New US diesel era

Oct. 16, 2006
As US fuel consumers enter a new era of highway diesel fuel this week, the first and probably only thing many of them will notice is the price.

As US fuel consumers enter a new era of highway diesel fuel this week, the first and probably only thing many of them will notice is the price. It’s down from the high levels of this past summer but higher than the price of gasoline. While hardly lacking in precedent, a diesel premium to gasoline tends to attract the attention of drivers of diesel-powered vehicles, who have been conditioned by history to think their fuel should be the cheaper of the two. It’s also something to which truck drivers and other diesel users should accustom themselves.

Gasoline and diesel trade in disparate markets, of course. Because prices of both fuels move with the price of their raw material, a crude swoon since August explains much about their recent declines. Otherwise, the fuels have different demand and price influences. Gasoline is subject to seasonal driving patterns. Diesel prices, because the fuel is chemically so similar to heating oil, are sensitive to winter weather. Market differences like these keep the diesel-gasoline price relationship in flux and perhaps less relevant to economic analysis than, for example, crude-product price differentials.

Diesel premium

But gasoline and diesel prices are what appear on service station signs across the country. It’s the difference between them that fuel consumers will notice-and complain to politicians about. And regulations taking effect this week lift chances that the diesel premium to gasoline will become more the norm than the exception. Oil industry officials, therefore, should prepare for questions from a driving public facing a new round of fuel-market changes.

Starting this week, 80% of the diesel produced or imported by all but the smallest refiners and sold at retail for road use must contain no more than 15 ppm sulfur. That’s a 97% cut in diesel sulfur content. The Environmental Protection Agency mandated the ultralow-sulfur product to protect emission-control equipment required on diesel engines entering the market next year. When it proposed them in 2000, EPA said the engine and fuel changes would cut emissions of ozone precursors by 95% and of soot by 90%.

The refining industry spent an estimated $9 billion to install equipment needed for compliance. Beyond the capital costs, the industry’s operating costs have increased for the hydrogen inputs, catalysts, processing severities, and other changes made necessary by the EPA diesel program. And there are indirect costs, such as new pressure on total oil supply as newly intense processing lowers product yields. Overall, therefore, the cost of making highway diesel has risen, although a crude-price slump now masks the effects.

In addition to the newly elevated manufacturing costs, diesel faces a market squeeze. Supply of ultralow-sulfur diesel in the US now largely depends on domestic and nearby hydrotreating capacity and availability of sweet crude. Because other countries also are lowering diesel sulfur content, competition for on-specification product in international trade will be intense, which means the price will be high. Meanwhile, US demand for highway diesel has a new and growing stimulus: the logistics of fuel ethanol, production of which is geographically diffuse and transportation of which requires trucks. Further boosts to demand for ultralow-sulfur diesel in the US will come from regulatory steps extending the requirement to 100% of highway diesel by 2010 and to off-road product in 2015.

Rising prices

Increased costs plus supply limits plus intensifying competition for international supply plus new demand add up to rising prices for highway diesel unless crude prices collapse. And no one expects crude prices to collapse. So the next few years might be very good to producers of diesel from biological feedstocks and natural gas, whose products are free of sulfur. But they may challenge consumers of diesel and of goods transported by diesel vehicles.

When regulations raise fuel costs, consumers ultimately bear the burden. In this case, the costs will yield health benefits associated with lower levels of air pollution. Those benefits are very important. But the costs can’t be severed from them. The relationship must not be forgotten when questions arise about diesel prices, as they will.