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Fuel Costs Matter to Public Transit Systems' Bottom Lines; Expert Examines Short- and Long-term Effects of Fuel Costs

Special to Passenger Transport

Principal, Linwood Capital, LLC
Minneapolis, MN

Compared with other public entities, public transportation is a fuel-intensive industry and therefore the cost of energy used to operate vehicles is a major budget item.

During the past 10 years, fuel prices have been variable and volatile. When prices go up, a public transit agency’s budget can be exceeded or reserves depleted.

On the other hand, when prices decline, the opposite is true. Over the past three years, diesel prices are down 53 percent. Will fuel prices remain low or will they rise again?

The main drivers of the price of ­diesel are:

Inventory levels: When supplies are higher, prices are lower;

The value of the U.S. dollar: When the dollar is weak, it takes more dollars to purchase a barrel of oil; and

Speculation: More speculation means higher prices.

For most of 2011-2014, diesel prices were averaging more than $2.50 per gallon but reached highs of about $3.25. These price increases were mainly due to the Organization of the Petroleum Exporting Countries (OPEC) constraining supply and high levels of speculation in petroleum markets.

During this time, U.S. shale production (fracking/horizontal drilling) grew rapidly, causing more reserves at a time when OPEC was limiting supply to support price. OPEC had two choices: Continue to constrain supply to sustain price, or to produce more, drive prices lower and stop the growth of U.S. shale production.

In late 2014, OPEC chose the latter. From then until January 2016, inventories ballooned, speculation plummeted, the U.S. dollar surged and investment in developing new oil resources, i.e., the oil rig count, dried up. As a result, diesel prices decreased from $2.98 to $0.87 per gallon. This decline had OPEC’s desired effect—to decrease U.S. shale drilling and production. U.S. crude production decreased by 1 million barrels per day, and the number of drilling rigs in the U.S. fell from 1,600 in October 2014 to about 300 in May 2016.

In early 2016, prices began to increase again in keeping with OPEC’s plan. These increases also caused U.S. shale production to grow, thereby causing a market surplus to continue. The world was still producing 1 ­million-2 million barrels per day more than was being consumed, keeping prices low, a setback for OPEC.

In November 2016, OPEC and other oil-producing nations curtailed their daily production of crude by 1.8 million barrels per day (roughly 2 percent of global consumption). As expected, prices increased—which was good for OPEC—and also good for American shale producers who increased output.

Since OPEC’s plan went into effect, U.S. oil production has increased by over 600,000 barrels per day, effectively erasing one-third of OPEC’s price gains with no end in sight.

Currently, prices are low because of large and growing inventories, low speculation, a daily market surplus, a strong dollar and weak demand growth. Should any of these change, prices will increase.

The futures market for diesel fuel allows future costs to be locked in by contract. These prices can be different from today’s pump price. Since inventories are large, current futures prices are higher than spot prices representing the cost of fuel storage. Markets are expecting prices to be higher in the future as demand increases, the surplus returns to balance and inventories shrink.

How far can prices move? The market tells us that except for extreme circumstances, the uncertainty of diesel fuel prices is approximately +/- $0.50 per gallon about one year into the future. Many public transit agencies hedge the cost of their diesel fuel by using a variety of tools. If the fuel budget can be brought down closer to the more certain cost created by hedging, the savings can be used for other productive actions.

What’s Next?

As the economist Adam Smith pointed out in his Wealth of Nations (1776), commodities cannot sell in the long term for much more than their marginal cost of production.

As petroleum prices were very high from 2011-2014, the marginal cost to produce a barrel of oil was estimated to be about $80 per barrel—which is fine when it can be sold for $100.

As prices plummeted, however, American shale producers learned to produce much more cheaply such that the marginal cost of production is now about $50-$60 per barrel.

This means that for the time being (barring any supply shocks, etc.) it is highly unlikely that the price of oil will exceed $60 per barrel. Global economic growth and the petroleum demand that accompanies it will eventually solve the problem.

Fracking may not be able to keep up longer term since new wells deplete quickly and sustained production is a function of a high level of sustained drilling unlike traditional wells. The problem is that all current investment is going to fracking and not to traditional oil production. As fracking increases, marginal costs will increase.

Since expansion of traditional production will have been somewhat neglected, there may be a supply squeeze, giving OPEC more opportunities to drive up prices. The big questions are whether the daily production from fracking will be limited by higher costs or by other factors like transportation and whether traditional production will be able to pick up the slack after a longer period of underinvestment.

OPEC’s goal is higher prices for petroleum. But as prices rise, there is more incentive to increase shale production.
For the public transit industry, if you think prices will increase on average over the next three years, then this could be a good time to hedge.

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