Carrier Pricing and the Impact of Diesel Fuel: Is the Pendulum Swinging?

As diesel prices hit record levels, we have a shipping environment unlike anything we have seen in the past.

It's the relationship between the shipper and the carrier, the shifting of power, the question of who controls the price. It's a cycle that takes place once or twice every decade. The ebb and flow of transportation rates mirror the supply and demand needs of the shipping public and the available capacity of tractors, trailers and drivers. As we add in record high diesel prices with a stagnant (or very slow-growing) economy, we have a shipping environment unlike anything we have seen in the past. Rising fuel costs and the slowing economy have reduced available truck traffic, thereby squeezing trucking profits.

Following the last two years of carriers chasing a declining level of tonnage, thus lowering rates, shippers can expect, and should start planning for, rate increases. The shrinking transport capacity is coming back in line with shipping demand as carrier bankruptcies have removed capacity from the market place. Shippers should start preparing for rate increases in the 3-4 percent range for the second half of 2008 and the beginning of 2009. This compares to less than 1 percent for the first half of 2008 and declining base rates for 2007. These percentages do not take into consideration the effect of carrier fuel surcharges.

As 70 percent of the nation's freight tonnage moves over the highways on trucks, already thin profit margins have moved carriers from the black to the red. According to America's Commercial Transportation research group, more than 45,000 vehicles, or 3 percent of the tractor fleet, have disappeared from the industry since last year. Carriers with at least five trucks are going out of business at an accelerated pace. The American Trucking Association reports that in the first quarter of 2008, 935 operations have shut down. This is up from 385 in the first quarter of 2007 and is the highest quarterly failure rate since the 2001 recession. The soaring price of diesel fuel to over $4.60/gallon today versus $2.50/gal from just a year ago has had an enormous impact on carrier profitability. For a big rig that gets six miles to the gallon, an 80 percent increase in fuel in 12 months is not built into the transportation industry business model.

What's the cause of our record high diesel fuel prices? Whether it's OPEC, the Federal Reserve, the U.S. Congress, Wall Street or the oil companies, everyone has an opinion. Let's start with one of the world's biggest hedge fund traders. George Soros said, "Although weak U.S. economy, depleting supplies from aging oil fields, government fuel subsidies and record Chinese and Indian demand could explain the parabolic surge in energy prices, the crude oil market is also significantly bloated by speculation."

A weakened U.S. dollar places upward pressure on the cost of crude. Each time the dollar falls by 1 percent, the price of a barrel of oil rises by $4.00. The same is true in the reverse. If the U.S. dollar were to strengthen by 10 percent, it's probable that oil prices would fall by $40.00. While oil production is shrinking in 54 of the world's oil producing nations, oil demand also is increasing in China, Russia and Middle East countries. These three markets combined are now consuming more crude oil than the U.S. by burning 20.7 million barrels/day, up 4 percent from a year ago. These emerging economies are picking up the slack in the oil market by more than offsetting the 1.3 percent contraction in the U.S. oil demand to 20.3 million barrels/day this year.

With most of the transportation industry tractor-trailers being diesel powered, why is diesel fuel considerably higher than gasoline? In recent months U.S. retail diesel prices have averaged anywhere from 25 cents to more than 75 cents above the retail price for gasoline. As the Energy Information Administration reports, historically diesel pricing has been lower than gasoline. So what has changed?

Crude oil is the main factor in the price of diesel fuel, and fluctuations in the crude market greatly influence changes in diesel prices. Other factors include crude inventories, distillate fuel production and refining, changes in demand, the introduction of ultra low sulfur diesel, seasonal price variation, tax rates and the scarcity of diesel imports. The introduction of ultra-low sulfur diesel in 2006, which promised to improve air quality but costs more to produce, have added cost.

Seasonal price variations have been a factor, too. Historically, gas prices have been higher in the spring-summer months while diesel has been higher in the fall-winter months. Summer gas formulations tend to require more expensive ingredients for improved air quality and engine performance, while diesel prices are impacted by winter heating oil and the fall crop harvest needs.

In addition, tax rates, including federal and state taxes, are higher for diesel and gasoline. Diesel has a federal tax rate of 24.4 cents/gallon compared to 18.4 cents for gas. State and local taxes have a nationwide average price per gallon price of 53.6 cents/gallon for diesel versus 47.0 cents for gasoline.

Spurred by economic growth, U.S. demand for highway diesel has been rising roughly triple the rate for gas; 3 percent over the past five years compared to 1 percent annually for gasoline. As a result, diesel accounts for more than one-fifth of all U.S. highway fuel used.

Demand for diesel has been growing strongly throughout the world, so finding additional diesel fuel to import has become more difficult. China, India, the Middle East and Europe continue to proportionally grow their diesel needs faster than the United States. Thus the relative unavailability of diesel for import, and in response to the surging worldwide diesel needs, domestic refineries have managed to increase production of diesel and heating oil by 15 percent from 2002 to 2007.

Ultra-low sulfur diesel (ULSD) fuel was introduced in 2006 and is called "clean diesel." This new fuel was developed as a response to Environmental Protection Agency mandates for cleaner diesel engine emissions. Today, ULSD accounts for 70 percent of all U.S. produced diesel, having cost the refining industry more than $8 billion in capital investments for new equipment to produce and distribute this diesel.

The trucking industry is highly dependent on diesel fuel. While alternative fuel options continue to be researched, investigated and tested, the energy required to move an 80,000-pound vehicle is most efficiently and effectively managed with diesel. So options for diesel remain very limited.

As the North American economy improves, history would indicate that we will cycle thru this slow period. The transportation industry has experienced a loss in its carrier base caused in part by extraordinarily high diesel fuel prices. Therefore Economics 101 dictates that as the demand for transportation services increases and the supply of availably transportation providers dwindles, prices will rise. Those shippers that have been able to develop long-lasting relationships with their carriers, versus taking advantage of short-term pricing pressure opportunities, will be in the best position when the power of the pricing pendulum swings in favor of the carrier.