A Primer: Why Cheap Oil Doesn't Mean Cheap Gasoline or Diesel

I was listening to the radio the other evening and the topic of discussion was gasoline prices in the Lower Mainland. The callers (and host) were expressing their anger that gasoline prices had not dropped with the recent drop in oil prices. I listened as various callers and pundits discussed words like "collusion" and "price fixing" but I was surprised that no one appeared to understand the basics of supply and demand in the North American fuel market. You see there is no terrible conspiracy causing gas prices to rise in BC (and North America), instead it is simply a direct result of market forces and the supply/demand curve. This morning, I had a similar discussion online and in a series of tweets tried to explain the current situation but figured that this topic is one that is so badly misunderstood that I may as well present a very simplified explanation here. Please note, I bolded those words on purpose. This is only a simple overview but recognize there are a lot of complexities that I do not have the time/space to address.

Let's start with the basics. One thing that people tend to forget is that crude oil and gasoline are very different commodities. Crude oil is a mixture of petroleum hydrocarbons (as presented in the ALS Laboratories Petroleum Fractions by Carbon Range chart 2.4 MB .pdf). To explain it as simply as possible, petroleum hydrocarbons are made up of a mixture of individual hydrocarbon molecules. A hydrocarbon molecule is simply an organic molecule made up entirely of carbon and hydrogen. The hydrocarbons can vary in type from small linear molecules (methane, ethane, propane, n-butane etc..) to cyclic and aromatic molecules like (cyclohexane and benzene) to huge monstrous unsaturated compounds (asphaltenes). Moreover, not all crude oils are the same. They can vary from light crudes (Brent Light crude with a higher proportion of lighter molecules) all the way to heavy crudes and oil sands. In order to separate these mixtures into useful components we need a refinery.

Refineries are the locations where crude oil is broken into its component parts for sale. The Wikipedia page on refineries will tell you what you need to know about how refineries operate. The critical thing about refineries is that they are incredibly expensive to build and they are incredibly expensive to operate (see this ref on the Economics of Refining). With such tight margins, a refinery has to operate at near capacity to be worth the money spent to build and operate it. As such we don't have a lot of spare capacity available in North America. From an economic perspective the supply and demand curves match up very tightly. Because of their margins, refineries make more money if they are bigger and as such most of the smaller refineries around North America have closed down. In the BC lower mainland, for instance, the Chevron refinery sits as the last of its breed. It operates at about 55,000 barrel a day and comes nowhere near to meeting the local demand for fuel. Most of the remaining Lower Mainland fuel demand is met by a group of refineries in Washington State (in the Puget Sound). Refineries tend to be located at nexus points where they can get ready supplies of raw materials (crude) and where they can then ship the material out easily (usually in a tanker). Refined fuels are typically not sent around the country in normal pipelines (that are also used for crude) because they pick up too many impurities. Thus, if a refinery in Edmonton sends a load of gasoline down the Trans-Mountain pipeline it typically needs to be polished (have the impurities removed) in Vancouver before it can be sold for retail use. Instead refined products are shipped via dedicated tankers, barges or rail cars. That is why we have the big tank farms in Vancouver. A lot of our fuel is imported by tanker, barge or rail car and stored in tank farms before being sent out for retail sale.

As I mentioned above, refineries are expensive and we do not have a lot of extra capacity in the North American system. Any interruption of the refining system will reduce supply, which consequently results in a rise in price. So even if you have all the cheap oil in the world in your backyard, if your refinery is down then gas is going to be expensive. This brings us to the news. Anyone interested in the oil business knows that right now there is a major labour battle going on in the United States between refinery workers and the refinery owners (Reuters story). This strike has affected the supply of gasoline by reducing the North American refinery capacity by a pretty substantial margin. Moreover, more bad news is on the way as a major explosion at a big California refinery (Reuter story) is only going to tighten up supply. I would be filling up my tank sooner than later if I were you (although you may already be too late) as the gas prices will have to move to reflect this loss of supply.

The other question I was asked today was why gasoline and diesel prices do not appear to run together very well. Specifically, diesel stayed high even as gasoline prices dropped. This brings us back to how refineries operate and supply and demand. As I discussed above, crude oil is a mixture of hydrocarbons. Gasoline and diesel on the other hand are carefully designed formulations. Gasolines are made up of a mixture of hydrocarbons typically in the 5 to 12 carbon ranges (C5-C12). Different formulations will have more of the lighter mixture than others but for the most part that is the part of the crude oil used for gasoline. Diesel is made up of the C8-C24 ranges. A quick look at the hydrocarbon chart will show that a lot of other hydrocarbon products are also derived from that part of the crude oil mixture. The most important of these are fuel oils which are used heavily in the East to keep houses warm. Refineries have the ability to "crack" or "coke" heavier petroleum hydrocarbons into smaller units but this process is limited and the process adds cost to the product. What this means is that for the most part the oil companies have to choose whether they are going to use that part of the crude oil for diesel or for fuel oil. Unfortunately, in the last decade or so the number of trucks and trains that depend on diesel to operate have increased substantially. This has put a stress on the availability of diesel. Moreover, the incredibly cold weather in the East has resulted in a higher than expected demand on fuel oil, to keep those people on the Eastern Seaboard from turning into icicles. So given a strong demand for diesel; a higher than expected demand on fuel oil; and limited refining capacity, we have a perfect storm for diesel prices. Put simply, don't expect a drop in diesel prices anytime soon and expect that even when gasoline prices start to drop (assuming the labour issues as solved) that diesel prices will still remain higher than gasoline prices for the foreseeable future.