U.S. distillate fuel oil inventories have fallen to the lowest seasonal level for eight years, a sign of booming manufacturing and freight transportation demand.

Distillate shortages are another manifestation of the supply chain bottlenecks that are fueling inflation around the world as the economy expands rapidly after the coronavirus recession.

Low distillate inventories will boost demand for crude oil and are likely to put upward pressure on prices over the next few months as refiners and distributors try to rebuild them to a more comfortable level.

Stocks fell by more than 2 million barrels to just 123 million barrels over the week to Jan. 28, according to data from the U.S. Energy Information Administration (“Weekly petroleum status report”, EIA, Feb. 2).

Inventories were 26 million barrels (17%) below the pre-pandemic five-year average and at the lowest level for the time of year since 2014 and before that in 2005.

Most distillate fuel oil is used in manufacturing, freight transport, mining, farming and within the oil and gas industry itself as well as heating homes and other buildings.

Of all petroleum-derived fuels, distillate consumption is, therefore, the most highly geared to the state of the manufacturing and freight cycle.

Distillate stocks have been trending down since the middle of 2020 and fell below the pre-pandemic five-year average for the first time in the middle of 2021.

They have tracked the recovery in manufacturing, which started to recover from the middle of 2020 and moved above its pre-pandemic level in mid-2021.

The U.S. manufacturing expansion has begun to decelerate but the sector is likely to continue growing for at least the next 12 months.

Distillate consumption is set to continue rising which will put downward pressure on inventories and upward pressure on refining margins and crude prices.

U.S. refining margins for producing low-sulfur diesel from imported crude oil are already running at the highest level since 2008.

In Europe, gas oil margins are close to the highest level for a decade, showing strong demand and low stocks of distillates are a worldwide phenomenon.

As a result, hedge funds have become increasingly bullish towards distillates boosting their combined position in the U.S. low-sulfur diesel and European gas oil contracts by the equivalent of 54 million barrels in the last six weeks.

Bullish long positions now outnumber bearish short ones by a ratio of more than 5:1, in the 82nd percentile for all weeks since 2013, reflecting a widespread expectation that distillate prices will continue climbing.

Distillate shortfalls will continue to exert upward pressure on oil prices until Saudi Arabia and U.S. shale producers raise their output faster, or more likely until the economy enters a slowdown.

About the author: John Kemp is a senior market analyst specializing in oil and energy systems. Before joining Reuters in 2008, he was a trading analyst at Sempra Commodities, now part of JPMorgan, and an economic analyst at Oxford Analytica. His interests include all aspects of energy technology, history, diplomacy, derivative markets, risk management, policy and transitions.

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