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Petroleum Product Market Outlook - April 2006

Petroleum Product Prices

Crude oil prices briefly reached US$75 per barrel in April driven by increasing tensions in Iran and on-going production outages in Nigeria.  Although crude prices have since receded to about US$70 per barrel, geopolitical concerns and production problems in oil producing countries are expected to contribute to high crude oil prices for the foreseeable future.

In addition to this upward pressure from crude oil, gasoline prices are experiencing pressures of their own.  The Canadian average gasoline price in April was 106.2 cents per litre.  This compares to an average price in April last year of 91.7 cents per litre, an increase of more than 14.5 cents per litre from a year ago.  Figure 5 provides a graph of recent crude oil and gasoline price trends in Canada.

The seasonal increase in gasoline demand, April through September, traditionally results in higher gasoline prices during the summer.  However as noted in the previous sections, this year, a number of supply issues across North America are adding to the upward pressure on prices.

Figure 5
Crude and Gasoline Prices

Source: NRCan and MJ Ervin & Associates

In addition to challenges associated with the implementation of ULSD regulations, refiners in the U.S. are phasing out the use of MTBE as an oxygenate in regions of the U.S. that require reformulated gasoline.  MTBE will be replaced with ethanol, which requires different handling procedures.  Because gasoline blended with MTBE cannot be co-mingled with ethanol-blended fuels, the distribution system will need to be purged of the old product before being replaced with ethanol-blended fuel.  To help ease the problems associated with this transition the U.S. government recently announced that they would relax federal reformulated gasoline requirements.  However, fuel supply problems are still anticipated in some markets and this will put further upward pressure on gasoline prices across North America.           

Finally, strong demand from developed economies, particularly North America, and from emerging economies like China and India for oil and refined products, continues to put upward pressures on prices.  Speculation that the significant problems that resulted from hurricanes in the Gulf Coast last year could be repeated this year are also contributing to current price increases.
 
In April 2006, crude oil costs and consumption taxes represented about 77% of the retail price of gasoline.  The remaining portion corresponded to industry margins.  These margins cover the costs of producing and distributing gasoline as well as provide a profit for the refiner and retailer.  The seasonality of these margins is reflected in Figure 6. 

Traditionally, there is a 5-6 cent/litre difference between the peak summer prices and lower winter prices, all other components being equal, which reflects the strong up-take in demand during the summer driving season and the higher costs associated with producing summer grade gasoline.  This year, the normal seasonal swing has been masked by the dramatic changes in crude oil prices.   Ignoring the seasonal fluctuations, refining and marketing margins have been flat over the past several years.

Figure 6
Refining and Marketing Margins

Source: NRCan and MJ Ervin & Associates

According to the U.S. Energy Information Administration’s Short-term Energy Outlook (STO) released in April 2006, U.S. gasoline prices are expected to average $2.62 US per gallon this summer, up 25% from last summer’s average.  Price increases of this magnitude in the US can be expected to lead to a similar rise in prices in Canada this summer. 

In addition, the STO projects that margins between gasoline prices and WTI crude oil prices in the U.S. will rise 1.5% partly due to the imposition of new costs associated with the ongoing transition to Tier 2 gasoline (new standards to reduce the sulphur content of gasoline by up to 90%) and the phase out of MTBE in gasoline.

Diesel fuel prices in Canada rose to 99.2 cents per litre in April 2006 from 89.6 cents per litre from the same period in 2005. According to the STO retail diesel fuel prices are expected to average $2.62 per gallon over the summer, up 21% from last summer. Before 2005 the retail price of gasoline was usually higher than the retail price of diesel fuel. Starting in 2004 diesel fuel has generally sold at a premium to gasoline throughout the year. Growth in world demand for distillate, particularly in China and Europe, pushed the price spread between diesel fuel and WTI crude oil from $0.76 per gallon in 2003 to $1.07 in 2005.

The transition to ULSD will be difficult for the industry and will result in increased production costs and distribution complexities. The new low sulphur diesel product will necessitate the purging of existing storage and distribution equipment to overcome contamination issues. In fact the larger difficulty will be in the delivery of the new diesel product rather than producing it.  During this transition period, diesel fuel prices may be driven more by short-term supply / demand balance than by average production cost economics.

Historically, Canadian gasoline prices have been higher than diesel prices at the retail level due in large part to the preferential tax treatment for diesel⁵.  However, strong demand growth for diesel fuel vis-à-vis other petroleum products has put significant upward pressure on distillate prices so that diesel fuel is often selling for a higher retail price than gasoline, despite the difference in tax treatment. Given the current challenges and increased costs associated with producing ULSD, diesel prices are likely to exceed gasoline prices this summer.