By John Mayes and John Auers
As those of you who drive cars calling for higher octane gasoline can attest, the relative price of premium gasoline (91-93 octane, compared to regular 85-87) has increased significantly, particularly in the last year or two. This is a dramatic acceleration of a trend which began in 2011, and which came on the heels of a time when growing ethanol volumes had decreased octane values to historically low levels. In the first decade of this millennium (2000 to 2010), the USGC differential between wholesale premium and regular gasoline averaged about 10 cents per gallon (cpg), equating to premium prices just 6% above regular. The ever increasing volumes of high octane ethanol being mandated into the gasoline pool, along with decreasing consumer demand for premium both played a role in suppressing octane prices during this period. Things have changed in the last few years, though. Premium demand has picked up as new vehicles increasingly require higher octane fuel, and ethanol volume growth has slowed as it bumps against the “blend wall.” In the 2011 to 2014 time period, the premium differential increased to average almost 10% and exceed 25 cpg. The sharp drop in petroleum prices over the last 18 months has provided another bump to premium demand as consumers opt to buy more of the now much cheaper premium grade, and this has resulted in an even larger relative premium differential, averaging almost 15% in 2015. So what does the future hold? Increasing vehicle mileage mandates (leading to more cars requiring premium grades), the push toward lower sulfur gasoline, and the growing abundance of low octane gasoline components will all tend to increase either premium demand or octane costs, pushing differentials higher. On the other hand, the possibility of substantively higher ethanol consumption (if the blend wall can be breached) has the potential of offsetting these factors and even reducing the premium differential in the longer term, as could the return to higher overall prices result in discretionary consumer switching away from the more expensive grade. Taking all these into consideration, will premium spreads continue to do like the “Little GTO” – “Turn it on, Wind it up, Blow it Out,” or will they fall back with the “Gassers and the Rail Jobs” to pre-2011 levels? We’ll provide some thoughts on that in today’s blog.
The increase in gasoline prices in the 1970’s resulted in the end of the “muscle car” age and the ushering in of smaller cars with a lesser appetite for octane. Even more important was the development of computerized engine technologies which prevented “knocking” even when less than optimum octane gasoline was used. This resulted in a long term decline in premium gasoline sales as a percent of total gasoline sales in the U.S., beginning in the mid 1980’s. As noted earlier this trend began to reverse, and consumers are now buying increasing quantities of higher octane grades. Since February of 2010, premium gasoline sales have increased from slightly below 9.0% of total sales to a current level of over 11.3%. While the lower absolute price of premium gasoline is certainly a component of the higher demand, the greater factors driving this shift appear to be from longer term forces.
The primary cause of this reversal is attributed to the ongoing Corporate Average Fuel Economy (CAFE) program. CAFE is requiring increasingly higher mileage standards for new vehicles, forcing automobile companies to adopt a series of technologies to achieve compliance. One of the most significant of these is the growing use of turbocharged engines. Turbocharging has the ability to not only improve fuel economy but also engine performance; but at a higher initial vehicle purchase price. Manufacturers of turbocharged engines generally require higher octane fuels. Those that do not; generally recommend their use to achieve the full capabilities of the engine.
In 2009, Ford introduced its 3.5 liter V6 EcoBoost engine as an option for a number of its auto lines. While turbocharged engines had been available for decades, the higher costs of the engines generally restricted their use to sports cars and higher-end foreign models. With additional engines introduced in 2010 and 2011, Ford began utilizing this technology in increasing numbers of its U.S. sales. By 2013, nearly 80% of Ford’s vehicle lines had the option for EcoBoost engines.
The primary global provider for turbocharging technology is Honeywell Transportation Systems. Honeywell is forecasting continued growth for turbocharged engines, not just in the U.S., but also in numerous other countries, such as China. Within North America, Honeywell indicates that turbocharged vehicles sales have grown from only 2% in 2008 to 21% in 2014 (this includes turbocharged diesel engines). Honeywell expects this to jump to 38% in 2019. In China, Honeywell forecasts turbocharged engine sales will rise from 23% in 2014 to 41% in 2019. Globally, 43% of 2019 engine sales are forecast to be turbocharged which would equate to 49 million vehicles. As a result of this initiative, it would seem likely that premium gasoline sales will continue to rise through the near future and place continued pressure on the regular/premium gasoline price differential.
Premium gasoline sales vary significantly between regions within the U.S. Sales in PADD II are the lowest at 7.5% of total gasoline sales while PADD V has the highest at 17.1% (more than twice the PADD II level). The U.S. average in 2015 was 11% of total gasoline sales.
The shift to higher octane fuels is not just occurring in North America but in many other regions as well. Driven by the same desire to improve fuel economies, much of eastern Asia is adopting the European standard of 95 RON gasoline.
Complicating the octane balance for U.S. refiners will be the introduction of Tier III gasoline requirements in January of 2017. These new regulations will reduce the sulfur content of gasoline from 30 ppm to 10 ppm. Most refiners will achieve these levels by treating the dominant source of sulfur in the gasoline pool, catalytic gasoline from the FCC unit. While not a major obstacle for most refiners, catalytic gasoline treating effectively reduces sulfur levels but also reduces the octane of the product by converting olefin molecules into paraffins.
An additional complication for refiners will be the growing pool of low octane light naphthas. Natural gasoline production in the U.S. has been increasing for several years and much of this is processed by refineries. As more refineries adapt to processing shale crudes, the light naphtha streams are also increasing. Even as the supply is increasing, demand for these low octane naphthas in the U.S. has declined in recent years. Ethane has now replaced light naphtha as the primary feedstock for ethylene production in steam cracking. The net result of these shifts is a rapidly growing abundance of low octane gasoline components at a time when premium gasoline demand is rising.
The major potential offsetting factor impacting the octane balance relates to the future use of ethanol. Ethanol has an exceptionally high octane with research values generally in excess of 120 and motor values generally in excess of 100. Higher levels of ethanol blending into the gasoline pool could alleviate future octane limitations. The current path of the EPA in setting renewable fuels targets through 2016 indicates a desire to push ethanol blending volumes higher while at the same time acknowledging actual structural limitations, i.e. the “blend wall.” When facing these same conflicting issues in the past, the EPA has backed away from aggressive ethanol blending volumes in recognition of actual blending capabilities. As a result, ethanol growth in the gasoline pool has stalled in recent years.
Even if the EPA forces greater volumes of ethanol into the gasoline pool, a potential octane shortage may not be averted. If E85 becomes the preferred path, the additional octane from the ethanol will not be fully utilized. Typical E85 has an (R+M)/2 octane much higher than premium and results in an inefficient use of the octane supply. If E15 becomes the preferred path, the additional octane will be more efficiently used and would more likely offset the additional strains developing in the gasoline pool.
While the future may be uncertain, there is currently an ability to produce octane in surplus to market requirements. Existing ethanol levels have caused most refineries to either operate their reforming units at reduced severities or to blend naphtha directly into gasoline. As a result, initial increases in octane demand can be met easily without major capital expenditures.
As a result of these conflicting market forces, the future trend of the premium/regular price spread is clouded. At Turner, Mason & Company we continually evaluate the effects of governmental policies, shifts in consumer demand patterns and driving styles to forecast not only gasoline demand but also the future value of gasoline octane. This topic is discussed in greater detail (with future pricing forecasts) in our 2016 Crude and Refined Products Outlook which will be published in February.