Crude economics

by Julia Kuzeljevich

TORONTO, Ont. – Over the past few months, there’s been quite a furor over the price of fuel. There’s also been a lot of rhetoric. Depending on what camp you’re in, and how the rising price of fuel has affected your life, solutions such as a tax break or higher surcharges make a lot of sense. Many truckers have been telling Truck News that the price of fuel is breaking their budgets and threatening their livelihood. But a lot of the rhetoric around fuel pricing definitely deserves a closer look. The issue, however unpleasant, is complicated, and it’s not easy to pin the blame in one place.

The mighty barrel of oil, which seems to determine how much money leaks out of our wallets at the pumps, is actually a figurative term these days. Crude was once stored in actual barrels, but today it’s shipped mainly by pipeline. The so-called barrel is simply 159 litres.

But that one figurative barrel yields much more than diesel for your tanks. Depending on the season, it will typically be developed into gasoline, distillate fuel oil (both home heating and diesel fuel), kerosene-type jet fuel, heavy industry oils, liquefied refinery gases, still gas, coke, asphalt and road oil, petrochemical feed stocks, lubricants, and kerosene. In the summer season, the refinery will put more of the crude through the distillation process required for gasoline. And in the winter, it will put more into diesel production.

“There’s roughly about 20 per cent of a crude barrel that you can’t sell, and about five per cent is consumed or lost in production,” says Margaret Kelsch, marketing services manager with Imperial Oil.

The price of gasoline is particularly high in Eastern Canada because many refineries have been trying to meet higher-than expected demands for diesel fuel.

Where the money goes

When it comes to the pricing, however, the money is fed into several directions. If you consider a diesel price of 66.3 cents per litre in Ontario, for example, you’re looking at 26.3 cents going to crude, 23.1 to taxes, 10 cents to the refiner for margins, and 6.9 cents to the marketer for margins. All of these elements make up the price we pay at the pumps.

But why such price hikes over the last year? The main factor is the price of crude.

To a certain extent, the price of a commodity such as fuel is controllable. For example, as recently as two years ago, when the Asian economy was doing badly and bringing other economies down, the price of a barrel of fuel dropped to around US $11 – the commodity value is typically expressed in U.S. funds. OPEC (Organization of Petroleum Exporting Countries), together with other world leaders, actually agreed that a price of $16 a barrel would be better for their economies. To offset the oversupply of fuel they had produced, they cut back production. As the Asian crisis improved, and other economies went on a growth spurt (remember that the North American economy continues to boom), there was a higher demand for fuel to run more trucks, bigger cars, and more flights because of increased travel.

The price of crude oil started to rise again, and last month reached more than $30 a barrel.

But the biggest shock came early this year, when a cold front hit northeast markets in the U.S. and increased the demand for heating oil. This drew heavily on the supply of diesel, and since refiners weren’t stocking big reserves to protect their margins, a lack of supply pushed prices skyward.

The explanation, as we’ve heard it time and time again, is that fuel price closely hinges on a supply and demand equation, and certain factors can throw the whole thing out of whack. OPEC was to meet at press time (March 27) to discuss whether or not it will increase production. And the very perception that they might not is itself enough to keep prices volatile. Those who buy and sell fuel on the commodity market won’t quite be sure what kind of supplies to keep.

“It’s certainly true that markets will be pricing at different levels. Futures markets may decide prices are going down. Refiners are attempting to do the same thing. We’re trying to look at OPEC and see what they will decide,” says Steven Kelly, an international energy consultant with Purvin and Gertz Inc. “That creates some challenges. In some sense, that’s caused a lot of turmoil in international markets. The reality is, they (OPEC) have not agreed to anything yet. We have this expectation of lower prices so refineries are running with lower stocks. But they weren’t running at low utilization rates. Over the last quarter, there were some run cuts ’cause margins were so bad. So the market is vulnerable to shocks.”

But we make our own …

But if Canada is a net exporter of fuel, meaning that we essentially produce enough both to use and to export, why should we be so vulnerable to these shocks? It’s because we are so tied to prices on international markets.

“World prices are not negotiated or set by producers, but set by traders, based on perceptions of supply and demand,” says Rick Charland, publisher of the Calgary-based Daily Oil Bulletin. “Every country will have different costs to extract oil. About US $18 per barrel is a healthy price for a Canadian upstream oil patch,” he says. But countries such as Saudi Arabia can often extract it at a cheaper price, says Charland, so that’s why we still import much of our oil.

“On pure economics, we ship a lot of fuel into the States and import fuel from the North Sea,” he says.

Since Canada’s oil companies can sell fuel on the U.S. market for world prices, they don’t have to cut Canadians a deal.

“The oil companies are saying ‘It’s a world commodity, and this is what we’re gonna charge.’ There is no reason to favor domestic consumers with lower prices,” says Ron Rosnak, of En-Pro Associates, an Oshawa-based company that tracks fuel prices.

Rosnak says that the simple supply-demand mechanism itself was enough to create an imbalance when coupled with the severe winter weather in the U.S. northeast.

“Crude last year was the lowest it had been in almost a decade. OPEC countries said if we want to see the price of crude get to a more reasonable price, we have to cut supply and the amount of crude exported. This time they stuck to their guns, and no one country produced more than the others.”

Fortunately, OPEC’s sphere of influence can only go so far, says Rosnak. People have long memories. He says that OPEC members themselves, just as they did a few years ago when crude prices were low, will recognize the limits of controlled production. “OPEC realizes the price is too high. They are not the only producers. They could make a short-term gain, but if Mexico, Canada and Norway, all major producers and non-OPEC members, were to maximize production, OPEC would lose customers,” says Rosnak.

Different pressures

Canada is the third highest exporter to the U.S. for gasoline, and the second highest for middle distillates such as diesel, so our oil companies are in a good position to take advantage of higher world prices. But our domestic pricing structure is complicated by the fact that, in different parts of the country, prices are particularly sensitive to what’s going on south of the border.

“Everyone’s talking about crude, but in the east crude is not what should be looked at,” says Rosnak.

For Eastern Canada, fuel is priced according to what is known as the import/export alternative. Because there are such major centers to the south, they look at the prices in New York, Albany, etc. “A major indicator for U.S. prices is the commodity cash price at New York Harbor,” says Rosnak. Eastern Canada also relies much more on fuel being trucked in, since the region does not have close access to pipelines.

In the West, the price of crude is the major influence on price, with the exception of Vancouver, which closely watches the Seattle market, says Rosnak. (Still, B.C. has seen a recent price increase that has been largely linked to the price of crude.)

Rosnak says that if prices were better over the border, it
would work the other way. “If the prices are not competitive, the unbranded resellers would head to Buffalo to get their gasoline,” says Rosnak. “If prices in Toronto were too low, the opposite would occur.”

“This practice sort of explains what happens with gas and diesel prices. Prices in the east were more affected by what was happening in the U.S. Northeast. They increased substantially when compared to prices in the west,” he says.

“New York has to be thought of as one of the clearing houses for the whole Atlantic region. Some product from Canada will move into the New York region. We’re also quite aware of European and Caribbean product selling surplus into North America,” says Purvin and Gertz Inc’s Steve Kelly. “In the west, prices are more linked to crude. It’s bounded by what’s happening in other centers, but pricing is sort of niche market.”

Ultimately, it’s business as usual for oil companies, who are often accused of price gouging when the balance goes out of whack.

“We can get ‘x’ amount of dollars for it in Buffalo, so why should we post a lower price in Toronto? It doesn’t matter if there’s a lack of competition. Even if there’s one company left, and they can sell higher south of the border, they’ll sell for that here,” says Rosnak.

No competition

So if there’s no question that Canadian producers have to make themselves competitive with world markets, just how competitive are those producers domestically?

“In a nutshell, what we’re saying is there’s no competition,” says Manju Sekhri, executive vice-president of the Independent Retail Gasoline Marketers Association of Canada. (IRGMA represents unbranded non-refiners such as Cango and Mr. Gas, and branded non-refiners such as those that fly the Petro-Canada flag.)

In the 1980s the federal government became involved in a National Energy Program to promote a Canadian producing, refining and marketing business. Petro-Canada, a Crown corporation, was created so that Canada could move toward more self-sufficiency. Ironically, there has since been a reduction in the number of refiners and marketers in Canada, and a number of players (Supertest Petroleum, Canadian Oil, and Texaco Canada among others) have since exited the Canadian market. Since many of these companies were major suppliers to what is known as the “independent retail” market – those who retail fuel but do not refine it – advocates of independent retailers say that their market share and competitiveness is being squeezed.

“What we see is a declining number of competitors in the last 10 years at retail levels. At the wholesale level, with all the mergers and acquisitions, we’re left with three national refiners that wholesale, and one regional (per province),” says Sekhri. She says the Canadian oil market is one where one price setter sets the stage, and all the rest follow. Sekhri says an amendment to the Competition Act, which was last changed in 1989 to favor Canadian big business over U.S. interests, might provide some structural change that would increase competition.

“The percentage of these type of outlets is now 85 per cent of the market. The majors have increased their direct participation at the retail level so that they have more influence on setting the price,” she says. Sekhri says that in most industries, retail is the most costly segment of the business. Some refiners make a bigger profit at the refineries than at retail stores, she adds.

Refiner margins are basically rack price minus crude prices, and it’s with this money that the companies cover costs such as maintenance, depreciation, employees, taxes, and some profit. Retailers’ margins, (roughly the pump price minus the price at the rack or filling center) would cover maintenance, sewage, water, employees and the recovery of capital costs.

Although producers say marketing margins have gone down over the last decade thanks to restructuring and better productivity, there is still the perception that oil companies are gouging all they can. “Our producers say they are smaller, and they need higher refiner margins,” says Manju Sekhri. In the U.S., if you need a higher margin, you’re out of business.”

“Margins are coming down because of things like efficiency programs. In some markets, margins have even sunk below cost recovery,” insists the Canadian Petroleum Producers Institute’s Bob Clapp. “A larger city with a larger throughput will typically see a lower margin.”

“Typically, you’d expect you’d need to earn a better margin at the retail level,” argues Sekhri. ” It’s the opposite here. We believe there to be an oligopoly at wholesale … The problem with oligopolies is they match on prices, and probably by no more than 1/2 cent a litre.”

Others disagree that there is a lack of competition, or that it is the major factor underlying the high prices.

Competition exists

“Our answer is that there is plenty of competition,” says Clapp. “The thing that gets lost in the debate is who are the independents? There are some who are competing very aggressively, thank you very much,” he says. Companies such as Canadian Tire, for example, will often sell fuel as a lost leader because they do so well in other parts of their business. “The face of the independents is changing. More and more you’ll see companies like Costco and WalMart getting into the gas business,” says Clapp.

And competition is a relative term. During periods of low crude prices, especially in 1998 when they were at around $11 a barrel, there was certainly no outcry against how those prices might hurt producers.

“It’s interesting that the issue of competition only comes up when prices are high,” says the Oil Bulletin’s Charland. “We’ve had a period of low prices for the past 12 years.”

Fuel taxes steady

So are we in a “sit-it-out-and-wait” scenario, victims of the vagaries of the market? Some say yes. And some are crying for government intervention in the form of tax relief. Some say tax relief is just a red herring in the whole debate.

Although it’s true that tax makes up a hefty portion of fuel costs (23.1 cents out of a 66.3-cent litre of diesel), fuel taxes have also not risen recently. “Sure, we should care. But there’s been no fuel tax increase in the last five years, so a tax reduction won’t solve any problem in future,” says Sekhri. “Because we have a market dysfunction and oligopoly in the first place, there’s no proof that a tax reduction would reach the consumer,” she says. “At least we know now that taxes will go to something else.”

“The tax debate is a government policy decision. On a thing like that we’re just silent,” says Clapp. ” We just want to make sure people understand the components of the price when they buy a litre of fuel.”

Some refineries have announced plans to begin posting a price breakdown on the value of fuel.

“Taxes are higher here than they are in the U.S., but they’re considerably lower than in Europe,” says Imperial Oil’s Margaret Kelsch. Consider that in countries like England, where the tax component of fuel at $1.60 a litre is $1.40.

Relief is coming

So where do high fuel prices go from here? Already, with some milder weather in March and slightly lower barrel prices, many parts of the country are seeing a bit of relief. And diesel prices have again dropped back below gasoline in most parts of the country. The federal government has responded to concerns by financing a new study. The Conference Board of Canada, an economic think tank, backed with $600,000 from the Feds, will be studying the markets and pricing practices of the oil and gas industry. There have already been 13 such studies of the industry in the past 15 years.

For the time being, we’re left with the question of seeing how much supply OPEC will produce. “If OPEC increases crude production, prices will come down. But oil companies would also have to run refineries at full tilt, without problems (fires, etc.) Otherwise inventories will not be rebuilt,” says Rosnak.

“What refiners have done and what they can do is rationalize costs,” says Purvin an
d Gertz’s Kelly. “But at some stage you can’t operate without a certain amount of inventory.” Refiners, he says, are simply using a just-in-time delivery system like a growing number of the other businesses.

And as we continue to demand the fuel, there will be a continuing drain on the supply. It’s all a matter of crude economics. n

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