The year 2022 was difficult for oil-importing countries, including Pakistan, as commodity prices shot through the roof. The steep increase in the cost of refined products, such as diesel, placed a significant strain on their trade balances and left consumers feeling the pinch at the pump. With a volatile global market, government officials in Pakistan must take proactive measures to mitigate any potential crisis in the future.
Diesel is a kind of middle distillate, as opposed to lighter distillates such as gasoline and heavier distillates like furnace oil. These distillates, as the name implies, are produced when crude oil goes through the distillation process and other stages of treatment in an oil refinery. What sets the middle distillates apart is that they are mainly used in the commercial sector. They are consumed by freight transportation, agriculture, manufacturing, and other industries. Their demand, therefore, primarily comes from economic activities.
The demand for diesel skyrocketed in 2022 as the global economy rebounded from the pandemic. On top of this, supply-side issues, such as inadequate distillate production in two of the world’s biggest producers of refined products — the US and China — as well as the Russia-Ukraine conflict, led to record-high refining margins for diesel. The refining margin is the difference between the price of a refined product and the cost of crude oil.
The refining margins on gasoil, which serves as the foundation for diesel, reached an unprecedented peak of more than $70 a barrel in Asian markets in mid-2022. While it has since fallen to the $30 to $35 a barrel range, it remains significantly higher than the single-digit levels it often traded in 2021 and 2020.
If domestic refineries operate at full capacity, which can fulfil all local diesel demand, the annual net forex savings could be close to $1bn
Pakistan has historically relied on international markets for around 40 per cent of its diesel supply. The country has five oil refineries that could theoretically meet all of its diesel demand. However, these refineries often operate below capacity due to longstanding industry issues that have yet to be addressed by policymakers. This leaves Pakistan with little choice but to import diesel, placing a strain on the country’s foreign reserves.
In the last financial year that ended in June, Pakistan imported 5.39
million MT of high-speed diesel (HSD), mainly from Kuwait and the UAE, with a cost of $3.85 billion (average exchange rate of Rs178.12 per USD), as per PBS data. This shows the high cost of importing HSD, despite low refining margins in the latter half of 2021. With persistently high refining margins, the import bill may remain elevated in the future as well.
The future of diesel prices is uncertain, with the potential for both bullish and bearish scenarios to unfold that could impact refining margins.
On the one hand, the global economy is experiencing a slowdown, as warned by World Bank, the International Monetary Fund, and other notable institutions. Pakistan’s economy will also likely face challenges this year due to precarious economic conditions characterised by double-digit inflation, inadequate foreign exchange reserves, and substantial fiscal and current account deficits. This will likely decrease the demand for fuels, including diesel, in Pakistan and abroad.
Concurrently China, which boasts the largest refining capacity in the world at 17.5m per day, has increased export quotas for its refineries for 2023 by 20pc so far as compared to the same period last year. Moreover, Kuwait and India could also ramp up diesel exports. These changes in demand and supply can exert downward pressure on refining margins.
Pakistan relies on international markets for around 40pc of its diesel supply
On the other hand, China’s reopening may outweigh concerns about the global economic slowdown, potentially resulting in an increase in demand and a rise in prices for crude oil and refined products. At the beginning of this year, China lifted border restrictions that had been in place since the onset of the coronavirus pandemic. This coincides with the 40-day Lunar New Year travel period, which is likely to lead to a surge in travel activity.
Additionally, the European Union is planning to ban imports of Russian diesel from February, which may lead to a decrease in Russian exports. These factors may push the refining margins on diesel higher.
The future is uncertain, and it is imperative for Pakistan to plan for potential adverse scenarios. This includes ensuring economic stability and protecting the country from the negative impacts of fluctuating diesel prices. As previously noted, diesel margins are already high, and any further increase in prices can have a severe impact on Pakistan’s finances.
Considering the challenges that oil companies have been facing with obtaining letters of credit, a sharp increase in prices could make it difficult for them to procure diesel from abroad, potentially triggering a fuel crisis. It is essential for policymakers to take a proactive approach to mitigate these risks and ensure the country’s resilience.
Effective crisis management entails taking preventive measures. Policymakers must anticipate the potential threat of rising diesel prices and take action accordingly. One effective strategy is to ensure that domestic refineries operate at full capacity, which can fulfil all local diesel demand and save foreign exchange reserves by eliminating imports. As per one estimate, the annual forex savings (net) could be close to $1bn. Moreover, this can also reduce the country’s vulnerability to any geopolitical or supply-chain disruptions that may occur in the international markets in the future.
Despite a volatile global market, it is crucial for government officials to take preventive measures to mitigate future crises. Addressing the longstanding issues with domestic refineries and strengthening local energy sources could be viable options for the country to reduce its dependence on imports and improve its resilience against future oil price shocks.
Published in Dawn, The Business and Finance Weekly, January 23rd, 2023