No stability in sight for fuel prices

by Adam Ledlow

TORONTO, Ont. – In a recent poll by the American Trucking Research Institute, fuel prices came in second on a list of the top trucking industry issues of 2006 – just beneath the driver shortage.

But for diesel customers looking for some stability in an industry as volatile as the oil business, unfortunately there’s only one guarantee – more uncertainty. Michael Ervin of MJ Ervin & Associates offered this prediction during a panel on fuel prices at the Ontario Trucking Association’s annual convention in November.

A common misconception, Ervin says, is that major oil companies simply set prices on a whim, when in reality there are three levels in the path of petroleum: the global level, the regional level and the local level.

Three levels in petroleum path

The global market deals with supply and demand. Worldwide demand for crude oil has never been higher, with emerging markets such as India and China compounding the already huge demand from the North American market.

Though the overall supply is technically dwindling, there is still a great deal of crude oil in the ground.

The problem, Ervin says, is how quickly we can get it out.

The biggest player associated with the regional market is the refineries, and though the number of refineries continues to drop, refining capacity is still able to meet demand.

However, the gap between capacity and demand is quickly closing, Ervin says. The simple solution would be to build more refineries, yet none have been built over the past 25 years.

Why haven’t more refineries been built? The short answer is cost. In a sector where profitability is difficult, the fact that it takes about five years to build a refinery at a cost of $2 to $3 billion doesn’t exactly have investors lining up on the oil industry’s doorstep.

On top of that, it’s also difficult to find a North American community that will welcome a refinery as a new neighbour.

At the third and final level of the petroleum path, the local level, you have the resale and commercial markets – namely the fuelling stations themselves. Prices at this level are affected by mark-up by the retailer.

The current mark-up at pumps in Toronto is about two to four cents per litre.

While that may not seem like much, the ever-increasing amount of competition weighs heavily on prices. Media coverage of escalating fuel prices has also made buyers more aware of prices than ever before.

Putting it all together

So what happens when you tie the three levels together? Ervin said the best example of the three markets working together to affect price involve geo-political factors like the war in Iraq and Hurricane Katrina.

For example, at the global level, dealing with the aftermath of Katrina immediately spiked the demand for oil in many parts of North America to help deal with the crisis.

At the regional level, Katrina wiped out 25% of refining capacity, and in turn, the local market struggled to make up for this deficiency by charging astronomical prices at the pumps. Canadian retailers, in turn, raised wholesale prices in order to be competitive with the US.

With an unpredictable global landscape, it can be very difficult to guess what the oil market will do next.

Analysts’ price predictions have been inconsistent at best, with estimates ranging between $40 and $100 per barrel.

Ervin says the truth lies somewhere in the middle, with prices lingering at their current $60 per barrel.

Fuel hedging

Though Ervin’s uncertain fuel forecast may not be the most satisfying bit of news a fleet manager gets this year, there are ways to help provide stability with fuel costs. Daniel Hofstad, a risk management consultant with FCStone, says fuel hedging is one way to protect against fuel price volatility.

FCStone is a commodity risk management company offering various risk management programs to a wide range of industries.

Fuel hedging sets a cap for the maximum fuel price a customer company pays over a 12-month period. When prices rise above the cap, the customer receives a refund, and if prices should fall, the customer simply reaps the benefits of lower prices at the pump.

Of course, there is a premium associated with hedging, much like an insurance company, but with it comes peace of mind, Hofstad says.

Though some may look at hedging as an opportunity for profit, Hofstad says it simply gives certainty to a fleet’s budget – a welcome change for fleets operating in the uncertain world of fuel prices.

“There are a lot of players and a lot of dynamics involved with fuel prices. The volatility and uncertainty of oil prices will definitely continue,” Ervin says.

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