Rising prices, on land and sea

Although diesel fuel markets in the United States experienced some short-term volatility in the last 12 months, for the most part prices have behaved as expected. This is in line with the outlook we offered in our article last year, when we predicted that diesel fuel prices would stay in roughly the same place as they had been throughout 2012. And that is indeed what happened: As we write this, the U.S. average retail price is within 5 cents per gallon of where it was a year ago, which amounts to less than a 2-percent change.

The reason for this steady diesel market over the medium term is the steady crude market. While crude prices are slightly higher than they were a year ago, the year-over-year difference is around 5 percent. In the longer term, crude oil futures still indicate that crude prices are projected to fall by nearly 10 percent from current levels (see Figure 1). This has remained true even as turmoil has begun to spread in the Middle East. Unfortunately, for diesel buyers this longer-term easing in crude prices may not translate into lower diesel prices in the near future.

Article Figures

[Figure 1] Light sweet crude oil prices (historical and futures) Enlarge this image

[Figure 2] U.S. diesel price vs. underlying crude price: 1994-present Enlarge this image

Behind the volatility
While overall retail diesel prices are largely unchanged (see Figure 2), some parts of the United States have experienced more volatility than usual. For example, diesel prices increased by more than 10 percent during February and March in New England and the Mid-Atlantic states. While it is not uncommon to see a seasonal rise in diesel prices in those regions, the magnitude of that increase was greater than normal.

Two main factors contributed to that increase in price volatility. The first was the weather. The extreme cold brought by the "polar vortex" significantly increased the demand for heating oil in New England, one of the few parts of the country where heating oil and propane are still major fuel sources for residential heating. The composition of heating oil is very similar to diesel, and it is becoming even more similar as more states phase in low-sulfur specifications for home heating oil. So when it is cold outside, demand for heating oil goes up, putting stress on the available supply of diesel.

The second contributor to this price volatility was probably the so-called "unconventional revolution" in oil production and its impact on diesel supplies. U.S. domestic crude production is increasing, and most of that increase is coming from Light Tight Oil (LTO), sometimes referred to as shale oil, in places like the Bakken field in the Dakotas and the Eagle Ford field in Texas. At the same time, heavy Canadian oil-sands crude continues to be an important crude source for U.S. refiners. These crudes have a different assay, or profile, than that of the historical mix of crudes processed in U.S. refineries.

The combination of these factors created a "dumbelling" of U.S crudes. This term alludes to the relatively large amount of light and heavy "ends," or extremes, of the crude spectrum, that ultimately result in lower diesel production. This situation reduces production of diesel because it is a middle distillate most easily produced from the center of the crude spectrum. While refiners can make capital investments to handle a new crude slate, for example cracking the longer-chain molecules in the heavy ends, it takes time to bring new equipment on stream. It is likely, therefore, that any capital investment plans would have to be supported by an expectation of continued strength in diesel prices. This may well be the case, given the lower diesel production due to the "dumbelling" effect described above.

One way diesel purchasers can prepare for this expected increase in price volatility is to implement a hedging program, whether by buying financial instruments such as futures contracts, call options, and collars, or simply by negotiating a hedged supply contract. This may work in the short term, and it may have been sufficient to avoid paying a premium in the U.S. Northeast and Mid-Atlantic this past winter. However, a hedging strategy alone is not likely to be effective in more extreme scenarios or in the face of longer-term, unpredictable price changes.

Global rise in demand
Growth in demand for diesel, both domestically and abroad, is another factor that will put pressure on diesel prices to decouple—or at least stretch—the historical relationship with crude. Globally, diesel is now in greater demand than gasoline, and that is unlikely to change given the preference for diesel in Europe and many emerging markets. Meanwhile diesel's market share in the United States is growing, and that trend is expected to continue. The Diesel Technology Forum predicts diesel's share of the light vehicle fleet could double or triple from its current level of around 3 percent by the end of the decade. In fact, more than 40 new diesel-powered vehicle models will be introduced in the next three years in anticipation of increasing U.S. consumer demand for "clean diesel."

But another large and potentially global demand driver also looms. Segments of the marine transportation market may begin switching from heavy bunker fuel to diesel when changes to marine-fuel sulfur specifications are announced. These changes will likely occur within the next decade. For these reasons, demand growth will ultimately outpace supply growth, leading to higher prices.

Regardless of the future scenario that materializes for diesel prices, the best way to prepare is still a risk management strategy that considers these and other risk scenarios in a wider context. A risk management strategy that combines different elements gives diesel users the best chance to weather price volatility or inflation. Hedging, different types of supply sources, diverse contracting terms, demand management strategies, and appropriate governance should be part of a robust diesel management strategy.