Europe is far from ready for Putin to start a diesel war
As the G7 embargo heralds a new supply crisis, the West will regret letting its refining industry shrivel
Europe has subcontracted an irreplaceable chunk of its refining capacity for diesel, fuel oil, and refined products to Vladimir Putin’s Russia. It increased this dependency after the first invasion of Ukraine in 2014 with scarcely a thought for energy security.
This has guaranteed another turbulent ordeal for European governments and societies as the G7 embargo on these refined fuels kicks in at the end this week.
Frantic buying before the deadline has ensured that we have enough stockpiles to cover the coming weeks. But once these are exhausted there is a very high risk that Europe will either have to ration diesel and other fuels, or face a supply crisis and a run on forecourts. We may be fooling ourselves that the energy crisis is essentially over.
It is possible to obtain diesel from the Middle East, India, or China, but the maritime infrastructure is not adapted to exports of refined products at such scale over such distances on those routes. The US cannot plug the gap in the way it has over recent months with liquefied natural gas (LNG). Europe has survived Putin’s gas war in relatively good shape – with American help and luck from mild weather – even if the squeeze has required a painful change in behaviour and the loss of some heavy industry.
Benchmark TTF gas prices are now marginally below pre-invasion prices. February contracts are today trading at €55 (£48) MWH, down from a peak of €342 during the panic last August.
Europe has entirely shrugged off the crude oil embargo imposed in December, perhaps because it is not yet in Putin’s interest to retaliate with an oil price shock. For now, the G7’s price cap on Russia’s worldwide sales is working like a charm. Urals crude is trading at a punitive discount of $46 on Asian markets. Comparable Brent futures are nearer $86. The Kremlin has not been able to muster a sufficient “shadow fleet” to evade the Western stranglehold on tankers and insurance. It is at last being starved of revenue. There is no internal bond market worth the name to fund wartime borrowing, so the budget deficit is starting to choke Putin’s regime.
However, the coming ban on diesel and refined products is more treacherous for Europe. These fuels are harder to replace. “Europe is a big ‘net short’ on refined products. It has too much gasoline and not enough diesel capacity. It is an historic mismatch,” said David Fyfe, the IEA’S former oil guru and now chief economist at the energy group Argus.
“It needs to import 3m barrels a day and it has been getting a third of this from Russia. How do you find 1m barrels a day of diesel supply? That’s where the pinch point is. We could see big shortages,” he said.
The market has already been under stress. The diesel “crack spread” over crude prices topped $45 in Europe earlier this month. “That is five times the normal level,” he said.
This lack of refining capacity exposes a fundamental failure – yet another – in European energy policy and strategic thinking. The region encouraged drivers to switch to diesel cars through tax incentives.
But it diverted efforts from direct injection technology that might by now have led to much more efficient petrol engines. It created a powerful vested interest with sunk costs that was determined to block the move to hybrids and electric powertrains.
What is extraordinary is that Europe bet so heavily on diesel while at the same time allowing its refining capacity to shrivel. The Kremlin drew the Europeans into this trap by offering Russian energy companies a lower tax rate on refined products. Yes, you can blame some loss of Europe’s refineries on EU carbon prices, which have rendered European plants ever less competitive and accelerated a shift into biofuels plants instead.
What should we now expect from Putin? Will he accept the strangulation of his energy revenues meekly? This is a war that he cannot afford to lose, says CIA director Bill Burns, a man who knows him very well. We should instead assume that Putin will strike when the conditions in the energy market work most to his advantage.
He is an opportunistic predator. He waited until there was an acute global gas shortage before launching his gas war in mid-2021. Today’s oil prices have been suppressed – up to a point – by the economic slowdown in the US and Europe, and by omicron in China.
That will change as China reopens fully in the early spring and Asian aviation rebounds, adding 1.6m barrels a day (b/d) to jet fuel demand. It will collide with a global oil market that has little spare capacity outside Saudi Arabia, and is tighter than it looks.
The Biden Administration has been disguising the true picture by releasing an average of 800,000 b/d from the US Strategic Petroleum Reserve, stretching executive power to prevent a Democrat meltdown in the midterm elections. That cannot continue. US shale cannot come to the rescue this time. The rig count is falling and the “good rock” is running out. Morgan Stanley expects Brent crude to hit $110 (£89) by the middle of the year.
There is a school of thought that Putin will engineer an oil shock with a cut in Russian production of up to 3m b/d, calculating that he can recoup on price what he loses on volume. Once the winter is over, the damage to Russia’s oil fields from throttling back output is less severe. But such a move would hurt oil importers worldwide.
Diesel and refined fuels are a better instrument of geopolitical pressure. Russia accounts for 6.5pc of global refining capacity. Putin can slash this instead, while letting his crude flow freely to India, China and Latin America for refining in their plants. That way he inflicts maximum pain on Europe without too much collateral harm to friends and neutrals.
Putin’s strategy has not changed. His goal is to set off an uprising of European societies against their own governments before his own capacity to wage war is undermined. He lost the first round of the energy contest in 2022. He may yet force a stalemate in 2023. Europe is going to rue the day that it so negligently let its refining industry go to the dogs.