Authors: Ryan M. Couture and John Auers
A few weeks back we did a two part series discussing recent developments in the diesel market (“Fast and Furious”, Part 1 and Part 2) and how they have impacted the diesel supply/demand balance. One of the developments we mentioned in those blogs was the recent Volkswagen scandal, which is important enough to warrant its own series of blogs. As we study the situation, we are reminded of the words of infamous “Wolf of Wall Street” himself, stockbroker Jordan Belfort, “If you give people a good enough ‘why’ they will always figure out the ‘how’.” Just as that philosophy led to Mr. Belfort’s rise and fall, they also describe the impetus that drove Volkswagen into not only becoming one of the leading diesel automobile manufacturers, but also into the crisis they now face. The ‘why’ incentives to creating an inexpensive diesel engine that could meet very stringent U.S. emissions standards led to the ‘how’ of an elaborate defeat device that allowed Volkswagen to apparently do what other automakers found economically and technically infeasible. The resultant admission of such a scheme has sparked a scandal which will stretch on for years in courts around the globe. VW’s stock price has plummeted, it has become the butt of late night comedians’ monologues, and two of the most respected automotive engineers in the business could face serious criminal charges. As details continue to unfold, among the latest tidbits of news is the announcement that two movie studios (including Leonardo DiCaprio’s) secured the movie rights to a proposed book on the subject. It’s certain the prospective movie will focus more on the powerful personalities behind the scandal rather than larger market impacts, possibly using literary license to replicate the outrageous and hilarious behavior we saw portrayed by DiCaprio in his depiction of Belfort. This has even led to the suggested catchy title for the movie, which we have used for our blog (credit goes to Matt@ShiftCarBlog). Rather than getting into that, we will focus more on how this event might impact the market for diesel fuel. It is increasingly apparent that “The German Wolf” may have damaged consumer diesel vehicle confidence and the ultimate diesel vehicle future, the question is by how much?
Coming “Clean”
While “dieselgate” may have first made international headlines on September 18, 2015, when the U.S. EPA issued a Notice of Violation of the Clean Air Act to Volkswagen AG, the road to this point has been years in the making. Volkswagen and Audi had appeared as wizards to many in the industry, producing a small diesel engine that was able to meet emissions without requiring the costly selective catalytic reduction systems others required to meet U.S. standards. GM ex-CEO Bob Lutz said in an interview after the news broke “I kept asking our engineers: ‘What’s wrong with you guys? VW seems able to do it, are they magicians or something?’ The engineers said they couldn’t answer that question.” As VW and Audi marketed their “Clean Diesel” mantra, they won over groups of environmentally conscious U.S. (and global) consumers, selling millions worldwide.
As the truth has come out, the reality has gotten increasingly worse for VW. Facing rejection of approval for their 2016 TDI, VW finally admitted that nearly half a million vehicles in the U.S. and 11 million worldwide contained the “defeat device.” The “device” was in the form of emissions-cheating software installed in the car that was able to adapt the car’s performance depending on whether it was being tested. As the story grows, the situation has turned from what was initially viewed as a flagrant violation of U.S. law into a full-fledged international crisis for VW. Spanning across their brand portfolio (Volkswagen, Audi and Skoda), their admittance has triggered government investigations across much of North America and Europe as well as parts of Asia and South Africa thus far, while triggering a shakeup in the management ranks.
In the wake of the news, the waves have impacted other manufacturers, both directly and indirectly. In the days after, BMW stock plunged amid news of potential issues with their diesel vehicles. While the company promptly denied any allegations that such defeat devices were in use, it did not stop the skittish market from pummeling the stock 12%, before ultimately staging a rebound. Other diesel manufactures such as Mercedes, Fiat Chrysler and Ford came under scrutiny as well, although to date only Volkswagen is under investigation. While these companies may have done nothing wrong, they will face fallout from “dieselgate.”
Das Auto
For over two decades, Europe has led the world in diesel passenger car use. What exactly drove this surge in Europe, while it struggled to take off elsewhere? As moves toward efficiency and concerns about global warming grew in the 1990s, and a focus on CO2 emissions increased, paths diverged on the correct path to combatting the situation. While Japan focused on hybridization, Europe chose the diesel path, a path that the EU had begun to question prior to the emissions scandal, but which has become a priority since.
When it comes to the U.S., there are several factors which impacted the slow dieselization of the passenger car market. The first attempt into “consumer” diesel engines in the late 1970s and early 1980s in response to the Oil Crisis by Detroit was a flop. Diesels became synonymous with noisy, dirty and unreliable. That consumer memory proved hard to erase, and for a time, domestic diesel passenger cars all but disappeared from the U.S. market.
Europe also experimented with diesel during the same time. Diesels remained a small, but not insignificant minority in Europe through the 1980s and early 1990s. European manufacturers became world leaders in small diesel engine design during that time. As popularity grew and technology advanced, these brands (VW, Audi, Mercedes and BMW) introduced limited diesel options to the U.S. market. These vehicles were more expensive to both purchase and maintain than their typical gasoline counterparts, and while they offered higher fuel efficiency, the low overall U.S. fuel prices and higher diesel taxes made economics more difficult to justify. They filled a niche in the market, but never gained the same foothold.
After the Kyoto protocol, as countries looked for ways to reduce CO2 emissions, European governments (with a push of lobbying from European auto manufacturers) embraced diesel vehicles as the solution. With the technology advancement of preceding years, by the early 1990s, diesel engines had improved dramatically. Due in large part to advancements in fuel injection, diesel passenger cars became increasingly more efficient than their gasoline counterparts. Owing to their increased efficiency, they produced less CO2 per mile than gasoline vehicles, just what the legislators were looking for. Europe was able to increase the number of diesel passenger cars from around 10% in the early 1990s to over 35% in 2013, through a combination of lower taxes on diesel fuel and lower tax and registration fees on diesel passenger vehicles. Combined with the generally high fuel taxes (and prices) in Europe, this led to incentives to purchase diesel vehicles despite their higher upfront cost. With the increased volume of sales and revenues, it also enabled European manufacturers to master their craft of diesel small engine production, or so it was thought.
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With the increasing focus on environmental consciousness in the recent years, auto manufacturers have touted the benefits that different technologies provide. European manufacturers have marketed the better fuel economy and longer range of their diesel vehicles to customers willing to pay a premium for what was thought to be both a convenience and reduced environmental footprint. Some U.S. manufacturers also began to add diesels back into the lineup. At the same time, Japanese manufacturers marketed hybrid vehicles for much the same reason. The modern diesel engine finally began to erase the memories of “your grandma’s diesel,” growing market share to 2.9% today. While nowhere near the numbers in Europe (or hybrids, for that matter) the number of registered diesel cars has climbed by 50% since 2010.
Conclusion
The VW admission will undoubtedly cost the company billions of dollars, but the potential effects reach well beyond VW itself. After cultivating the belief over several years that diesel cars offered an environmentally conscious alternative to hybrids, that reality might be, at least for VW, it was just smoke and mirrors. While it is very difficult to predict how governments, the media and ultimately the greater public react to this development, it is certainly not good news for the diesel automotive market and by extension diesel producers. Does it mean we have seen the beginning of the end for the growth of diesel passenger vehicles, at least in the U.S. and Europe? How about the rest of the world? While it is too early and the possibilities are too complex to definitively answer those questions, we will explore the implications and address the potential impacts that they will have on diesel supply/demand balances, prices, and refiner options in the next installment.
As news events unfold, Turner, Mason & Company continues to analyze what they may mean for the industry at large. We are constantly monitoring how changes in market dynamics can impact all segments of the oil industry. The changes in demand in regions throughout the world promise to change the landscape of the global refining market, seeking a new equilibrium with regard to supply, demand and commodity prices. In response to the changes from both a supply and demand side, we have analyzed this developing equilibrium and the factors which will determine the outcome in a new study, The Evolving New World Order: Rebalancing Global Oil Supply in the Next Decade. In collaboration with Schlumberger Business Consulting, Turner, Mason & Company seeks to provide in this study an integrated perspective on petroleum markets, from upstream production to downstream demand. The prospectus and a subscription form can be found by clicking here, and we are happy to answer any questions by phone or email.