Stable on Trend, Instable in the Short Run
Do I have to worry about diesel prices again? As the price of diesel, and gasoline, steadily rise it is time to spend at least a little energy reviewing the situation in transportation fuel markets. How much energy and worry depends on one’s perspective? From the strategic perspective, the answer remains “What, me worry?” If you are younger than 50-years old, you might not know of the cartoon character, Alfred E. Newman, who responded to any challenge with those immortal words. In this issue, he would be on solid ground. Nothing, save the chance of radical political disorder, is poised to cause the energy stress thought to exist from the Mid-Seventies until only five to seven years ago. Technology continues to expand the size of recoverable petroleum reserves – at a great enough pace to offset both growth in demand and the inefficiencies of much of the oil-producing world. Moreover, the unexpected, miraculous doubling of U.S. production capacity over the last ten years puts the swing supply of oil in our hands, not the Saudis’, The only major remaining issue is oil’s links to global warming. However, the economic costs of moving to an oil-less economy with today’s technology are sufficient to blunt any meaningful ban on oil use globally. Moreover, the developed-world countries who might consider such a policy are already reducing their consumption of oil per unit of GDP. As we look for forces that could disrupt the comfortable equilibrium we enjoy, in 2018, downside possibilities are at least as strong as the up-side exposures. This is because the U.S. has demonstrated drilling technologies (especially fracking) that are in only limited use in the rest of the world. Few of the other oil fields in the world are operating with the efficiency of American practice. Were they to adopt those methods, supply would expand significantly, perhaps by as much as 30%. Eventually the other fields will adjust giving us just one of the reasons why informed observers have declared the energy crisis “over.”
Yeah, but fuel is up more than 50% since early 2016 and looks like it will get higher. This is the second perspective, the tactical one that sets the price at any moment of time. This perspective is a function of two separate but related processes. The first of those processes is the gradual increase in the price of oil as demand slowly exhausts supplies of easy-to-extract oil. Back in the Fifties and Sixties oil, Texas and the Persian Gulf, came out of the ground for between $2 and $10 per barrel. Now, artic oil, the 2018 frontier of development, costs over $100 per barrel. Prior to the invention of fracking we were headed towards sustained prices above $100 per barrel. That’s where those high prices in 2008 and 2014 came from. It was economics not OPEC that was driving the increases. But beginning in the Teens, those clever engineers found a way to get historically unavailable oil out of rock for $30-$60 per barrel. For a while it looked like $30 per barrel would be the new rule. Crude prices fell into the twenty dollar range. Now geological realities suggest that $60 per barrel will be the appropriate benchmark. So we have $60 oil in 2018. In addition, recent history has taught us that the amount of oil drilling flexes with price, adding or subtracting supply in response to price – just like in your Economics 101 text book. You can see those dynamics in the chart at right. The number of rigs expands or contracts as prices rise or fall. Such economics are expected to rule for the next five to ten years. If you want more precision you will have to seek it at the altar rail or from your favorite mystic. This all means that we have entered a period of relatively stable prices in the $50-$70 per barrel range that translate to diesel between $3.00 and $3.50 per gallon. Such stability reminds us of the comfortable years of the late Eighties and Nineties when oil prices stayed near $20 per barrel, the ruling benchmark of that time. Now that demand has increased beyond the capacity of those $20 fields, the new level is $30 to $40 higher.
That’s a big increase! “What, me worry?” It is not a big worry because of that stability. We have long since made our peace with $60 oil and $3.50 diesel. As long as it doesn’t jump another big increment, current policies will suffice. Fleets need not pursue any radical changes in technology, but will be incented to continue the promising improvements in fuel economy we see yearly. Those improvements have offset about half of the increase in fuel prices since 2016 and have produced costs a third below those of early 2014. Shippers need not restructure their fuel surcharges, as budgets will seldom be affected by more than the 4.2% fuel has brought the last twelve months.
Watch out! Here come the economist’s nasty qualification: To fully prepare ourselves for energy price swings we must also factor in the second process I mentioned in my introduction to the tactical perspective. As with many human endeavors, commodity prices, and oil is a classic commodity, are subject to a succession of random movements and over and under reactions. One can see this in the accompanying chart. The straight red lines are the underlying trends that I talked about above. Each time the red line changes there has been some big change in supply conditions. The blue line is the actual price, alternately swing above and below the red lines. History tells us that prices swing, sometimes widely, but temporarily. Let’s put that in 2018 terms. $2.50 is probably a good sustainable range for unleaded gas prices assuming $60 oil. But oil is currently at $70 per barrel and could go higher. Here’s the point. These cyclical swings usually go higher or lower than expected and correct later than expected. So truckers, brokers, and shippers have to put up with a bunch of noise in their fuel pricing, temporary swings that seem to have little to do with economics. Right now the most likely swing direction is up. I would not be surprised to see $100 oil and $4 diesel before we see the last of 2018.
There is something you need to do. No, it’s not to invest in natural gas trucks or shift more volume to intermodal. It is rather to understand the volatility of the environment and adjust. Fuel surcharges become important to maintain workable pricing agreements under the pressure of price volatility. Executives need to remain calm during these swings, secure in the knowledge that different prices will soon be available. Put simply, your capital budgets and operating practices should be based on $60 oil; your operating budgets should be able to flex up to $100 oil, or, sometime during the next recession, down to $30 oil. That is the nature of these economics – stable on trend but instable in the short-run detail.
You can get some insight into short-run forecasts: The experts follow two short-run variables when forecasting oil prices. The first is seldom seen in the popular media but has real power in the market place. It is the swing, of “surplus” capacity in global supply. For many years that capacity was principally the property of the Saudis, hence their prominence in oil politics. Now spare capacity in the U.S. fracked fields has joined the Saudis’ supplies, as shown in the accompanying chart. That addition is a big reason why the market is stable at $60 per barrel, not $100 per barrel. In the short run, the level of the swing capacity helps us understand the direction of prices. You can see in the numbers from 2015 a low level of surplus, indicating upward pressure, which occurred last year. However, the production response to rising prices has substantially increased the swing capacity. Those levels suggest strongly that prices will moderate in late 2018 or early 2019. Traders look hard at these numbers, including factoring in the effects of embargoes on Iranian oil or other short-run factors. When a commentator suggests that some supply will leave the market, you merely need to subtract that number from these to get an idea of the effect. Less than two million barrels per day indicate trouble. More than three MBD’s is a good thing. So the drop in 2018 is less of a threat then it looks. Yes, the surplus is down a full MBD, but the level remains high. The Saudi portion of these number are available on the EIA website, but the American additions are my estimates and are available only here.
Inventories are the most immediate indicator. The EIA website also publishes oil inventories under its short-term outlook section. The number to look at is the OECD inventories, a measure of the amount of crude in storage, available for refinement. That amount determines the prices refiners pay for their crude. If inventories are high, the price falls and vice versa. The chart I provide here shows those inventories, high in 2015 and 2016, explaining the low prices of those years. However, in late 2017 and early 2018, the levels fell, and prices reacted, moving up. Note that the 2018 levels remain well above the low numbers of 2014. That level is another reason why most commentators think the current rise in prices will be short-lived. The EIA website also displays diesel stocks (inventories). Although this chart has the same shape as the crude oil chart, the volatility of the diesel stocks is roughly twice that of crude. This volatility reflects the nature of refining, factoring in refining capacity and other variables, like the weather. It means that diesel prices will frequently cycle by more than crude. Also, regional differences affect prices. The main thing for truckers to remember is, again, the balance between the stability of the underlying trend and the inherent volatility of the short-term factors. It calls for flexibility to deal with the variability and the calm to understand that, over time, things are okay. There is no need to change strategy or fuel type. One need merely to flex prices along with changes in fuel price.
 Emerging technologies promise a fossil-fuel-less future in thirty years or so, but that is a discussion for a different and longer-term forum.
 Before taxes.