LONDON, April 4 (Reuters) - U.S. manufacturers have

finally pulled out of the long, shallow slump that started in

the middle of 2022, which will support petroleum consumption

especially for diesel and other middle distillates in the months

ahead.

The Institute for Supply Management's purchasing managers

index for the manufacturing sector climbed to 50.3 in March

(34th percentile for all months since 1980) up from 47.8 (18th

percentile) in February.

For the first time in 17 months, the index rose above the

50-point threshold dividing expanding activity from a

contraction, putting an end to an unusually prolonged but

shallow cyclical downturn.

The production sub-index surged to 54.6 (45th percentile) up

from 48.4 (15th percentile) in February and was at its highest

level since May 2022.

New orders were also positive at 51.4 (27th percentile)

signalling the expansion should have momentum in the near term.

The manufacturing sector seems to have passed the worst of

the downturn in the middle of last year and displays early signs

of recovering.

Chartbook: U.S. manufacturing and fuel use

In contrast, the much-larger services sector, which has also

been much more resilient, showed an unexpected deceleration,

after a strong expansion earlier in the year.

The purchasing index for the services sector, including real

estate, construction, mining and farming, slipped to 51.4 (14th

percentile) in March from 52.6 (20th percentile) in February and

53.4 (27th percentile) in January.

Overall, however, the U.S. economy continued to expand last

month, with a greater balance between manufacturing and

services.

Reflecting the increase in business activity as well as

employment gains and persistent inflation, traders have pared

back their expectation for a reduction in interest rates later

this year.

Futures prices show a roughly equal chance the central bank

will cut overnight interest rates two or three times by a total

of 50 basis points or 75 basis points by the end of 2024.

Three months ago, the central bank was expected to cut rates

as much as six or seven times by a total of 150 or 175 basis

points.

FUEL CONSUMPTION

Stronger manufacturing and the associated increase in

freight are likely to boost petroleum consumption especially for

diesel and similar middle distillate fuel oils.

More than three-quarters of distillate fuel oil is used for

freight transport and manufacturing, so fuel consumption

normally tracks changes in the business cycle measured by the

manufacturing index fairly closely.

Distillate consumption was down by around 2% in the three

months from November to January compared with the same period a

year earlier.

But the winter was unusually mild, cutting consumption of

distillate heating oil, and growing use of biodiesel and

renewable diesel has been nibbling away at the market for

petroleum-derived distillates.

Even if biodiesel and renewable diesel are taken into

account, total distillate consumption was essentially flat in

the November-January period compared with a year ago.

However, if the manufacturing recovery proceeds, distillate

consumption should start to rise through the rest of 2024.

DISTILLATE INVENTORIES

Stocks of distillates were 13 million barrels (-9% or -0.73

standard deviations) below the prior 10-year seasonal average at

the end of January, according to the latest monthly data from

the Energy Information Administration.

Since then the deficit has remained broadly stable with

inventories 15 million barrels (-11% or -0.90 standard

deviations) below the 10-year average at the end of the week

finishing on March 29.

Drone and missile attacks on tankers in the Red Sea and Gulf

of Aden have led to extensive re-routing of distillate trade

between North America, Europe and Asia, in most cases resulting

in longer voyages.

But there has been little or no impact on the actual

availability of distillates in the United States, confounding

expectations stocks would tighten and prices would rise.

Futures prices for ultra-low sulphur diesel delivered in May

2024 are trading around $30 per barrel over U.S. crude oil

delivered in the same month, but the premium or crack spread has

narrowed from $40 in early February.

The crack spread has fallen to its narrowest since before

Russia's invasion of Ukraine in February 2022, a sign supply is

comfortable for the moment.

Hedge funds and other money managers have sold the

equivalent of 23 million barrels of U.S. diesel over the six

weeks since the middle of February.

The fund community has moved from a fairly bullish position

on diesel in the middle of February to a mildly bearish one by

the end of March.

Fund sales have likely anticipated, accelerated and

amplified the weakening of distillate prices relative to crude

causing the crack spread to narrow.

OUTLOOK FOR 2024

Distillate inventories have not fallen as rapidly as

anticipated earlier in the year as the market has adapted to the

disruption of tanker routes.

But inventories display a strong cyclical component so the

manufacturing recovery is likely to lead to a further depletion

of inventories and put upward pressure on spreads and prices

later in 2024.

Ukraine's drone attacks on Russia's refineries could also

diminish global supplies later in the year because Russia is a

major diesel exporter.

The relatively low level of diesel inventories means there

is little cyclical slack inherited from the downturn in 2022/23.

Renewed consumption growth in 2024/25 is likely to tighten

fuel supplies quickly and lead to early upward pressure on

prices.

Together with a tight labour market, the limited spare

capacity in diesel and other energy markets is one reason

central banks are forced to be cautious in cutting interest

rates.

Related columns:

- Distillate futures see big outflow of speculative money

(April 2, 2024)

- Global freight acceleration will lift fuel prices (March

27, 2024)

John Kemp is a Reuters market analyst. The views expressed

are his own. Follow his commentary on X https://twitter.com/JKempEnergy

(Editing by David Evans)