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A structural, not a seasonal, shift in transportation fuels?

A structural not a seasonal shift in transportation fuels

By Tim Fitzgibbon

Retail gasoline prices typically rise during the summer driving season. But that increase this summer has not been driven by the usual factors. We believe that’s because a structural, not a seasonal, change in transportation fuel demand is emerging that could have big-ticket implications for refiners.

Briefly put: Demand is rising faster for diesel fuel than for gasoline, which could force refiners to rethink capital spending plans.

Refiners traditionally have relied on higher margins from gasoline during the second and third quarter to offset lower margins in the first and fourth quarter. But in a market that, so far in 2018, has not seen traditional summertime premiums for gasoline over other fuels, the long-term viability of that strategy may be undermined.

US refiners have traditionally tended to invest heavily in technologies like coking and fluid catalytic cracking that yield high amounts of gasoline from each barrel of crude-oil input. Investing in other technologies, such as hydrocracking, which favors the yield of diesel from each barrel of crude, have been less attractive.

Demand trends for diesel suggest it is time to rethink some of these capital decisions. For more on that, see our article, Diesel demand: still growing globally despite Dieselgate.

Getting this right is no small matter. But rather than consult tea leaves or palm readers, refinery executives can simply look at current drivers of demand for both fuels and place their bets accordingly.

  • Higher oil prices: Strong growth in global demand for crude oil, coupled with 18 months of production restraint by OPEC and Russia, have rebalanced global markets. Demand for gasoline is more sensitive to price than demand for diesel. Thus, higher prices at the pump have had a greater effect on gasoline than diesel.
  • Rising fuel economy: In the US in particular, a wave of tightening vehicle efficiency standards that began with new cars delivered in 2016 is now starting to have measurable effects on final demand. Even as overall vehicle miles travelled has risen, demand for fuel has held flat. US fuel standards are scheduled to rise continually until at least 2022, though the Trump administration has expressed a desire to loosen the efficiency standards beyond 2022.
  • Electric vehicles: Though few are predicting the end of the internal combustion engine (ICE) in the near term, countries and automakers are starting to make serious commitments to increasing the number of non-ICE vehicles. Our research has found that consumer demand is starting to shift in favor of electrified vehicles (EVs) and that has strong disruption potential. We projected a rapid uptake of EVs, growing by as much as 32 percent per year from 3 million vehicles today to over 200 million vehicles in 2030.
  • Industrial/commercial demand: Strong economic growth globally is leading to strong demand growth for diesel. Diesel and its off-road equivalent is the liquid fuel of choice for commercial transportation (trucking and rail) and industrial uses (factories and heavy equipment). With economic growth shifting to developing countries, the share that industrial/commercial demand takes of total demand continues to widen.

Most of the current upward retail price pressure on transportation fuels stems from a rebalanced global crude oil market, which has caused prices for Brent crude oil to rise. Compared to the summer of 2017, Brent prices are up over 50 percent, to about $75 per barrel today compared to $50 last summer.  Prices for all products have risen as a result.

But beyond the change in absolute prices of crude or refined products, an interesting change in the relationship between prices has emerged this summer that we think represents the early stage of a reordering of demand, and thus profitability, for different transportation fuels.

A look at gasoline prices relative to crude (Exhibit 1) shows a very different relationship than in prior years. Specifically, there has been virtually no seasonal rise in summer prices compared to winter pricing, which typically are depressed.

Low prices for gasoline have not eroded margins from refiners. In fact, prices for refined products on average remain strong. Most importantly, diesel prices are seeing unusual strength so far in summer, which typically is a period of weaker demand and lower prices. Higher prices for diesel are essentially offsetting lower gasoline prices, keeping refiners profitable (Exhibit 2).

What looks like an anomaly could be the early signs of a long-run trend that could change how we think about the relative pricing of gasoline versus diesel as well as cause refiners to rethink expensive upgrade projects. We think the trend bears continued watching. Refiners may want to hold off pulling the trigger on capital projects designed to produce additional gasoline and instead take a second look at projects that produce more diesel.

Tim Fitzgibbon is a senior industry expert based in Houston.