Growing competition for Asian supplies, coming at a time when fuel demand from China and India are expected to rise in line with their booming economies, will help tighten a market whose gains this year have been capped by high supplies.

“You already have strong demand from China and India, and rising demand from Japan as their reconstruction activities get into full swing, now with Brazil as an unexpected wild card, the distillates market will tighten further,” said Victor Shum, an analyst with energy consultancy Purvin and Gertz.

Higher demand could push Asian diesel crack spreads up by around 20 percent from current levels by year end, he said. 

Brazil’s diesel demand is expected to outpace supply by 170,000-175,000 barrels per day (bpd) in 2011 and 2012, widening from 95,000 bpd last year on average, according to a forecast from US-based consultancy Energy Security Analysis Inc. (ESAI).

The shortfall has led to Brazil looking outside the US, its main source of clean fuel products, and toward Asia to feed its growing appetite for diesel.

For example, South Korea’s gas oil exports to Brazil have risen to 20,000 barrels per day (bpd) this year from nothing five years ago, according to a report by investment bank Deutsche Bank.

“You wouldn’t think that an arbitrage from South Korea to Brazil could work, but it shows the strength of demand,” said Richard Gorry, director at consultancy JBC Asia in Singapore.

Indian refiners, who accounted for around 70 percent of Asian diesel exports to Brazil last year, have started exploring the possibility of supplying diesel on a term basis with South America’s largest economy, industry sources said.  

Asia is expected to have a net surplus of 400,000 bpd for the remainder of the year, as capacity-driven increases in supply outpace demand, the ESAI data showed. 

The US Gulf coast typically satisfies most of Brazil’s requirements, but competition for US supplies from Europe and other Latin American countries have helped keep open the arbitrage window between Asia and Brazil. 

“There’s been strong buying by Chile, Peru, Argentina and Colombia, with some of the oil companies there locking in term contracts this year,” said a US-based trader.

“Weaker freight rates this year have helped the economics of the arbitrage. Some companies may also enjoy better rates than others because of their relationships with shipping companies.”

Clean rates for Long Range (LR1) tankers fell to a one-month low this week.

The spread between Singapore gas oil swaps and Nymex US Gulf Coast ultra-low sulphur diesel futures, a rough gauge of arbitrage opportunities between Asia and South America, has been very volatile this year, swinging between a premium over $11 to a discount of almost $9 a barrel. 

A deeper discount reflects a greater chance for east-west arbitrage shipments to be profitable.  

Asia will be a key supplier for Petrobras in the next few years, Guilherme Franca, Petrobras global crude trading manager, told Reuters in an interview last week.

“Asia will continue to be an important region for middle distillates, so we expect to keep our (sourcing) position there for the coming years,” he said at an industry conference in Singapore. 

Most diesel in Brazil is used to fuel trucks, due to limited alternative shipping methods in the vast country, analysts said.

Brazil’s heightened presence in the Asian gas oil market puts it squarely in competition with fellow BRIC economies China and India.

In China, demand for the refined fuel is forecast to rise by 7 percent this year to 3.36 million bpd and almost 5 percent to 3.53 million bpd the following, according to the data from the International Energy Agency. India is expected to consume 5.5 percent more diesel in 2011 and 5.7 percent more in 2012, IEA said.

“Asia is net long diesel, and that’s weighed on the market this year even with China and India growing strongly. The Brazilian imports have helped to reduce some of that supply and that has boosted sentiment,” said a middle distillates trader with an Asian refiner.

In the short term, Indian demand is also seasonally higher in the fourth quarter because of increased transport use, while signs of Chinese diesel imports emerged last week, raising hopes of significantly higher volumes moving into the world’s largest energy consumer in the coming months.

Supplies are also likely to face higher than usual demand in the last quarter as strong European demand for heating fuel draws away Asian barrels.

“European diesel demand will also go up in fourth quarter due to heating demand, that will also drive diesel cargoes going to Europe form India and Korea,” said Shum.

Asian gas oil’s premium to Dubai crude has spiked above $20 at various points this year, lifted by a cut in Japan’s fuel exports following an earthquake and tsunami that damaged the country’s refineries and China’s decision to curb exports in May to meet domestic demand.

The front-month gas oil crack is currently hovering around $18 a barrel, higher than last year’s peak of around $15 a barrel.

Perhaps more pertinent to the Asian-Brazil diesel arbitrage is the supply side of the equation, where no additional refinery capacity is expected to come online in South America’s largest economy before 2013 at the earliest.   

Current plans call for Petrobras to add 1.46 million b/d of refining capacity to the current level of around 2.9 million b/d through the construction of four new refineries by 2019.

“However, projects in Brazil are vulnerable to delays as state oil company Petrobras may allocate less funding to downstream investment in favor of boosting upstream investment,” said Deutsche Bank commodities analyst Soozhana Choi.

The first phase of the Premium I refinery with 300,000 bpd of capacity has been delayed from 2014 to 2016, while the second phase with an additional 300,000 bpd has been pushed to 2019. 

“Unlike China, which has aggressively pursued a refinery expansion program that has ultimately made it broadly self sufficient in many key refined products, Latin America is going in reverse and appears to be increasingly dependent on imports to meet demand,” said Choi.

Even if all refinery projects go ahead as planned from 2012-2017, Brazil will grow increasingly short of gas oil and gasoline, she said.