesel at this moment?

Josh: Yeah. I think that refinery outages in Spain more likely push prices up. There's also gonna be support from seasonal demand increasing and a lot of Russian refineries, despite Russian product not entering directly into Europe, there's still the kind of knock-on through Turkey. A lot of Russian refineries are gonna be entering maintenance as well. So, that's another element of the market that will be tightening in the coming months.

Gabriella: So, we've mentioned the impact of unscheduled outages, inevitable scheduled maintenances. Base oils, we touched a little bit upon permanent closures and the impact that that has had on availability and pricing, but there are more permanent closures that are happening in the refining landscape in Europe at this moment, correct?

Christian: Yes. So, I think the big one that took place last year would be E&I's 600,000 tonne a year Group 1 base oil unit. But what we've seen, and this adds to a kind of geographic element of the power outage in terms of tight supply in this region is Motor Hellas, and Corinth is still operating at a reduced production capacity. So, MOH or Motor Oil Hellas and Corinth is currently operating at a reduced production capacity due to a fire that broke out last year. And if we look at a broader refining landscape, Josh, I believe, you can touch on this.

Josh: Around this year, around 400,000 barrels a day of capacity is scheduled to shut. We know that Petroineos' Grangemouth refinery in Scotland has started its wind-down. Shell has shut the vesseling refinery in Germany, and a third of the capacity at BP's Gelsenkirchen refinery, also in Germany, will shut later this year.

Gabriella: The vesseling is good news from the base oil side of things, as it is actually converting to a much-needed Group 3 unit.

Christian: Yes, and emphasis on the much needed, there is a reliance on import flows of Group 3 for Europe, and this adds a domestic output for Group 3 material, which is very important at the moment when we look at the Group 3 landscape because European prices have been falling quite aggressively due to an oversupply and a strong import flow of this Group 3 material from the Mideast Gulf. And projects such as this can at least add some further capacity inland that can cater to this growing demand as the industry shifts more to premium base oils such as Group 3, and this is an ongoing trend that Shell's conversion will time nicely with this growing movement towards premium base oils.

Gabriella: Well, thank you, everyone. This has been a very interesting discussion to show the interconnectedness between each of these commodities and how structural changes, especially regarding closures, wider closures in Europe and the exit of Russian oil products coming towards Europe is really impacting prices as well as wider manufacturing or lack thereof, and a contraction within the European economic landscape. So, thank you, all, and thank you for your time.