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US sees shift due to changing supply and demand

As the US witnesses a shift in the use of alternative fuels, Dr Abhishek Deshpande, oil markets analyst at Natixis, explores the trends that may affect demand for and supply of diesel products over the coming decade

The US energy industry is undergoing a rapid transformation. This applies not just to the rising supply of oil and gas, but also to changing patterns of demand for energy products.

Increased substitution between diesel, gasoline and natural gas dominates the outlook for US fuel demand. This is particularly evident in the transport sector, which comprises more than 68% of current demand for US oil products. Such a trend is in addition to rising costs for vehicle users, higher corporate average fuel economy (cafe) requirements, increased bio-ethanol consumption and stringent emission laws.

But as fleet carriers, manufacturers, industries and consumers slowly make the transition towards natural gas, it is now necessary to consider how fast this transition can really take place. And moreover, in view of the current changes in diesel, gasoline and natural gas, evaluate the potential scenarios for the near future.

US distillate supply and demand

Supported by the robust global economic growth between 2000 and 2007, US refineries have, over the past decade, increased their distillate production capacity. Average annual distillates production rose from 3.98 million barrels a day (b/d) in 2005 to 4.54m b/d in 2012, up 14%, compared with an increase of only 3.8% for gasoline production over the same period to 8.99m b/d. Meanwhile, there has been a substantial shift in the patterns of fuel demand across different sectors of the US economy.

Indeed, although there has been strong demand for road transportation over the past 10 years, helping to keep demand for diesel afloat, the sectors that are more susceptible to direct competition from natural gas have seen a steady erosion in the growth of demand. This trend is an important one to consider, even if we are still five to six years from experiencing a real sea change in terms of liquefied natural gas (LNG) trucking demand.

Substitution is already happening in some sectors

For now, demand for LNG trucking remains in a catch-22 situation, with truck users reluctant to switch to LNG until the necessary infrastructure is in place; while distributors are reluctant to commit to major new infrastructure until LNG truck volumes increase.

That said, some stakeholders have stated their intentions to roll out additional refuelling stations, partly in response to their expectations of higher demand. Clean Energy Fuels Corporation and Shell, for instance, are rapidly investing in new fuelling stations across the US.

Meanwhile, demand for heating oil, traditionally a major part of US distillates demand, has declined 5% year-on-year since 2002. This demand is likely to continue falling as US households replace old and expensive oil-based central heating systems with cheaper natural gas, a process being boosted by the recovery of the US housing market.

And refinery usage is also playing a part in the shifting dynamics of the US energy industry. High drilling activity in the US - due to the shale oil and gas boom - has led to a rapid increase in distillates demand from refineries, increasing significantly from the pre-2006 growth of between 8% and 15% year-on-year to the post-2006 growth of between 20% and 45% year-on-year. And although there is a risk of substitution by natural gas in this sector too, the lack of infrastructure means that the industry may need to plateau its shift until natural gas is more easily accessible.

Making the switch from gasoline to diesel

In the passenger car and light truck sector, there is another substitution occurring that affects fuel demand. And that is the fact that consumers are switching from gasoline vehicles to those running on diesel. Indeed, with cafe requirements now in place, automobile purchasers are being encouraged to buy diesel cars - particularly since they offer 30% better mileage than gasoline vehicles.

Certainly, demand for diesel-powered vehicles will gradually catch up with their gasoline counterparts in the future. Yet there are extra consumer costs hindering this transition in the current environment. Diesel-powered passenger cars are more expensive, for instance, and there remains a significant price differential between gasoline and diesel - plus, the federal excise tax on highway diesel is greater than the equivalent tax on gasoline.

Even though sales for diesel passenger cars increased by 25.6% in 2012, it could take another five years before diesel demand is truly affected by this trend. This is because the absolute number of vehicles remains small in terms of both total car sales and total diesel consumption. Likewise, it will take an extended period before gasoline demand is displaced to any significant degree by the sale of diesel-powered automobiles. The shift away from gasoline cars could also be slowed by the rising trend of new "downsized turbo-powered gasoline cars", which have fuel efficiencies approaching that of diesel cars.

As the US economy continues to improve, there is expectation that US demand for distillates will increase by around 2% per annum over 10 years. Thereafter, demand for distillates will likely stabilise due to the rising percentage of natural gas displacing distillates demand within the US.

But considering sector trends in demand, we should expect diesel and natural gas to be used interchangeably in a variety of sectors in the future, depending on which fuel is cheaper.

The outlook for prices is an important consideration

The pace of demand changes for diesel, gasoline and natural gas will depend crucially on the evolution of their relative prices. For now, US natural gas holds a substantial price advantage over diesel, even with the additional costs associated with liquefaction, storage and transportation.

Over time, as distributors benefit from increased industry competition, there is substantial scope for falling prices for LNG. And this will widen the discount between LNG prices and diesel prices, even if natural gas prices rise more rapidly than diesel prices in coming years.

Also, the price premium of LNG trucks over their diesel equivalents is likely to fall due to improvements in technology. Indeed, manufacturers, such as Cummins, are actively developing new engines designed to benefit from the growing demand for LNG. The pay-back period for a heavy-duty LNG trucks is therefore likely to fall over the coming years, and hence we would expect to see a growing proportion of the fleet moving to LNG.

Two potential scenarios beyond 2017

With all of this in mind, we can imagine two potential scenarios beyond 2017. In the first, LNG demand rises both internally and externally to the US. Externally, due to higher exports that could have a positive impact on natural gas prices, similar to that experienced by diesel exports between 2000 and 2005. Indeed, natural gas exports to Mexico are expected to grow three-fold to 5bn cubic feet a day (cf/d) between 2012 and 2014. Similarly, US exports to Canada are up from almost nothing to 2.7bn cf/d in the decade leading up to 2012.

Meanwhile, internally, we could see a significant rise in US truck demand for LNG, which could potentially start cannibalising significant volumes of US truck fuel by 2025, thereby generating a far more pronounced negative effect on diesel demand.

At the same time, due to stringent Environmental Protection Agency requirements put in place last year, there is potential for the US marine fleet to turn towards LNG, while rail companies could follow suit. And oil and gas companies may choose to switch to natural gas for their drilling activities.

This could all have substantially negative effects on US diesel demand, and therefore on diesel prices. Under such a scenario, the US is likely to increase its diesel exports, although this may not be enough to avert downward pressure on diesel prices. It would, however, narrow the discount between LNG and diesel, and lead to an equilibrium in which the costs of diesel and LNG are broadly comparable - further encouraging transportation companies to switch easily and efficiently between the consumption of the two fuels.

In the second scenario, the transition from diesel to LNG occurs at a far slower pace depending on the effect of LNG exports on natural gas prices. If exports push natural gas prices rapidly to a point where it is no longer economical to use LNG versus diesel, this may deter truck, rail, marine and oil companies from making the full transition to LNG, leaving diesel as the preferred fuel for transportation and industrial activity. Excess supply of oil from non-Opec nations could also halt this transition process if it resulted in a sharp fall in oil prices, making diesel prices more competitive versus LNG.

Indeed, in both scenarios we expect an increase in natural gas's share of the overall global energy basket. But a slow and steady ascent of US natural gas prices is likely to be more beneficial to the LNG industry than a rapid catch-up between LNG and diesel prices.

Clearly, any doubts surrounding diesel displacement in favour of natural gas are unwarranted, especially in the US transport sector. It is no longer a question of if this transition will occur, but more  when and how fast it will take place.

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