Diesel serves as the primary commercial fuel in the US with over 70% of the nation’s goods being transported in diesel-powered vehicles. It is one among several important fuels such as gasoline and heating oil that are obtained from crude oil. It is also one of the most volatile commodities in the global market in terms of price fluctuations.
Retail prices of diesel largely mirror the prices of crude oil in the market, which in turn is sensitive to demand and supply and economic conditions. The most recent example of volatility in prices of diesel fuel was seen in the year 2008, which saw a dramatic change in fuel prices due to the onset of the global economic crisis and declining consumption of fuel in the latter half of the year. The monthly average price of crude oil fell from $133 per barrel in July to $41 per barrel in December. Monthly average prices of diesel fuel followed suit by peaking in July at $4.764 per gallon and plunging to $1.427 per gallon in November and rising modestly to $2.45 per gallon in December.
(B) Calculating Retail Price of Diesel Fuel
Let us first take a look at how the retail price of diesel fuel is computed. Several factors are considered while computing the retail price of diesel fuel. These include the following –
(1) Cost of production and delivery of diesel fuel to consumers
Diesel fuel is obtained as a distillate in the process of fractional distillation of petroleum or crude oil.
The refining, processing, procurement and distribution costs of diesel fuel include –
(a) Cost of crude oil
(b) Refinery processing costs
(c) Marketing and distribution costs
(2) Operating Cost of Retail Station
Retail outlets can be owned and operated by refiners themselves or by independent organizations that purchase diesel fuel from refiners or distributors and resell the fuel to consumers. Operating costs of retail stations depend on various factors such as –
(a) Local market conditions
(b) Location of the outlet
(c) Marketing strategy of the retail station owner
(3) Federal, State and Local Taxes
In 2008, Federal excise taxes levied on diesel fuel amounted to US 24.2 cents per gallon while State excise taxes were US 22.0 cents per gallon on an average.
The final retail price of diesel fuel reflects the costs incurred by each unit of the supply chain comprising refiners, marketers, distributors, and owners of retail stations. The relative share of the various components in the final retail pump price of diesel fuel changes with time based on market conditions and also varies across different geographical locations. The figures below illustrate the share of each cost element in the national average retail price of diesel fuel at $4.43 per gallon as of May 2008 and at $2.45 per gallon as of December 2008. It can be seen that the dip in price of crude oil from May to December is reflected in the lower proportion of crude oil price in the overall retail price of diesel fuel for December 2008.
Figure 1: Major Cost Components of Retail Price of Diesel Fuel – May 2008
Source: Energy Information Administration
Figure 2: Major Cost Components of Retail Price of Diesel Fuel – December 2008
Source: Energy Information Administration
(C) Global Market Factors Affecting Retail Price of Diesel Fuel
Computing the retail price of diesel fuel is not as straightforward as it may appear to be. There are several worldwide factors, political and economic, that influence supply and demand of crude oil and diesel fuel leading to variations in retails prices.
(1) Supply and Cost of Crude Oil
Global supply and demand of crude oil affects the price of crude oil, one of the most important components in the retail price of diesel fuel. Member nations of the Organization of Petroleum Exporting Countries (OPEC) own about two-thirds of the estimated reserves of crude oil in the world and account for 40% of the global crude oil production. The last few years witnessed unprecedented increase in crude oil prices worldwide due to disruptions in crude oil supply during the Arab Oil Embargo of 1973, the Iran/Iraq war in 1980, invasion of Iraq in 2003, unrest in Nigeria, and hurricanes in the Gulf of Mexico in 2005. The trend of surging crude oil prices reversed with the recent onset of the worldwide economic crisis.
(2) Worldwide Production Capacity & International Demand of Diesel Fuel
Refineries in the US have been operating at 90% of their production capacity for more than a decade. Tight worldwide refining capacity and competing international demand for refined distillates affect the price of diesel fuel in the US.
(3) Imbalances in Supply & Demand
Diesel fuel is primarily a transportation fuel. Problems at refineries or inadequate and delayed imports lead to unexpected disruptions in the supply of diesel fuel. As inventories fall, there is competition amongst wholesalers and marketers who are willing to bid higher for available stocks of fuel. This pushes the retail price of diesel fuel upwards. Price spike due to insufficient supplies is a scenario commonly observed in all commodity markets.
(4) Seasonal Variations in Demand
Prices of diesel fuel increase during the fall, dip in late winter, surge during early spring, and again drop a bit during the summer. Demand for diesel dips in spring and summer as gasoline consumption increases during these peak-driving seasons. In autumn, diesel consumption increases due to increased agricultural and transportation activities before the onset of the holiday season. Stores are known to increase inventories during the holiday season in winter.
(5) Geographic Variations
Retail outlets that are farthest from refineries and distribution terminals have higher diesel fuel prices to account for the costs incurred in transportation of the fuel. Local market conditions such as number of retail outlets, traffic patterns, State and local fees also influence the final retail price of the diesel fuel.
The figure below illustrates the change in the nationwide average monthly retail price of diesel fuel in the US from May 2002 to January 2009. The rise and fall in fuel prices in 2008 is clearly the most drastic change observed in recent years.
Figure 3: Retail Price of Diesel Fuel in the US from May ‘02 to January ‘09
Source: Energy Information Administration
Figure 4: Price Trends of Diesel Fuel in France, Germany, UK and the US from January ’02 to December ‘08
(D) Why did diesel prices worldwide increase significantly in the last few years until 2008?
In the US, the average price of diesel fuel has historically been lower than that of gasoline. In October 1998, the national average price of diesel fuel was $1.039 per gallon and that of gasoline was $1.038 per gallon. As of October 6, 2008, diesel fuel was priced at $3.875 per gallon whereas gasoline was priced at $3.484 per gallon. The price differential comes about due to several factors including domestic and global supply and demand forces, economic development, and political and regulatory influences. A few of these are explained below –
(1) Fuel Production
As per the current refinery structure, each barrel of oil produces more gasoline than diesel. 19% of each barrel of oil is used for the production of diesel fuel as against 47% of each barrel that is used for production of gasoline. This implies lower production costs for gasoline than for diesel.
(2) Increased Demand for Diesel
Demand for diesel, especially in Asia, Europe and the Middle East grew more rapidly than US demand for diesel. Developing countries saw an increased requirement for diesel to support rapid industrialization. Financial incentives in Europe favored the use of diesel over gasoline to such an extent that more than 53% of all new cars sold in the European Union in 2007 were diesel cars.
(3) Change in Worldwide Supply Balances
Europe’s increase in demand for diesel put a strain on its production capacity. With increased exports from the US to Europe and Latin America, diesel fuel inventories in the US dipped to a five-year low. In 2005, the US contributed to 13% of the diesel fuel imports of the European Union.
(4) Stringent Environmental Standards
Effective June 1, 2006, ultra--low sulfur diesel fuel (ULSD) began to account for at least 80% of the production of refineries in the US. Sulfur is naturally present in crude oil and the refineries were required to adopt additional measures and processes to produce ULSD. This led to an increase in the cost of production of diesel fuel. This in turn affected the retail price of the product.
(5) Fuel Taxes
Effective October 1, 1997, the federal government has imposed a tax of 24.4 cents per gallon on diesel fuel as compared to a tax of 18.4 cents per gallon on gasoline. In addition, each state levies a diesel tax. This ranges from 8 cents per gallon in Alaska to 32.9 cents per gallon in Wisconsin. The nationwide average is about US 22 cents per gallon. Currently, 15 states levy a greater tax on diesel than on gasoline whereas only 6 states impose a higher tax on gasoline than on diesel.
(E) A Closer Look at the Rise & Fall in Prices in 2008
Till the beginning of 2008, booming economies worldwide led to increased consumption of products such as diesel, gasoline and jet fuel, derived from crude oil. At the same time, world supplies of crude oil and derived products were threatened due to political tensions in oil-rich countries like Iran, Nigeria and Venezuela and also due to reduction in output from the aging oilfields of Mexico, the US and other nations.
In the face of a weakening dollar in early 2008, the financial world began betting heavily in favor of oil and other commodities. The Energy Department of the US government began to purchase 40,000 barrels per day (bpd) of sweet crude oil, which has low sulfur content and is low in viscosity, for its Strategic Petroleum Reserve, thereby inflating demand for the product. Consequently, we saw crude oil prices peaking at an astronomical amount of $147.50 per barrel on July 11. The US Energy Department stopped filling the Strategic Petroleum Reserve on July 1.
However, there was a drastic reversal of trend as the threat of a worldwide economic recession began to loom large and consumption of oil-derived products began to decrease. Demand for crude oil and derived products fell by more than 800,000 bpd in 2008, the steepest drop since 1982.
A similar trend in Europe led to a rapid rise and plunge in demand for crude oil in the European Union (EU). In 2007, the US and the EU compelled refiners to produce ultra-low-sulfur diesel fuel. Addition of several countries to the EU created a surge in demand for diesel and crude oil refiners began to bid against each other to secure supplies of low-sulfur crude oil. However, the euro began to fall against the dollar and European motorists began to feel the pinch of increasing crude oil prices. To add to the mayhem, refiners worldwide have now begun to introduce efficient processes and are now able to produce ultra-low-sulfur diesel from less premium grades of crude oil. All these factors led to a great turbulence in the world market for crude oil and consequently affected the consumption of oil-based products such as diesel fuel.
Forecast for the Years Ahead
According to statistics provided by the US Energy Information Administration (EIA), the downward trend in prices of crude oil and diesel is expected to continue in 2009 and 2010 due to low demand, weak economy, and failed attempts by the Organization of Petroleum Exporting Countries (OPEC) to trim production in order to support substantially higher prices. While oil consumption is expected to continue to decline in 2009, increasing oil production capacity in OPEC and non-OPEC nations will lead to surplus production. The imbalance caused by excess supply and reduced demand will be detriment to the desired upward pressure on prices.
Projected Price Trends
Crude oil prices are expected to average $43 per barrel in 2009 and $55 per barrel in 2010. The price of diesel fuel, which averaged $2.45 per gallon in December 2008, is projected to average $2.27 in 2009. Price trends will be largely dictated by the duration and depth of the worldwide economic downturn, the timing and pace of recovery, and actual production by OPEC refineries.
Projected Consumption Trends
Global consumption of diesel is expected to drop by 800,000 bpd in 2009 followed by a modest rebound in 2010 by 880,000 bpd from the previous year’s levels. Oil consumption is expected to increase in countries that are not members of the Organization for Economic Cooperation and Development, namely China, the Middle East and Latin America. However, decline in consumption in OECD countries is likely to offset any increase registered by non-OECD nations.
The US consumed 65 billion gallons of diesel in 2007. In 2008, consumption of petroleum products in the US fell by about 1.2 million bpd. This trend is expected to continue in 2009 with consumption levels expected to fall by an additional 400,000 bpd. The expected economic recovery in 2010 is likely to boost consumption of petroleum products marginally by 150,000 bpd.
Projected Supply Trends
Supply of crude oil and diesel from non-OPEC nations fell by 340,000 bpd in 2008 due to delays and disruption of projects in the Gulf of Mexico and Central Asia. Non-OPEC supply of crude oil is expected to increase by 180,000 bpd in 2009 and by an additional 90,000 bpd in 2010. However, there is a lot of uncertainty pertaining to increase in supply from non-OPEC nations since these regions face a far greater risk than OPEC nations from unexpected project delays and the credit crunch prevalent in the market, which could render high-cost projects unviable. The good news is that supply from nations such as the US, Azerbaijan and Brazil is more than likely to compensate for decline in production in non-OPEC nations.
In 2008, the US produced an average of 4.9 million bpd of domestic crude oil, a decline from the 2007 production levels by 140,000 bpd. Domestic production is likely to increase in 2009 by over 300,000 bpd to an average of 5.25 million bpd, marking the first significant increase in production in the country since 1991. Output is further expected to increase by 50,000 bpd in 2010 with new refineries slated to go on stream by late 2009.
It is expected that until 2010, refineries will continue to see a drop in margins due to continued decline in the consumption of diesel and other products in the US and other parts of the world. A lot is dependent on the rate of recovery of world economies. The faster the recovery of global economies, the lesser would be the decline in consumption of oil and derived products such as diesel. While all of this information should shed some light on how prices are determined, and possible trends in the future, nobody can truly be certain what the future holds as far as oil or diesel fuel prices are concerned. The only thing we can be certain of is that like most economic cycles, it will surely continue to go up and down, to what extent or extremes, we’ll just have to wait and see.