Diesel Prices Soar Beyond Crude, Gasoline – And Should Stay That Way

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In addition to the pain of higher prices in general at the pump, truckers are faced with the fact that diesel has risen above increases in crude and gasoline.

The numbers are stark on how much diesel has risen relative to other benchmark oil prices in recent weeks. According to the Department of Energy Energy Information Administration (EIA), retail gasoline is up 26% year-to-date, but diesel is up 42.8%.

While it’s easy to blame the Russian-Ukrainian war, given Russia’s huge role as a supplier of diesel, the reality is that the price of diesel relative to crude and gasoline has started to rise well before the Russian invasion.

The price truckers pay at the pump is still determined primarily by the price of crude. But if the relationship between crude and diesel undergoes structural changes that add another 10 to 15 cents per gallon to the gap, those gains will impact the retail price of diesel even if crude remains perfectly still.

How wide has this gap widened? The attached graph shows the difference between retail gasoline and retail diesel, based on the average price published each Monday by the EIA.

For the diesel-consuming industry, this price is not an abstract figure released by the government; it is the basis of most fuel surcharges. A year ago, that spread was just under 40 cents per gallon. Based on the most recent prices released on Monday, the gap is now around $1.20 per gallon.

But the retail price is at the end of a long supply chain that includes the production of crude, the selection of the types of crudes to be processed by a refinery, and the allocation of the refinery’s output between gasoline, diesel, jet fuel and other products. This growth in the gasoline-diesel gap is ultimately the last step after changes in the spot product market.

Monday, simple spread on the CME commodity exchange between the price of first-month Brent crude and ultra-low sulfur diesel was $1.65 a gallon. Part of that number reflects this week’s squeeze in the diesel market. As the May contract on CME headed for expiration on Friday, traders with short positions due to close their trade before the end of the week found barrels scarce. It is therefore a one-off which will come to an end before Friday.

Even though this week’s numbers are vaguely ignored as having been caused by these unique circumstances, it’s hard to overstate how out of whack the differentials between diesel and Brent crude have become.

The spread broke through $1 per gallon on March 18. At the start of 2022, it was around 47 cents. For all of 2021, the spread averaged less than 40 cents. (Brent is the preferred benchmark for comparison because it is the global crude benchmark and diesel is also traded globally.)

These movements are obviously not all motivated by the Russian-Ukrainian war alone. So what’s going on?

Philip Verleger is an energy economist with diesel in his sights. For example, in the surge of what remains the highest crude price – $147 for West Texas Intermediate in early July 2008 – Verleger was unique among analysts in citing changes in diesel specifications as the tail wags the dog. The diesel was pulling crude, Verleger argued, not the other way around.

Verleger: Structural changes in the diesel market drive up prices

In a recent report, Verleger makes a similar argument. He sees the biggest difference in structural changes in the market, many of which are tied to government mandates, having permanently altered the diesel market in a situation where the traditional differentials between crude and diesel, and diesel and essence, have disappeared and will not be back. (Addendum: Nothing in the oil market is truly permanent, so it’s a relative term.)

In his report, Verleger lays out five basic facts about the chemistry of diesel that are key to understanding why its supply has tightened so much and why its price has soared far beyond increases in crude and gasoline.

Two factors cited by Verleger are well known: oil refining produces a level of diesel that is a percentage of production but structurally cannot easily be increased; and that each crude has its unique chemistry that produces varying yields of diesel and other products.

But Verleger also cites lesser-known factors.

First, low-sulphur crudes that are good feedstocks for making desulphurized diesel are on the decline. Second (and this relates to low sulfur supply), sulfur must be removed from diesel due to government mandates. And third, “Such desulphurization capacity is limited and expensive to build.”

“At this point in 2022, these considerations have combined to limit the supply of low-sulphur diesel,” Verleger writes, citing some of the different gaps such as gasoline versus diesel.

Verleger sees the diesel futures curve as an indicator of how unusual the diesel market has become – as he puts it, it’s a chart “that seems to come from an entirely different sample or universe”.

In a perfectly balanced market, the price of any commodity as it goes off schedule increases, to reflect the time value of money and the cost of storage. So July widgets will be a bit more expensive than June widgets, August widgets will be more expensive than July widgets, etc.

When markets tighten, the most valuable widget is one that can be delivered immediately. The highest price is the first month (or another period), the second most expensive is the next period and so on. This is called offset. That’s a sign of a tight market, and in diesel now, that’s a doozy.

Diesel prices down on schedule show breadth of tight market

Verleger cites statistics of the gap between the first month and the third month for the ultra-low sulfur diesel market on the CME commodity exchange. But the 12-month gap also reached unprecedented numbers.

Verleger calls it the “hoarding bonus”. His report cites the three-month figures, but the same phenomenon occurs in the 12-month figures. The 12-month backwardation for the year between February 2021 and February 2022 averaged just over 7 cents per barrel. Earlier this week it was above $1.18 a barrel, for a 12-month “hoarding premium” of around $50 a barrel.

This is unprecedented and is partly due to continued month-end compression. But even if that passes, Verleger’s report sees other factors at work in today’s market, beyond the sulfur-related structural issues he cited.

In a separate five-point list, Verleger mentioned continuing problems with the diesel market.

— Increased demand for low sulfur diesel.

— A drop in Nigerian oil production, which is reducing the supply of a key low-sulphur crude.

— “Limited desulfurization capacity.”

— The use of diesel, a product similar to diesel in Europe, to produce electricity because natural gas is very expensive.

— Sanctions against Russia, by governments or private companies, choking off a large supply of diesel.

In discussing higher demand, Verleger cites an issue that was hot three years ago but has faded from the limelight: the marine fuel regulations known as IMO2020. On January 1, 2020, it came into effect worldwide, mandating fuel for ships with much stricter sulfur specifications. (IMO stands for the International Maritime Organization, the global organization that made the rules.)

It was expected that molecules, which would otherwise be turned into diesel, would be diverted to produce fuel that meets the IMO2020. The fear and consensus in the market was that such a diversion would drive up diesel prices.

Then the pandemic hit, demand crashed and fears of a diesel shortage disappeared. But although it is only a brief mention in his report, Verleger sees it as a factor in today’s market. “Trucking and rail activity has increased,” he writes. “The transition to low sulfur marine diesel has also increased its use.”

Verleger doesn’t see the squeeze ending any time soon.

“Given these circumstances, distillate may be in short supply for months or years absent changes in regulatory policies, an economic downturn that reduces demand, or technical advances,” he writes. “In the short term, distillate prices will likely continue to rise relative to other petroleum products.”

The Verleger weekly report has a projected price for crude based on several factors, including commodity prices and inter-month relationships. He conceded that recently the model got it wrong and the crazy distillate market is the reason.

But it’s not just a one-off error. On the contrary, he says, it could be a harbinger of things to come. He notes that the use of diesel is a demand that is not elastic, as it tends to be consumed by intermediaries, such as truckers. As the price increases, demand does not decrease as gasoline consumption does.

“As a result, distillates could pull prices to incredibly high levels absent a significant economic downturn,” Verleger said in a very optimistic conclusion.

More articles from John Kingston

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