By Ryan M. Couture and John Auers
In last week’s blog, we looked at the rapidly changing global market environment for diesel and other distillate based fuels. The dramatic drop in oil prices over the past two years has certainly played an important role, but as we discussed last Tuesday, many other trends are at work in changing the dynamics of diesel markets. Some of these, such the fallout from the Volkswagen emissions cheating scandal, among others, are causing regulators and the public to change their view of diesel from a “clean fuel” to a “dirty fuel,” causing serious “headwinds” for diesel demand. Others, such as moves to lowering sulfur limits for bunker fuel, provide potentially significant “tailwinds” to future demand. Difficulty in knowing what happens to global economic growth, especially in light of the Brexit vote last week, provides a major unknown to the “wind direction” propelling or repelling diesel demand. Certainly the majority of action in the diesel markets has taken place beyond U.S. borders in recent years, as economically driven demand growth in developing countries and regulatory driven dieselization in Europe have been the marquee events. However, the U.S. remains a dominant player both on the demand and supply sides, leading the world in domestic consumption, refinery production and exports of diesel. In this week’s blog, we will examine trends impacting the domestic markets in an effort to determine whether diesel remains a “cool rocking daddy” or becomes a “long gone daddy” in the U.S.A.
“I’m ten (actually five) years burning down the road”
Over the five years from 2010 to 2014, global diesel demand growth has far outpaced gasoline demand growth, 1.7% vs. 1.0%. In the U.S. this trend was even stronger, as diesel grew by 1.5%, while gasoline consumption fell by 0.2%. This led to major shifts in pricing relationships, with diesel growing to a wide premium vs. gasoline, a big change from historical patterns. But the drop in oil prices has dramatically reversed this trend. Low consumer prices have led to strong growth in gasoline demand throughout much of the world, averaging 3.4% annual growth on a global basis in 2015. At the same time, diesel demand grew at less than half that rate, averaging 1.2% globally. As we discussed last week, this demand growth was distributed very unevenly on a regional basis. Asia/Pacific continued to show strong gains, just as they have for much of the last two decades. However, other previously fast growing markets, such as the Middle East, Latin America and Russia, where petroleum production is important to the local economies, were negatively impacted by low oil prices, with diesel demand declining in those regions. Certainly the region which saw the biggest shift in 2015 was Europe, which led the world in diesel demand growth at 4.1% in 2015, a dramatic turnaround from the declines experienced in the previous five years.
As we discussed last week, diesel demand does not react as directly as gasoline does to low prices. Diesel demand is driven in large part by the strength of (or weakness in) the economy. In the U.S., where only a very small percentage of passenger vehicles use diesel, this is even more true. While gasoline saw an increase in 2015, as low prices spurred consumers to drive more, a slow economic recovery caused diesel demand to decline by 1.4% to less than 4 MMBPD. For the first three months of 2016, diesel demand was even weaker, almost 9% (370 MBPD) below levels in the first quarter of 2015, due in part to the mild winter which cut into heating oil consumption. While demand has picked up since then, it continues to be bumpy and nowhere near as robust as gasoline demand.
Just as was the case globally, in the U.S. regional diesel markets have been impacted differently by the drop in oil prices. The crude producing regions (PADD II and III) saw relatively large declines in demand, while demand in the rest of the country was relatively flat. Overall, U.S. diesel demand dropped by 58 MBPD, or 1.5% in 2015.
When putting these numbers into perspective, U.S. diesel demand in 2015 rests at the level it was in 2008, and near the peak set in 2007. Demand recovered after the recession in 2009, but never made it back to that peak. In the near term, demand will be dictated largely by the health of the economy and to some extent by fluctuations in weather that impact heating oil demand and consumption for farming (especially in the Midwest). In the long term, though, there are a series of factors that will impact U.S. diesel demand.
”Got in a little hometown jam”
Long term diesel demand in the U.S. faces several challenges. The primary consumers of diesel fuel in the U.S. are commercial medium and heavy-duty vehicles, ranging from your F250 diesel pickups to big rig semi-trucks. These trucks transport almost every item we use in our daily lives. While these trucks make up only 4.3% of vehicles on the road (although in some places, it seems like a lot more), they travel nearly 10% of total miles driven and consume more than 25% of the total fuel, most of that diesel. While regulations to improve fuel mileage for passenger vehicles, the CAFE standards, have had a lot of focus, medium and heavy-duty diesel vehicles got less publicity. The lack of attention does not mean they were ignored. The U.S. EPA has implemented Phase 1 and introduced Phase 2 vehicle regulations aimed at reducing greenhouse gas emissions and improving efficiency in these vehicles as well.
The Phase 1 regulations are currently underway, and impact model year 2014-2018 heavy-duty vehicles. The Phase 1 regulations divided the heavy-duty segment into categories by use type, setting separate standards for both engines and vehicles. It also set separate standards for CO2, NO2, CH4, and HFCs, in concert with fuel consumption standards. The Phase 1 regulations are intended to achieve a 7-20% improvement over the 2010 baseline numbers for fuel consumption, phased in from model year 2014 to 2017 vehicles.
Under the latest Phase 2 regulations, fuel consumption from big rigs could drop as much as 24% over the 2018 baseline. The changes will be implemented gradually for 2021 to 2027 model year vehicles. Also under Phase 2, the regulations extend to semi-truck trailers as well beginning in 2018, marking a first for the EPA. The Phase 2 regulations have only been proposed so far, though, and could change depending on the outcome of our upcoming elections.
Much of the gains in both Phase 1 and Phase 2 can be achieved via “off-the-shelf” technology. In fact, truck makers have actually managed to get a bit ahead of the regulations thus far. Since a majority of fuel is burned fighting wind resistance, the use of trailer side skirts, “trailertails,” rounding edges and reducing gaps all help with trimming resistance. Improved tires (single, wider tires have lower rolling resistance than the “dual tire” configurations) can put a dent in fuel use. Regenerative braking and smarter automatic transmissions also offer opportunities. Beyond that, moving to hybrid powertrains for urban applications offers even more opportunities. Experts say that these alone should be enough to get trucks to where the EPA needs them to be.
Moving forward, evaluating raising vehicle weight limits, autonomous vehicle controls that allow for “platooning” (where trucks follow closely to each other, as close as 25 feet, much like when people try to draft off the back of semi-trucks to reduce wind resistance), and allowing for larger “road trains” (longer multi-trailer configurations) can all provide incremental gains aimed at reducing fuel consumption. However, these will be more difficult to implement, and will require further legislation to change existing laws, as well as increased development and public trust in autonomous vehicle systems.
In addition to the EPA legislation that is already being implemented, Southern California anti-smog regulators have formed an alliance with several states including WA and NY, to lobby the U.S. EPA to legislate all trucks to run on natural gas by January 1, 2024. We view this legislation as a long shot; even if such regulations were imposed just in California, the complete changeover to these “zero-emissions” trucks would still take another two decades, due to long phase-in periods and slow turnover rates. Even then, without ubiquitous participation, out-of-state truckers that move goods from the Los Angeles/Long Beach twin ports would remain out of regulators’ jurisdiction but still on the road. Regardless of these regulations, the use of CNG for fleets such as in short-haul trucks, urban delivery trucks, garbage trucks and buses are on the rise. In these cases, it is not just an incremental but total reduction in diesel consumption, and will amount to a sharp drop in diesel demand for those segments.
While in the short term there will likely be little change, in the mid- to long-term, these efficiencies will impact diesel demand. The exact amount is up for debate, but in anticipation of these regulations, the EPA produced a separate demand case in their Annual Energy Outlook 2016 that evaluates the impacts of Phase 2 regulations. They forecast that in 2040, total medium and heavy-duty vehicle fuel use will be 18% lower than their reference case, resulting in a reduction from 3.4 MMBOEPD to 2.6 MMBOEPD for medium and heavy-duty vehicle usage.
Inexpensive natural gas has also prompted a move away from distillates for heating oil. While mainly used in the Northeast, demand has been in the 225-275 MBPD range for the past several years. As consumers move to natural gas, demand will slowly be lost there.
Finally, we cannot forget the impact of renewables in the fuel pool. Federal regulations target 2 billion gallons of biomass-based diesel be blended into transportation fuels in 2017. While 2 billion gallons amounts to 130 MBPD, this is likely to remain constant or increase even if total future fuel demand falls, meaning any declines will fall squarely on the petroleum portion of the fuel.
“Come back home to the refinery”
While the previous section spelled a lot of “doom and gloom” for diesel demand, we still predict that in the mid-term (2020-2030), demand will ultimately continue to increase. Domestic population continues to grow, and with that, demand for goods and services. In the near-term (through 2020), momentum from a slowing economy and low oil prices will cause some declines.
Despite the low absolute numbers, U.S. diesel vehicle registrations were still on the rise in 2015. The U.S. added nearly 330,000 new diesel passenger vehicles, SUVs and pickup trucks. While the total number of vehicles is still a fraction of total gasoline vehicles, the number of vehicles with diesel options has risen in recent years. While it is too soon to see what the impact the Volkswagen scandal and subsequent fallout will have, double digit growth rates of diesel cars and SUVs in several states (including California, at over 15%) will add to demand.
“Sent me off to a foreign land”
Independent of demand trends in the U.S., domestic refiners will continue to have export markets to supply. The U.S. transitioned from the world’s largest product importer to the largest product exporter over the past decade, and diesel has led the charge. A large majority of these diesel exports have gone to Latin America, while Europe has also grown more dependent on U.S. supplied product. Despite the economic woes of past years, Latin America remains a vast and growing market. Due to persistent challenges with the operation of local refineries, the region has become increasingly reliant on product imports to meet demand. While the current Latin American recession has depressed demand over the past couple of years, we forecast that demand will continue to increase in these developing areas.
Conclusion
U.S. diesel demand has seen a decline in recent months, despite strong gasoline demand. Going forward, diesel demand growth will face headwinds. In the near term, a weaker economy puts a damper on demand growth. In the mid to long-term, regulations aimed at improving vehicle efficiency and reducing GHG emissions, as well as shifts towards natural gas will reduce diesel demand. On the other hand, as the U.S. population continues to increase, demand growth will remain as more goods and services are needed, giving a boost to domestic demand, while ultimate economic recoveries in Latin America will boost demand for U.S. diesel exports.
We are currently preparing our 2016 Crude and Refined Products Outlook Mid-Year Update which we will be releasing in mid-July. In this, we will provide comprehensive price and demand forecasts for both domestic and international demand, including distillate demand. We will also delve deeper into the topics we mentioned and how they will ultimately impact both diesel demand and the global balance. For more information on this product or on specific consulting engagements, please send us an email or give us a call.