Diesel Dilemma: Will Russia Invade Europe Because of the Supply Crunch?

We have entered a weird period where diesel is not only on the minds of European consumers, US farmers, and cargo shippers everywhere, but it is also sneaking into the conversations of political and military planners. You will not be surprised to hear that most ground-based military equipment runs on diesel. So if Russia starts getting up close and personal with Estonia, Suddenly Europe will need a whole bunch of diesel to fight World War III I say this as a preface to a current transatlantic political debate Just last week, we were discussing the consequences of a U.S. diesel export ban The logic being that the U.S. is a net exporter of diesel So keeping it all in-country will increase domestic supply And therefore reduce prices Essentially, it would take away profits from U.S. refiners and subsidize U.S. farmers and shippers, with a whole bunch of inefficiencies also added into the system. If that were to come to fruition, Europe would be displeased. Roughly 40% of the European passenger car fleet runs on diesel. Europe itself can produce an upper limit of about 5 million barrels of diesel per day. Previously, the remainder of Europe's diesel needs came from Russia and the Middle East. But oopsie and oopsie again. The United States has picked up the slack, exporting about 450,000 barrels per day to Europe, accounting for up to two-thirds of Europe's current imports. If U.S. exports were to disappear, there are few other places that Europe can look toward. And with that, we can get to the next chapter in days of our transatlanticism. Depending on one's perspective, last week, the Trump administration either signaled an alternative to an export ban or issued a new threat to Europe. Open up your diesel reserves or the United States will implement the ban. The online commentary went about as you would imagine. Trump is trying to extort Europe again, and the continent must stand strong in the face of such coercion. Then we immediately shifted to peak comedy on Friday. The headline on France 24, EU fully rejects US threat to ban diesel exports unless bloc releases more fuel stocks Fast forward a few hours, and what is this? G7 members will release 100 million barrels of diesel after US threatens export ban I tap the sign. And for further comedy, France 24 did not even bother to give the article a new URL. Before anyone pulls a, well, ACTUALLY on me. Yes, the EU is not the G7, but the G7 includes France, Germany, and Italy, and this is a coordinated drawdown from the International Energy Agency, which is what the EU had earlier stipulated would need to govern any release. We also need to further update that headline, because it is up to 100 million barrels of diesel, gasoline, and crude, not just diesel. UP2 also does a lot of heavy lifting here, because releasing 0 is technically releasing up to 100 million barrels. Who is releasing what is undefined, and any releases of crude would hardly matter with refineries not having the slack to handle it. Nonetheless, before passing further judgment, I think we need to back up here and get a better understanding of the general strategic problem that Europe faced. Let's first explore why there is some weirdness in how to define the situation as a threat versus a statement of reality. The basic strategic setup is that Europe must decide whether to open up its reserves. Then Trump decides whether to ban exports. The case for, I am not threatening you, I am just explaining the reality of the situation, is that Trump would ban exports if Europe does not open up its reserves, but would not if Europe does. The logic there is that both of these options have the same effect of reducing U.S. prices, so the greater global supply acts as a substitute. And if Europe would prefer that option to an export ban, then it makes sense for Europe to take the lead. Where this comes off more as extortion is if Trump would not want to implement a ban no matter what Europe does, and he is pretending like he would to try to force action out of Europe. Remember to tap the sign as you leave. Now, I do not know whether Trump is serious here. We explored the possibilities last week, so it is not worth rehashing today, except to remind everyone that midterm elections are four weeks from the day of this video's release, and the crack spread climbed to another all-time high on Wednesday, before easing due to the news about the G7's move. Suffice it to say that it is reasonable to think that Trump is serious about an export ban. Thus, the interesting thing worth discussing is what happens if he is. So that is how we will spend the rest of our time today. I will leave it to the European intelligence agencies to decipher the truth themselves. Though, given the headlines, it seems that we already know what they think. Okay, so Trump's desire to implement an export ban depends on Europe's decision. What should Europe do? Well, the headline consideration that we will start with is what Russia might do in response. Remember, diesel fuels the ground game for Europe's defense plans. Sap diesel reserves, and you appear to be putting the continent on a weaker footing. Now combine that with how Putin is already looking to provoke Europe for the sake of crafting a crisis, only to turn around and use any sort of rally-round-the-flag effect to send more troops to Ukraine. What do you get? It sure sounds like a recipe for an incursion. Go visit Narva while you can. However, let's interrogate the severity of the potential problem. Estimates of diesel consumption by Russia and Ukraine in the current war are hard to come by. But we should try, so we might get a baseline guess at what Europe's diesel needs might be. Well, someone has tried to quantify carbon emissions over the first two years of the war. And if we very unrealistically blame all of that on diesel consumption, the parties burned a combined 146,000 barrels of diesel per day. To be super conservative, let's suppose that Europe by itself would burn an order of magnitude more than Russia and Ukraine combined. That still only takes us to 1.46 million barrels of diesel, which is roughly 30% of the daily output of European refiners. That may sound like a lot, but we are talking about World War III, I suspect Europe would figure out how to make that wildly conservative estimate happen. Also note that Russia's total diesel production capacity prior to the Ukraine war was about that amount. Currently, because Ukraine apparently hates Russian refineries, Russia's daily diesel production has dropped to the 1.1 to 1.2 million barrels per day range. Although there is a notable difference between Russian and European consumer demand, the general point is that Europe has plenty of diesel that it could commandeer in wartime. Then again, we are not here to discuss daily capacity and production. We are here to think about the diesel reserve. Well, Europe is holding onto about 290 million barrels. If you exhausted 1.5 million of those per day, without even bothering to buy more off the market, you would still have six months of diesel to draw down from. You would also have a period to ramp up before any serious invasion could begin. Little green men may show up in Narva without much fanfare, but a true war between Russia and Europe, the type that would require significant diesel expenditures, would need to be preceded by a long Russian buildup along the border. Basically, you would have a repeat of the Biden administration watching what happened along the Ukraine border and sounding the alarm bell, so there would be an opportunity to top off diesel reserves as the day approached. To be clear, any drawdown does ultimately take diesel away from the stores that could go toward a war effort. Russia would undoubtedly target European refiners, so there ought to be concern about persistent supply issues. And even if Europe has capacity to absorb a drawdown, it could also be using this time to expand stockpiles and be even better prepared. But our back-of-the-envelope calculation shows that the scale of this concern is not as substantial as it may have seemed on the surface. Here is another way to think about the scale of the problem. Previously, Europe relied on Russian diesel exports. This was true even after 2014, when Europe should have deduced that the whole Crimea thing signaled bigger problems. Europe did not start moving away from diesel generally until 2015, though, but that was because of the Volkswagen emission scandal and had nothing to do with security concerns. The diesel cars on the road remained on the road, and Europe kept importing from Russia. Ironically, to make matters worse, diesel engines have a longer life expectancy, so Europe kept planning to import from Russia for the foreseeable future. If this quantity of diesel was so pivotal to the war effort, then Europe had basically mortgaged its entire ability to fight decades ago. Goodness knows that hawks on both sides of the Atlantic have been critical of European defense spending, But those countries did not hand over a kill switch to Russia, because they are not that vulnerable to diesel shortages. The other half of the equation is to ask why the reserves are there in the first place. And the primary answer is not directly about military capacity. It is to mitigate supply disruptions of any kind. Now, we could split hairs about whether there is any supply disruption at all at the moment, when market supply is meeting market demand. But when we are dealing with a globalized commodity, true supply disruptions are hard to ever observe. The question will always be the price you have to pay to obtain that supply. The clear argument against releasing diesel reserves now is what happens if the problem gets worse in the future. Then you will have mitigated today's moderate problem, only to suffer a more substantial problem later. And as a corollary, if the current status quo will persist in the future, then you still help no one by releasing anything today. It is just a temporary band-aid devoid of any real problem-solving. None of us can predict the future here, and so whatever decision leaders make is a gamble. Nevertheless, individuals with a stake in the game are betting that we are currently experiencing peak diesel prices. Virtually every refinery on the planet is operating at peak feasible capacity right now. The only exceptions are Russian refineries that seem to keep breaking down for some reason. Hard to say why. Middle East refineries that have a greater downside risk of operating under Iranian coercion, but are increasingly coming back online. And the subset of smaller Chinese refineries that previously survived on discounted Iranian crude and are legally barred from international exports. Capacity elsewhere is maxed out. Refineries are only shutting down when they absolutely have to for maintenance, or now that we are in October, to make necessary reconfigurations for winter blends. The strong signal we are therefore observing is that refiners believe that now is the time to capture record profits. If the firms believe that the problems would stay the same or get worse, then they would be scheduling maintenance to ensure that their systems will work in the future when they can continue to secure record profits or get even larger record profits. Instead, they are endangering their systems because the expectation is that their windfall profits are fleeting. Again, we cannot be sure that their gamble will be the correct one, but we can clearly see their logic. Crude output emanating from the Middle East has returned to pre-war levels. Middle East refiners have been more cautious because they incur more risk operating behind the blockade. However, their overall behavior follows crude trends. So we would expect to see more refined products hitting the market, and thus a dip in global diesel prices. Hence the bet, among other refiners, to keep maximizing today's output. And it is probably better to trust the judgment of the individuals with billions of dollars at stake than the hot-take opinions coming from keyboard doomers. Sure, the wheel could land on green, but that ought not to be our collective expectation. In turn, releases from European reserves are not a band-aid. Or, to use that word again, they are not a band-aid in expectation. And thus, we have a compelling argument for the release of diesel reserves. We should conclude with some commentary about Europe's decision to immediately backtrack on its pledges to not back down in the face of pressure from the Trump administration. On one hand, everything that we have discussed so far should make clear that such suggestions were bluster from the start. European leaders might not like appeasing Trump, but they dislike surging diesel prices even more. And, historically speaking, voters do not respond well to incumbent leaders saying, these high prices are not my fault. It is remarkable how much online rhetoric fails to match what actual voter preferences are when push comes to shove. If anything is surprising about the agreement, it is that there is no actual European diesel reserve. Rather, it is a collection of reserves, each individually owned and operated by its respective state. Consequently, there is a classic free-riding incentive. Germany, for example, might not want the United States to impose an export ban. But even better, Germany would prefer if Italy paid the price by releasing Italian reserves to buff global supply. The surprise, then, is that Europe overcame its collective action problem. Or now, anyway. Hold that thought for a few weeks while we watch what happens with the implementation phase. Meanwhile, if you want to know what it is like to do the opposite of free-riding, I just finished an interview with an old crisis bargaining professor of mine who is currently in Kiev, teaching economics to students there. I will be posting that conversation to my secondary channel tomorrow. Click here to subscribe to that channel so you do not miss it. And if you enjoyed today's video, then please like, share, and subscribe, and I will see you next time. Take care.