Fuel For Inflation

Aug. 11, 2006
There are three drivers for fuel prices, according to Mark Hazelwood, executive vice president of Pilot Corp. Fundamentals, inventories and consumption,

There are three drivers for fuel prices, according to Mark Hazelwood, executive vice president of Pilot Corp. Fundamentals, inventories and consumption, looked stable as of late July. The geopolitical scene was tense because of fighting between Israel and Hezbollah in Lebanon and concerns over any role the world's fourth largest oil producer, Iran, might take in the conflict. But with more funds in the market, oil trades like an equity and the price drivers are not limited to the fundamentals, observes Hazelwood.

Speaking at an event hosted by equity analyst Stifel Nicholaus, Hazelwood pointed out that demand for diesel fuel follows truck tonnage and miles driven, and that means demand is flat to slightly down. The freight market is good, but he doesn't expect any surges like 2004 and 2005.

Increased inventories and lower demand have helped keep diesel prices somewhat in check despite escalating hostilities in the Middle East. Those tensions caused prices to spike to over $78 per barrel in early July before settling to $74.29 on July 23rd. Inventories of crude oil were up 12% over 2005 and diesel inventories were 2%-3% ahead of 2005, according to Hazelwood.

"We are seeing some reduction in demand for oil, perhaps less than we would like," says Ben Bernanke, Federal Reserve Chairman. Based on the same futures market activity Hazelwood alluded to, Bernanke says he expects crude oil prices to stay in the $75 to $80 range over the next two years. That said, he notes that if oil prices rise another $10 to $15 per barrel, it would have serious consequences for the U.S. economy, which, he notes, is already suffering from high fuel costs.

On the inventory side of the equation, supplies appear to be plentiful despite two unexpected refinery disruptions in July. Valero Energy Corp. shut down its St. Charles, La., refinery for 20 days for unexpected repairs. A power outage at a ConocoPhillips refinery in Illinois due to severe weather triggered some concerns in the market, but no long-term disruptions in production.

Is there enough refining capacity in the United States? Yes, barring catastrophic events like the 2005 hurricane season that took 25% of refining capacity offline. No new refineries are being built, but some refineries are expanding. (The last new refinery was built in Garyville, La., in 1976.)

The impact of ultra-lowsulfur diesel
A concern for carriers and shippers alike is the move to ultra-lowsulfur diesel fuel (ULSD) mandated by clean air regulations. As of July 1st, 80% of the diesel refineries' production must be ULSD. The reason for concern is that ULSD has about 2% to 2.5% less energy content than current low-sulfur diesel, says Hazelwood.

When vehicles incorporating the lower-emission engines mandated for the 2007 model year hit the road, retailers will have to offer ultra-low-sulfur diesel. Pilot, which operates travel centers across the U.S., will have ULSD by October 15th, but Hazelwood doesn't expect the new engines to be on the road until the second quarter of 2007.

In addition to 2% to 2.5% lower fuel efficiency, ULSD will initially cost retailers about 6 to 8 cents per gallon more coming from the refinery. That price will come back into parity with current diesel in about a year, Hazelwood predicts.

Also on the horizon is biodiesel. Chevron Corp. has announced that it formed a biofuels business unit to advance technology and pursue business opportunities related to production and distribution of ethanol and biodiesel in the U.S. The Chevron announcement was made at the ground breaking of a new, large-scale biodiesel plant in Galveston, Galveston Bay Biodiesel (GBB). GBB will produce biodiesel from soybeans and other renewable feedstocks, said Chevron. Initial production will be 20 million gallons per year when the plant is completed at the end of 2006.

Biodiesel production in the U.S. totaled 75 million gallons in 2005, according to Chevron. There are about 40 new plants being built. That will mean more biodiesel fuel will be available in two or three years, says Hazelwood.

With all of this market volatility, it would seem that carriers would be hedging fuel purchases. Indeed, some do, but hedging is less common because of the perception that we are near the top of the price curve. If prices are expected to rise dramatically, hedges work. If not, or if they fall, they have less value, says Hazelwood. Most of the motor carriers that use fuel hedges are privately held, so reporting on the impact of hedges on operational costs and profitability can be limited.

Many trucking companies are changing their strategy on fueling, according to Hazelwood. In the mid-1990s, JB Hunt did 65% to 70% of its fueling at terminals, today they only do about 15%. One reason is hours of service (HOS). Taking a driver off the road to come into a terminal decreases available hours. So, now they fuel more often at travel centers along the route.

Fuel surcharges are fairly efficient fuel cost recovery mechanisms, says Hazelwood. Still, carriers have made an issue of the lag time between fuel surcharges and costs when fuel prices rise rapidly. Shippers counter that carriers often leave the surcharge in place after the price has dropped. Overall, the cost and price have tended to sort themselves out over time, but when fuel costs don't drop, that initial lag impacts carriers' financial performance.

Arguably, owner operators have less clout when it comes to fuel buys, and many reports point to the number of owner operators who exit the market as proof that high fuel costs are changing the complexion of the industry. Volume discounts notwithstanding, if Hazelwood is accurate in saying more carriers have switched from fueling at their terminals to buying at truck stops, there's less difference in diesel price for the corporate entities versus owner operators than many think.

Fuel is only one factor contributing to the shrinking number of owner operators in the market today. At one time they represented 37% to 38% of the market, says Hazelwood, but today owner operators make up less than 20% of the market.

Owner operators have raised issues over surcharges that were collected by carriers and brokers and not passed along to the driver who was actually responsible for the fuel purchase. The Owner Operators Independent Drivers Association (OOIDA) has backed legislation to reform the surcharge process and is currently mounting a campaign among members encouraging them to institute fuel surcharges and advise customers of the fact.

When shippers weigh in on fuel surcharges, they take a firm line. In Morgan Stanley's Freight Pulse Survey, shippers commented that they were seeing some carriers start to incorporate fuel costs into regular rates. Others have developed their own fuel surcharge tables or put a cap on what they will pay carriers. The core message from shippers was that they believe carriers are using fuel surcharges as a revenue stream, not just a means to recover costs. Those shippers are negotiating the fuel surcharge right along with the rate, not merely accepting the charge the carrier wants to pass along.

It's significant that the Freight Pulse Survey, which uses Logistics Today readers as a large part of its research base, also indicated that shippers are holding the line on rates. Many report no rate increases or even rate decreases.

Future rates are another matter. Pilot's Hazelwood anticipates incredible demand for truckload in the third and fourth quarter because peak-season freight is time sensitive. This will put pressure on rates in the first and second quarter of 2007.

Shippers, carriers, and industry analysts agree with Hazelwood's observation that "the risk associated with the hurricane season is one of the scarier things that we have to face each year in this country." All but one refinery disabled by hurricanes in 2005 was back in operation as of June 2006, but 15% to 20% of crude producing platforms are still not up.

For the moment, inventories and supply are in line with demand, but the weather and world events are the wild cards everyone is watching.

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