Fewer diesel cars were registered in Canada last year than electric but, even though the minority of the population fuel up at the diesel pump, it doesn’t prevent the casual observation of how the price of diesel moves relative to gasoline. It wasn’t that long ago that diesel cost less, but that hasn’t been the case for more than five years and it was especially not the case in 2022. Diesel prices soared to record high levels and record high spreads versus gasoline. The reversal this year has been equally shocking, yet it is unclear whether we should be cheering or worrying.

 

 

 

Just looking at average prices in Canada for regular unleaded gasoline and diesel, the move in recent months has indeed been startling. The spread between the two peaked at just over 70 cents/lire in December – eclipsing the 50 cent gap that emerged after Russia’s invasion of Ukraine and more than tripe the previous highs over the past decade. There are several reasons for why diesel became so expensive relative to gasoline, keeping in mind that the prices for both fuels went through the ceiling after the invasion.

 

In addition to supply line disruptions, refinery shutdowns last year exacerbated already tight supplies of diesel. There was also a rebound in ground transportation that stoked demand over the course of the year, however, the recovery in air travel was even stronger. This meant that demand for jet fuel (pardon the pun) soared, and refineries leaned more towards the production of this segment of the barrel, thus taking away from the supply of diesel. The refinery situation has stabilized somewhat, which helps the supply side of the equation. That doesn’t explain how the average price of diesel at Canadian pumps has dropped from more than $2.40/litre to only $1.65 this week.

 

On the surface, this sounds like a wonderful thing given how we are trying to wrestle inflation down to the ground and get out of this cycle of rising interest rates. It definitely is a positive factor in reinforcing a disinflationary trajectory for our economy and the US (diesel prices south of the border are down more than 20% from November). It’s also a positive in terms of corporate profit margins. Just as soaring fuel prices pressured companies (and consumers) because of the transmission of higher transportation costs into final prices, the reverse is also true. It now costs less to ship and because we aren’t going from a globalized economy to a nationalistic make-it-at-home one overnight, transportation costs still matter. Again, this revives the profitability of firms and takes some additional pressure off retail inflation.

 

 

 

The problem is that the main driver behind falling diesel prices is a growing inventory of the stuff. Last week, total distillate inventories in the US rose to almost 14 million barrels, which was almost a 2-year high. Some economists are linking this build to a sudden drop in demand for diesel across the country, and that this is reflecting a slowdown in economic activity and possibly a transition into recession. That is indeed possible, but let’s put this all into some perspective.

 

First, as much as the spike in inventories was food for media headlines, it was only in November that we saw the lowest inventories in 10 years.  Demand for diesel did drop last week by a whopping 11% to 3.8 million barrels per day; however this comes after a surge to over 4.2 million barrels per day in the prior week, which was the highest since October.

 

There has definitely been a downward trend in diesel demand since the start of 2022, driven by higher prices and the impact of rising interest rates. Given that there can be a lag of 12 months or more between tightening in monetary policy and demand in the economy, it is likely that we will see even lower demand into the second quarter and beyond. That could put further downward pressure on diesel prices and it might even lead to a situation where we once again have gasoline and diesel parity.

 

But, what makes the use of diesel analysis problematic in terms of deciphering macroeconomic signals is that fossil fuels in general are losing their leading indicator qualities. On Wednesday, the White House (via the Environmental Protection Agency, EPA) proposed that two-thirds of new cars and 25% of trucks sold in the US will be all-electric by 2032. Some believe this plan could lead to an estimated 17 billion barrel decline in oil demand over the course of the next three decades. As I have discussed many times before, this isn’t a light switch. To achieve that forecast, there is a tremendous infrastructure build out that has to take place. 

 

 

 

For now, despite the pessimism stemming from banter around diesel, crude oil futures are rallying on increased optimism over global growth and we are now sitting with oil above $82/barrel versus only $64 on a few weeks ago. We are also heading into the summer driving season (based on this week’s temperatures, you may have thought that we were already there!) and that should see additional upside for the price of crude. If there are underlying economic strains that are being reflected in the price of diesel, we may even see the two prices converge this summer.

 

From a portfolio perspective, the evidence of an outright recession developing into the second half of the year is still not convincing, though we are going to see a break in recent “resilient” economic indicators. Inflation is moving in the right direction, as outlined by the Bank of Canada this week, but we are far from talking seriously about rate cuts in 2023. That means that stocks are still generally overvalued in our opinion. And should oil and gasoline prices advance in the coming weeks, the year-over-year comparables for headline inflation may not appease central bankers as some bulls feel. Yet, the decline in diesel is going to be supportive for margins of those companies more heavily reliant on transport. Keep watching those pump price signs.

 

On behalf of the Pyle Group, have a wonderful weekend.   

Andrew Pyle

 

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These are the personal opinions of Andrew Pyle and the Pyle Group and may not necessarily reflect those of CIBC World Markets Inc.