By Laura Sanicola

(Reuters) -U.S. supplies of fuels such as diesel and heating oil have dwindled and refiners are having trouble replenishing that supply, which could keep prices elevated for months.

Demand for distillates has been running ahead of pre-pandemic levels for months on strong manufacturing and trucking activity and more exports to Europe. However, production has not kept up as some refineries have closed since the coronavirus pandemic began while others put off maintenance.

The situation has fed inflation for consumers and end users, and analysts say higher costs could persist as refiners find it harder to make enough products.

As of Thursday, heating oil futures were priced at $2.83, the highest price in seven years.

Fuel availability is already being tested by frigid temperatures cutting across much of the United States and expected to persist for days. That has boosted demand for natural gas power generation, and some utilities in the path of the cold are preparing to use more distillate fuel oil to meet demand.

U.S. distillate demand in 2021 has been running at about 5% above pre-pandemic levels, putting inventories at 15% less than the five-year moving average https://graphics.reuters.com/USA-DISTILLATE/lgpdwxordvo, according to U.S. Energy Information Administration data. U.S. East Coast stockpiles are at their lowest since April 2020.

When inventories are low, refiners generally respond by ramping up output. However, global refining capacity shrank by more than 2 million barrels per day during the pandemic, while U.S. refining capacity last year fell 4.5% to 18.1 million barrels per day (bpd), according to federal data.

U.S. refiners are still running plants at lower rates than the five-year average to avoid producing too much jet fuel, where demand still lags 2019 levels.

“We actually don’t see a clear path in the near future to be able to restock diesel inventories,” said Gary Simmons, chief commercial officer at Valero, during the company’s earnings call last week.

The national average price for diesel was lately at $3.78 per gallon, highest since September 2014. In places like New England, oil-fired generation is surging, which could raise prices more. According to grid operator ISO New England, oil-fired generation was at 11% on Friday, with colder weather on the way.

Prices should ease as winter subsidies and demand for heating fuel drops off, allowing inventories to build again, according to Troy Vincent, senior market analyst at researcher DTN Markets. But if the cost of crude oil used to make distillates remains high, fuel prices might remain elevated.

“There are these unique dynamics this winter that have helped pressure inventories, so it’s hard to get a read on what the fuel market will look like in the spring,” said Vincent.

MARCHING BACKWARDS

Expectations for sparse distillate inventories have pushed the heating oil market into backwardation, a market term for a situation when current prices are higher than expected future prices.

Several traders with lucrative long-term diesel storage contracts are choosing not to renew them because there is no financial incentive to store diesel, traders said.

Traders make money from May through February, paying to store distillate fuels in return for selling them when they are worth more in the future. But the high current price makes that a less enticing play.

In Europe, record high natural gas prices have led European refiners to reduce production to save on those costs. That has tightened inventories there, boosting European diesel’s six-month spread to its widest backwardation since March 2008 last week. With demand high, U.S. exports of distillates to Europe have strengthened as a result.

(Reporting by Laura Sanicola; Editing by David Gregorio)

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