Prices to go down
Fuel prices are in the limelight again. It is not only because the prices are rising, supported by a sharp increase in oil prices and a slightly weaker currency, but also because gasoline prices have outpaced diesel prices, contrary to expectations that adaptation to the IMO regulations would boost diesel demand and that diesel production would generate stronger profit margins than gasoline.
The starting point: gasoline and diesel price expectations. I discuss them here. In a nutshell: the IMO regulations, coming into force at the beginning of 2020, will generate additional demand for diesel fuel from maritime transport, so its price relative to the price of crude oil (the crack spread) should increase. To meet this demand, refiners will need to increase throughput, exerting an upward pressure on oil prices. Also, more gasoline will flow to the market and, with no additional demand created for the fuel, its price relative to oil will be lower. This shift in relative prices (wider crack spreads for diesel fuel and narrower crack spreads for gasoline) will prompt refiners to implement adjustment processes, which, considering the investment cycle, started before the date of entry into force of the IMO regulations and are expected to take about two years. The change in gasoline prices relative to diesel fuel prices will trigger adjustments in demand for the fuels from end consumers, for instance in the passenger car and light commercial vehicle segments. Although these adjustments will take much longer as they entail fleet replacements, it is already evident that vehicles powered by diesel, a more expensive fuel, are being increasingly replaced by hybrids with petrol engines.
In late December, when I was drafting a post about how the situation in the fuel markets will change following the implementation of the IMO regulations, we witnessed a spectacular slide in oil prices, from over USD 86 per barrel (on October 4th) to USD 50 per barrel (a low last seen in September 2017), which ended on December 28th, a few days after the post was published. The reason was geopolitical factors, related neither to the IMO regulations nor the oil market fundamentals. The price of Brent crude fell by USD 36 (down 42%), followed by a drop in quoted prices of gasoline (down 38%) and diesel fuel (down 34%). The relationship between the prices of the two fuels also changed: dieselhas been more expensive than gasoline since October 5th. Given the structural reasons behind the reversal of the price relationship, I expected this situation would persist for some time.
Four months have passed since the date of that post. During this time OPEC members have cut oil output and the sanctions imposed by the US on oil exports from Iran and Venezuela have come into force. Exports from Libya dropped significantly as a result of the civil war. These geopolitical factors and the IMO regulations have led to a reduced supply of oil, for which there is continued strong demand from emerging economies. Since the beginning of the year, oil oversupply has shrunk by nearly 1 mbd. As a result, oil prices have continued on a virtually uninterrupted upward trend, rising USD 24 (48%). As was to be expected, an increase in oil prices translated into higher fuel prices. The ARA market saw the price of diesel fuel climb by over 30%, less than crude oil, which is normal when price pressures come from rising crude oil prices. Growing oil prices push diesel prices up and the crack spread narrows, whereas in the fourth quarter of 2018 rising diesel prices pushed oil prices up, widening the crack spread. What is surprising, however, is the increase in gasoline prices relative to oil prices. Since the beginning of the year, the price of gasoline on the ARA market has risen by over 50%, outpacing the rate of growth in oil prices. What is the reason behind the strong gasoline demand? Could it be that the relationship between the prices of the two fuels has returned to ‘normal’ and gasoline will again be more expensive than diesel? I think it is too early to say for sure.
The unexpected surge in gasoline crack spreads was an effect of an equally unexpected sharp decline in the crack spreads seen in the second and third decades of January, when gasoline surplus on the market prevented the increase in oil prices from feeding through to gasoline prices. Gasoline crack spreads fell to almost nil at the time, forcing many refiners to reduce gasoline output by shutting down gasoline production units for maintenance. The downtime coincided with the end of the winter season when the market was driven by seasonal sale of winter-grade fuel to prepare fuel terminals for summer-grade gasoline. Placing summer-grade fuel on the market had the opposite effect, as in addition to refuelling vehicles it is needed to replenish stocks, and demand for gasoline sharply increased. Unfortunately, Shell refineries were on strike at the time. A gasoline shortage caused the price to rise at a pace faster that crude oil, with stronger profit margins on gasoline prompting refiners to resume production. A drop in gasoline prices relative to crude oil prices should follow the increase in gasoline output.
When can we expect cheaper oil? In early March, Khalid Al Falih, Saudi Arabia’s Minister of Energy, said that he was leaning towards extending oil production cuts until the end of 2019. Since then the price of oil has risen by USD 10, which the market believes to be expensive as the spot price exceeds by USD 10 the ‘fundamental’ price estimated at close to USD 65 per barrel. The oil market is again in the state of backwardation which, though temporary, encourages speculation that keeps prices high. However, past experience shows that longer periods of expensive oil both speed up structural, that is lasting, declines in demand and stimulate supply. OPEC countries know that and will surely take this factor into consideration at their meeting scheduled for June.
Summary: The turbulence in gasoline prices follows from adaptation to the IMO regulations, and the process will take a few more years. Profound quarter-on-quarter shifts in crude oil prices are driven by geopolitical factors, which are hard to predict and avoid. How will the prices behave? I believe they will go down! Oil prices seem to have little room left for further growth, and I expect them to drop in the second half of the year on the back of rising US production, stimulated by high prices. Gasoline prices should also decline relative to oil prices, which is good news for motorists.