Thursday, March 13, 2008

The Diesel Blues

Except for truckers and the few Americans who own diesel automobiles, most of us pay little attention to the price of diesel fuel at the pump. Anyone who needed to buy heating oil this winter has noticed, however. Because the latter comes from the same part of the barrel as diesel and often differs only in the color of dye added to differentiate it from on-road fuels, heating oil has gotten caught up in the same factors that have driven diesel prices to record heights. This year the combination of normal seasonal patterns, long-term global demand trends, and a 25% spike in oil prices since early December have pushed these "middle distillates" to the brink of $4.00 per gallon.

While the average price of retail gasoline across the US is $0.66/gallon higher than the same week last year, diesel fuel has gone up by $1.13. The dramatic increase in the diesel price bears some of the blame for the recent spike in food-price inflation, compounding the impact of ethanol demand on corn prices. Residential heating oil has followed a similar pattern, currently selling at an average of $1.18/gal. more than a year ago. The question I hear frequently is why a fuel that seems easier to make than gasoline and historically sold at a discount to it should suddenly cost so much more, nearly 60 cents more, right now. The answer requires dispelling a myth and taking one of the biggest global fuel trends into account, bigger even than the rise of biofuels, at least for now.

Start with the notion that diesel is cheaper to make than gasoline. That was once true, when its production was mostly a matter of distilling out the middle fraction of light, sweet crude oils--hence "middle distillates"--and putting them in a tank for distribution. Much has changed since then, including big shifts in average refinery crude slates toward heavier, higher-sulfur crude oils and the promulgation of environmental regulations progressively restricting the sulfur content of diesel sold for on-road use. When I worked at Texaco's Los Angeles Plant (now owned by Tesoro) in the late 1970s, the diesel fuel we produced was permitted to contain up to 0.5% sulfur. After successive reductions, the implementation of the 15 parts per million diesel sulfur specification that went into effect in 2006 has removed 99.7% of the sulfur in diesel fuel, at an exponentially-increasing cost per ton removed, the closer the standard got to zero. As a result of these shifts, big parts of the diesel pool are now refined as intensively as much of the gasoline pool.

Global trends also strongly affect the price we pay for diesel and heating oil. At 20%, compared to gasoline's 45%, diesel's share of total US petroleum consumption is much lower than elsewhere. Globally, diesel outsells gasoline, 27% versus 25%, and its lead looks set to increase. Diesel consumption is closely aligned with economic growth, so the development of Asia has boosted diesel demand much more than gasoline demand, so far. In Europe the higher efficiency of diesel automobiles is a key element of the EU's greenhouse gas reduction strategy, and diesel models outsell their petrol competitors. Because most of Europe's oil refineries were built to yield a similar product slate to ours, this shift has produced a growing surplus of gasoline--a big source of our gasoline imports--and a distillate deficit that the EU's expanding biodiesel production can't begin to close. So when the US imports diesel and heating oil to meet seasonal demand, we are competing directly with Europe and Asia.

The global diesel demand trends and higher production costs described above aren't temporary factors, either, and they ride along on top of the steady rise we've seen in crude oil costs. There's no reason to expect that diesel will revert to being cheaper than regular gasoline, or selling at parity with it as it did in the late 1990s. If anything, the average premium over unleaded regular of about 13 cents per gallon that we've experienced since 2006 is likely to expand further. That's bad news for food prices, and it could make the introduction of new diesel cars here a tougher sell, although on a miles-per-dollar basis, diesel still looks cheaper than gas.

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