As goes oil, so goes diesel

In 1999, the average U.S. price of diesel fuel was about $0.50 per gallon wholesale and about $1.10 retail. So far in 2012, average prices have been about $3.00 per gallon wholesale and $4.00 retail. The biggest single factor in this increase has been the underlying price of crude oil. Increases in the price of crude have accounted for more than 80 percent of the rise in diesel prices.

Indeed, as Figure 1 shows, the correlation between diesel prices and crude prices over the past 20 years has been remarkable, reinforcing the expectation that suppliers will eventually pass on all price fluctuations, both increases and decreases, to customers. In short, if you want to predict diesel and gasoline prices, you need do no more than predict where crude prices will go—which, of course, is easier said than done.

Article Figures

[Figure 1] U.S. diesel price vs. underlying crude price (in U.S. dollars) 1994 to 2012 Enlarge this image

[Figure 2] Light sweet crude oil prices (historical and futures) Enlarge this image

For the foreseeable future, diesel prices will be driven more by crude price movements than by downstream dynamics such as refinery-capacity utilization or supply constraints. Still, it's helpful to briefly examine the dynamics of diesel supply and demand.

U.S. demand for diesel is expected to continue to grow moderately—about 1-percent average annual growth projected for the next 20 years. Given such slow growth, demand is unlikely to be a major factor in diesel pricing. This growth rate is slightly lower than that expected for the economy as a whole because many large industrial users and some fleet operators will convert to cheaper natural gas. The growth rate also is slightly higher than that for gasoline (for which demand is expected to be flat) because federally mandated increases in fuel economy will impact gasoline demand.

U.S. refiners will be able to handle the additional volume required to meet this moderate growth in demand. Refineries have flexibility to change the percentages of diesel and gasoline they produce. Historically, they have maximized gasoline production because of the demand mix in the United States. If demand grows more quickly for diesel than for gasoline, refiners can adjust production to some extent without making significant additional investments.

Additionally, in 2011, for the first time in generations, the United States became a net exporter of refined petroleum products. In short, as domestic diesel demand grows, there will be sufficient domestic supply capacity to meet it.

Where are prices headed?
Enough diesel fuel may be available, but the question on everyone's mind, of course, is: At what price?

The New York Mercantile Exchange (NYMEX) West Texas Intermediate (WTI) futures strip is a month-by-month measure of the expected value of futures contracts on crude oil. Because these contracts are publicly traded, they represent the market consensus on what will happen to crude prices in the coming years.

As Figure 2 shows, the market does not currently expect dramatic swings in the price of crude, and therefore, the price of diesel. (As noted earlier, we can expect diesel prices for the most part to move in tandem with crude prices.) Obviously, the market could be wrong. Indeed, Figure 2 would have looked similar in 2000 or 2005. It's possible that the market may now be failing to account for unforeseen runaway demand in previously low-profile areas, economic crises, political events in the Middle East, or other surprises. When such unexpected events disrupt oil prices, they can potentially cause big disruptions in the price that carriers pay for diesel and in key forecasting variables, such as consumer incomes or inflation rates. That's why it's a good idea to have a supply chain strategy that can succeed even in the face of the unpredictable.

Assuming the forward market is correct, and there will be no dramatic price swings for crude oil, supply chain managers can expect a continuation of the trends of the last three to four years. For example, today's high diesel prices are making long-haul transportation of "heavier" products too expensive, so we should see continued pressure on companies to move production of low value-to-weight products closer to demand centers. Although U.S. natural gas will probably not stay as profoundly cheap as it is right now, it will continue to be cost-competitive with diesel in situations where it is a genuine substitute.

Finally, don't look for any price breaks; the recent significant increase in diesel prices is likely here to stay. Therefore, it's very unlikely that we'll see any significant, sustained reductions in trucking, rail, or ocean freight costs in the future.