Authors: John Auers, Elizabeth Hilbourn and Ryan Couture
In “Oversupplying the Diesel Market, Part 1,” we talked about how strong diesel demand in recent years has driven a shift in the industry toward maximizing diesel production at existing facilities and investing in new diesel capacity. These developments have taken place not only in the U.S., but around the world and have been driven by a variety of factors (strong economic growth in developing countries, dieselization policies in Europe, etc.). But recent shifts in demand (and looming oversupply) are beginning to bring this logic (and supply balance) into question. In the past months, prices at the pump have harkened back to the late 1990s and early 2000s, with diesel prices at or below their gasoline counterpart. While the overall decline in crude prices has driven all prices down, this fall has helped increase gasoline demand, while economic weakness has kept diesel demand relatively soft. Last week, we focused on the supply side of the equation. This week, we will delve into what’s happening with demand, and the important factors to consider regarding future consumption.
“It don’t matter if you win by an inch or a mile, winning is winning.” – “The Fast and the Furious”
Diesel prices sank to unprecedented lows this past summer; well below gasoline prices. Normally, in the summer when demand shifts toward gasoline, the price ratio drops close to 1.0. In the winter months, as the demand for heating oil increases, the price ratio runs close to 1.1. This year, from April through August, diesel prices were extremely low, with July having an unheard of diesel-to-gasoline price ratio of 0.82. September is showing a diesel price recovery, as gasoline prices have fallen while diesel prices have remained flat. Will this price relationship hold over the winter months? Figure 1 shows the wholesale USGC ULSD to gasoline price ratio on a monthly basis.
We know that taxes on diesel remain higher than gasoline throughout the U.S., in part due to the higher federal tax, but also higher state taxes in many places. If we look at the ratio of diesel to gasoline price at the retail level, using EIA average retail prices from the mid-1990s to present, we see that the ratio since 2005 has seen a notable step change. Despite the current dip we saw this past summer (falling below 1.0 for the first time since 2009), the ratio still remains higher than when compared to the era from 1995-2005, as seen in Figure 2, below.
On January 1, 2015, Emission Controlled Area (ECA) bunker specifications went to 0.1% sulfur, meaning ships near the coasts needed cleaner burning fuel. The majority of ECA marine demand was filled by marine gasoil (MGO), which is effectively diesel. This increase in MGO demand potentially shows up in ULSD price spikes from December 2014 through February 2015 (seen in Figure 1); however, despite growing demand of distillate for marine fuels, over the past several months there has been a noticeable slump in distillate demand. Why is this? Has the world-wide expansion of diesel production been “2 Fast 2 Furious”?
“This time it ain’t just about being fast.” – Furious 7
The same demand contraction is happening in Europe and Latin America; the prime destinations for U.S. diesel exports (see Figure 3). Growing populations in emerging markets are opting for less expensive gasoline cars; while in developed countries, diesel is losing both the environmental and cost advantages over gasoline. In Europe, U.S. exports face competition from Russian exports; half of Russia’s diesel is typically exported. Diesel has and will continue to dominate in road freight transportation and other heavy equipment, but there is a rapid shift from diesel to gasoline cars. Increasingly, governments are fostering the use of smaller electric-hybrid cars that typically use small gasoline engines.
Though Figures 1 and 2 showed a substantial decline in ULSD prices compared to gasoline from March to August in 2015, the EIA data through June shows that there has not been a significant decrease in diesel exports. Is the world oversupplied with world-wide diesel consumption at approximately 26 MMBPD?
There is an increasing chance the diesel surplus may persist, as the scandal over Volkswagen AG diesel engine emission tests hurts demand growth in the longer term. The German auto-maker admitted to using bypass software to adjust engine performance when being tested to reduce emissions. This software was installed on 11 million vehicles across the VW, Audi and Skoda lines throughout Europe, Asia and North America. While for years, European governments have incentivized diesel vehicles, leading to a large number in the domestic market, there are increasing reasons to rethink those policies – the scandal, the latest of those. And with VW/Audi dominating the U.S. diesel passenger car market, the scandal threatens to mortally wound its chances of success. The dieselization of Europe and subsequent potential impacts of this will be the subject of a future blog.
“This is where my jurisdiction ends.” – “Fast and Furious”
China has had record distillate net exports at 2.86 million metric tons through August of 2015 (88 MBPD), according to Platts’ data. The net export number equates from 3.24 million tons of exports and 0.38 million tons of imports. The Ministry of Commerce in late August issued the fourth batch of oil product export quotas comprising 8.8 million metric tons of distillate. This means that export quotas for 5.59 million metric tons of distillate is unused, allowing the companies to increase exports for the rest of the year. Diesel exports continue to rise amid higher crude oil processing to meet robust gasoline demand. Crude oil processing in China has increased with recently issued crude import quotas granted to teapot refineries. Keep in mind that though the China diesel export increase appears to be rather significant, it is still only 10-15% the level of diesel exported from the U.S. However, it is the same story as in the U.S.; low petroleum prices are driving gasoline demand, but not diesel demand.
“I’ve got nothing but time.” – “Fast and the Furious Tokyo Drift”
One future saving grace may come in 2020, when the demand for diesel is expected to see another step change as non-ECA area bunker sulfur level is regulated from 3.5% to 0.5% sulfur. Depending on the outcome of a review to be concluded by 2018 (as to the availability of the required fuel oil), this date could be deferred to January 1, 2025. Regardless, the European Union Directive 2012/33/EU mandates a maximum fuel sulfur content of 0.5% to be burned in ships in the European Economic Zone in areas outside of ECA’s, beginning in 2020. Since most global crude oils could make a 3.5% sulfur resid, but not a 0.5% sulfur resid, we expect that much of the bunker market will be filled by diesel.
In order to put the January 1, 2015 ECA marine specification change and January 1, 2025 world marine specification changes in perspective, consider the volumes and the magnitudes. The ECA marine volume is estimated at 20% or less of the total marine demand. Also, the ECA marine specification change was from 1.0% to 0.1% sulfur while the world marine specification change will be from 3.5% to 0.5% sulfur. We estimate that a greater volume of the 0.5% sulfur world marine fuel can be fulfilled by a heavier mix than that of the 0.1% S ECA marine fuel. Regardless, the world will see an increase in marine distillate demand in 2025 as resid demand plummets.
“One last ride.” – “Furious 7”
Strong diesel demand in recent years has driven a shift in the industry toward maximizing diesel production at existing facilities, while investing in increased capacity with a focus on diesel production across the globe. But recent shifts in demand are beginning to bring this logic into question. As we showed, prices at the pump resemble the late 1990s and early 2000s, with diesel prices at or below their gasoline counterpart. The decline in relative crude prices has driven all prices down, but this fall in prices has increased gasoline demand while diesel, subject to the whims of the business economy, has remained weak. Additionally, higher diesel costs in recent years have driven pushes toward alternatives such as hybrid cars and natural gas consumption. Whether the shift away from resid in marine applications will be enough to buoy the otherwise softening market, or whether demand declines and continued (and possibly increasing) shifts away from diesel will keep prices nearer gasoline parity have yet to be seen.
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