Recently, I spoke with my old friend and colleague, Terry Higgins, on a study just completed for OPIS on “The New Economics of Octane.” What follows are highlights from the interview. You can listen or download the podcast below or listen to it in ITunes.
“We looked at the historic octane market values. They were reasonably predictable over time and at least reasonably explainable. Let me stop here for a minute and just say what I mean by market octane values. That’s simply the difference between high octane, premium gasoline price and low octane or lower octane regular gasoline price. And those price differences are largely driven by octane cost as opposed to others. There is some quality premium in there but mostly that’s an octane value. So anyway over the period, let’s say the last 10 years 2000 to 2011 or so, the market values of octane generally tracked movements in spot prices of regular gasoline or the spot price of crude oil.
Differential stayed within a very narrow range band where that differential was about somewhere between 5 and 7% of the absolute regular gasoline price. This really relatively held pretty consistent over time but then in 2012 that differential jumped up to about 10% and it’s remained over 10% ever since. It has been bouncing up and down and it actually reached a high of about 18% when crude oil prices reached their high but even when the crude oil and regular gasoline prices fell dramatically in 2015 it came off that 18% but still remains well above that. Even the 10% what was all in 2012 certainly well above the 5 to 7%. So that in itself raised questions. What is going on here and what really is driving this something dramatically different has happened in the marketplace.
Analysis revealed a number of factors but maybe not surprising to a lot of people that are looking at markets like tight oil production in the U.S. The expansion of like tight oil had a lot to do with it. Particularly it’s what I call the secondary effects of light tight oil production. Light tight oil had the impact on a number of things. First of all, it resulted in kind of a decoupling of oil and gas prices. The oil price was a lot higher than the energy equivalent gas or LPG price. And the reason that’s important for octane values is because the main way you produce octane in the marginal octane in every refinery is to what is called the reforming process and as that octane gets increased you make a little less gasoline. You make more LPG so with those differential prices expanding you kind of have an expansion or you have additional lost opportunity costs.
And that raises a lot of octane. The second effect of light tight oil is it produced a lot of low octane naphtha in the refineries and gasoline blending system. This is turn raises the cost in that octane. Third, light tight oil has modified the petrochemical industry and petrochemical operations and there is a traditional trade balance of high octane components from the petrochemical industry. These have been reduced, so the gasoline basically raised the cost of replacing that with refinery octane.”
“But those three factors doesn’t explain all of the costs. It explains a lot of the cost and particularly explained a lot of the initial cost that we increased that we saw in 2012. Now in addition to these there are two other traditional or identifiable situations that occurred. First, octane requirements had been falling for quite some time and that’s largely due to the fact that more and more ethanol was coming in to the system. High octane ethanol, so the amount of octane in that refinery has to make was declining and that was actually holding down the cost of octane. That growth in ethanol has slowed down a little bit in recent years. We’re still increasing that ethanol but it has slowed down a little bit. And then a another factor is the amount of premium gasoline has increased recently. For a number of years actually premium market share was going down and now it’s taking a reversal and it’s headed up.
And then the third is that there is also a little bit of an increase in gasoline demand and gasoline exports. So that’s basically what we’re seeing in the market. A lot of that has surprised people. The magnitude of these changes has surprised people. The second part of the question is what really have we seen that was a surprise in our study itself. Well, what we saw is that while we used models, we used spreadsheet calculations and we were able for a long period of this time to quantify why and how much the octane in these various factors impacted the market octane.
But when we got up to these higher octane, the very high octane levels what we found is that we could not explain what was going on in terms of the traditional octane drivers and even the non-traditional light tide oil related octane drivers. There was a piece of puzzle that was kind of difficult to understand. When we drilled down on this we found that we believe and can’t quantify it perfectly but we believe it’s totally related to the fact that all of these impacts coupled with the fact that gasoline demand and exports have been increasing have led to a situation where the refining gasoline octane producing capabilities are actually constrained and we’re at a point where in the short term where anymore octane that needs to be generated is going to be generated with the least efficient, highest cost options.
And therefore there is a significant portion of that total rise in octane market value that’s attributing to not fully quantifiable but an identifiable constraint within the refining system itself.”
“I think probably the major insight that the study reveals is that we do have this not fully quantifiable component that is related to refinery octane producing constraints. So now what will happen to that? Well, on the one hand there will be a drive for higher octane. The more additional octane that’s put into the marketplace or required from the marketplace is going to tend to raise octane costs. On the other hand we also have even though we’re looking towards a fuel economy standard for a few years down the road the combination of the recent growth in gasoline demand that we’ve seen and an increase requirements for exports from U.S. will result in an increase in production of gasoline from U.S. refineries.
Now ultimately we will see that, say towards after 3 or 4 years, it will start to decline a little bit because of fuel economy standards. So those are all the factors that are increasing the cost of octane and as we saw in our study it’s very sensitive. In other words, not a huge increase in what we quantify in the report is octane barrel requirements. It’s really the way you look at it in terms of a refinery. That’s the amount of the octane level multiplied by the production of gasoline and that’s octane barrels. And the cost can be sensitive to that and an increase in that will tend to hold prices up. Now on the other side another piece that we do point out that is very undefined is how are refineries going to respond to that?
Because they can make changes if they improve their refining capability then the cost won’t be as severe and in fact the cost that we’ve already seen may decline. That’s very difficult to project particularly in view that we look at the marketplace and the refining plants we don’t see any major or many significant major projects that’s going to lead to alleviating that issue.
On the other hand, there are many options that the refiners internally with smaller changes can do to alleviate the situation. I think the bottom line is that it’s worth watching the extent to which this octane grows. There will be some uncertainty there as to the cost. We can’t say it’s going to be much higher or lower but if the octane rises very large I would assume that the compensation is done by the refining industry will not offset it. If they’re not very large it could very well be that refining will adapt to that and we could see a flattening in those octane costs even a slight decline.
“Our study addresses this, but I will say there is still a lot of unknowns and there is a debate there as to the need for higher octane and I don’t think that is uniform or agreed upon either from the vehicle manufacturers or the fuel producers. But we do see an increase in octane. A lot of it based on what we see will be it will be fuel economy-related portion of that we’ve quantified in terms what we’ll see as growth as turbocharged vehicles. We’ve already seen an increase in that. We have seen an increase in octane already. It’s one of the factors that has driven the octane values up and what’s interesting there too is interesting to know is that the octane increasing the premium market share has taken on a little bit of change.
In the past, premium market share was very sensitive to price levels and to differentials between premium and regular gasoline. In other words, consumers had a point at which they would pay for that quality. We see that eroding. In fact, we see an increase in price in premium market share even when the fuel price of gasoline was going up and reached its peak, and we see it continuing even though the differentials between regular and gasoline. So for some reason consumer buying behavior has changed. That in part is maybe that more owner’s manuals are saying we require higher octane for those turbocharged vehicles designed as such or it may be that their recommending the premium and consumers are looking and saying and going allow with it.
So we do see an increase in octane. We made a projection in our study. We’ve looked at the EIA has a projection of turbocharged sales over time and we’ve turned that into a percent turbocharge in the marketplace. Now the turbocharged vehicles can be designed for lower octane and higher octane although from what we understand generally you’ll get the best performance out of the higher octane and so we’ve made some assumptions but all of our assumptions lead us to the fact that we see increase in premium market share over time and therefore an increase in octane requirement.”