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Vol. 4, No. 9
November 2009­­

EconomicLetter
Insights from the

Federal Reserve Bank of Dall as

What Drives Diesel Fuel Prices?
by Jackson Thies and Stephen P. A. Brown

Our model suggests

Americans who drive cars are no doubt aware of the drastic rise and

that spot diesel should

fall in gasoline prices over the past few years. What they may not have noticed

rise 25 cents a gallon

is the unusual movement in the price of diesel, a fuel primarily used in trucks,

over the next six months

buses, railroad engines, farm equipment and boats.

and 41 cents a gallon

Historically, gasoline has commanded a premium over diesel, but that

over the next 18 months.

changed in mid-to-late 2007, when diesel rose above gasoline. Diesel prices
remained higher until the full brunt of the financial panic hit and the world
economy slid into recession. Hard times depressed prices faster for diesel than for
gasoline, restoring the historical relationship—for now (see box, page 4).
On spot markets, diesel has sporadically risen above gasoline, but it’s
been rare for diesel to trade significantly higher on a sustained basis.1 From
1994 through 2004, gasoline traded higher than diesel 61.2 percent of the time

(Chart 1).2 Over the next four years,
however, gasoline was higher than
diesel only 24.2 percent of the time. If
we focus on 2007 and 2008, gasoline
traded higher than diesel only 21.1
percent of the time.
This deviation from historic norms
raises an interesting question—what
drives diesel prices? As with virtually
all petroleum-derived products, the
story begins with oil prices. Seasonal
patterns also play a significant role.
Demand for a range of oil-based products changes with the weather, and
prices fluctuate as refiners adjust their
output mix. Government regulations
are another source of price variability.
Earlier this decade, new standards
aimed at reducing diesel fuel’s sulfur
content required further processing
that increased refinery costs and prices
for consumers. Finally, short-term
changes in supply and demand—
including imports—factor into pricing
on a day-to-day basis.

As with virtually all
petroleum-derived
products, the
story begins
with oil prices.

Oil and Diesel Prices
The cost of crude oil is the most
important factor determining prices for

Chart 1

Relative Prices of Diesel Fuel and Gasoline
Price ratio, spot diesel to spot gasoline
1.8

1.6

Average, 2005–current
Average, 1994–2004

1.4

1.2

1

.8

.6

’94

’95

’96

’97

’98

’99

’00

’01

’02

’03

’04

’05

’06

’07

’08

SOURCES: Wall Street Journal; calculations and adjustments by the Dallas Fed.

EconomicLetter 2

F edera l Re serve Bank of Dall as

’09

both gasoline and diesel fuel. Over
short time periods, the prices of crude
oil and its derivatives can deviate from
one another. Over longer periods,
they’re highly correlated.
When crude oil touched an alltime high of more than $140 a barrel
in June 2008, spot prices for diesel
fuel rose above $3.80 a gallon. Early in
2009, oil fell to multiyear lows, pulling
diesel prices down with it. In January
2009, for example, oil was under $40 a
barrel and diesel fuel dropped below
$1.50 a gallon. In recent months, both
crude and diesel prices have turned
back up. On a given day, the price
movements weren’t precisely in sync,
but over the course of a year, they
tracked very closely (Chart 2A).
Determining what drives diesel
prices starts with an estimate of the
effect of oil prices independent of other factors. To accomplish this, we ran
a regression with diesel prices as the
dependent variable, and oil prices and
a constant as the explanatory variables.
The results indicate that the spot price
of diesel moves 2.86 cents a gallon
for every $1-per-barrel change in the
spot price of West Texas Intermediate
(WTI) crude oil, a benchmark often
used for market analysis.
This econometric model explains
approximately 99.4 percent of the average monthly spot diesel price and 75
percent of the monthly change in price.
The close fit and high level of explanatory power reflect the nature of petroleum refining, a capital-intensive and
high-volume industrial process. With
crude oil the primary variable cost for
refineries, it makes sense that oil and
diesel prices are highly correlated.
Looking more closely, though, we
see occasional deviations in the relationship between crude oil and diesel
prices (Chart 2B). These gaps suggest
that including additional variables
would more fully explain diesel prices.
Seasonal Swings
For products derived from crude
oil, transportation demand peaks in
the summer and heating use rises in

the winter. Refiners adjust their output
to match these seasonal changes. For
diesel, this simple formula has been
complicated by long-term shifts in
consumption patterns and by interconnections among petroleum’s various
end-use products.
Distillate is the precursor to diesel
in the refining process. After process-

ing to remove sulfur and meet emission standards, distillate becomes
on-highway diesel. With slightly higher
sulfer content, it becomes diesel for
off-highway applications. With different processing, distillate becomes heating oil for residential use.
Distillate accounts for 25 to
30 percent of U.S. refinery output.

For diesel, this simple
formula has been

Chart 2

complicated by long-term

How Oil Prices Influence Diesel Prices

shifts in consumption

A. Crude Oil Explains Diesel Movements…

patterns and by

Diesel, dollars per gallon

interconnections

4.5
4

Spot diesel
Diesel, initial fit

3.5

among petroleum’s
various end-use products.

3
2.5
2
1.5
1
.5
0
’94

’96

’98

’00

’02

’04

’06

’08

’10

B. …But a Closer Look Reveals Discrepancies
Diesel, dollars per gallon
4.5
4

Diesel, initial fit
Circles highlight
some of the variations.

3.5
3
2.5

Spot diesel

2
1.5
1
.5
0
2008
NOTE: Fitted value using oil prices as the sole explanatory variable.

2009

SOURCES: Wall Street Journal; calculations by the Dallas Fed.

F ederal Reserve Bank of Dall as

3 EconomicLetter

Recession at Root of Diesel-to-Gasoline Price Flips
This year saw unusual swings in the diesel-to-gasoline price ratio. At the start of 2009,
diesel was more expensive than gasoline; however, this relationship reversed by the end of
March. Six months later, the relationship reversed again.
The recession provides the key. Diesel demand is more sensitive to industrial activity
than gasoline. A slowing economy dampened diesel consumption, leading to rising inventories and the price-ratio flip seen in April through September.
With hopes of a recovery on the horizon, diesel rose to $2.10 per gallon in October—
causing the latest turnabout in the price ratio.
Despite the optimism behind the rise, inventories remain high, suggesting ample
supplies to cover existing demand. Taking these stocks into account, our model estimates
that diesel will go for $2.15 a gallon in June 2010, about 10.6 percent above the current
spot price (see chart). If inventories were normal, the model shows diesel would rise an
additional 12.1 percent to $2.41 a gallon.
A model developed by Stephen P. A. Brown and Raghav Virmani forecasts gasoline
prices of $2.13 a gallon in June 2010. Combining the two models’ results yields a diesel-togasoline price ratio of 1.13, well above the current ratio of 1.01. The higher ratio confirms
that the upward bias on diesel prices would be stronger without the elevated inventories.

High Inventories Restrain Diesel Prices
Dollars per gallon

4.5
Diesel fitted

4
3.5

Diesel estimate
assuming normal
inventory levels

3
2.5

Diesel estimate
using actual
inventory levels

2
1.5

Gasoline
estimate using
actual inventory levels

Gasoline fitted
1
.5
0
2006

2007

2008

2009

2010

SOURCE: Dallas Fed.

Gasoline, the product of a different
refining process, makes up 40 to 50
percent of this country’s production.3
For distillate, transportation is
the largest end-use market, accounting for approximately 70 percent of
consumption, up from 50 percent two
decades ago (Chart 3).4 U.S. passenger vehicles use relatively little diesel

fuel, but more than 90 percent of U.S.
goods are shipped via diesel-powered
transport.5
Home heating is the other primary market for distillate, although it’s
not as prevalent as it once was. The
Northeast—New England, in particular—is the primary region that relies
on heating oil for winter warmth. Most

EconomicLetter 4

F edera l Re serve Bank of Dall as

other regions have converted to natural gas, a mostly cheaper and cleanerburning fuel. Heating oil’s dwindling
importance can be seen in the decline
of residential use from 15.2 percent of
total distillate consumption in 1990 to
8.1 percent in 2007.
On- and off-highway diesel fuels
and heating oil are so similar that
they’re referred to as distillate in measuring consumption. Because they’re
so similar, changes in demand for one
product move all distillate prices.
Shifting consumption patterns
have altered the seasonal ebb and flow
of distillate/diesel pricing. In the past,
the highest price spikes came when
cold weather led to greater heating oil
consumption. In anticipation, prices
began to rise ahead of winter, and
refiners built up heating oil inventories.
When warmer weather arrived,
heating oil consumption declined,
pushing down distillate/diesel prices.
European refiners saw similar seasonal swings in their market, and they
increased diesel exports to the U.S.
in the summer months, putting added
downward pressure on prices.
As U.S. demand for heating oil
declined over the past two decades,
Europeans began using more diesel
fuel in their passenger cars. Together,
these factors gradually shifted the seasonality of distillate/diesel consumption. The sharp increases in winter
demand were reduced, and the sharp
increases in summer supply from
Europe were virtually eliminated.
The interaction of these factors
and their effect on production, imports
and inventories led to a changing seasonal pattern in diesel prices relative
to oil prices. The “crack ratio” provides
a measure of the relationship between
the two prices.6 It’s calculated by multiplying the spot price of a gallon of
regular diesel by 42—the number of
gallons in an oil barrel—and dividing
by the WTI spot price.
From 1993 to 2001, the crack ratio
shows peaks in the winter and troughs
in the summer (Chart 4). Gradually,
shifting consumption patterns led to

peaks in the summer months, with a
secondary peak in the winter trough.
Incorporating the seasonally
adjusted crack ratio into our model of
U.S. diesel prices improves its explanatory power. This second iteration
explains 99.5 percent of monthly diesel
prices. It also accounts for 76.3 percent
of the monthly change in price—a
gain of 1.3 percentage points over our
initial model.
Perhaps more important, adding
seasonal factors also increases the level
of accuracy. In our initial model, the
root mean square error was 8.08 cents
a gallon. After accounting for seasonality in the crack ratio, the error falls to
5.23 cents a gallon.
Even with the improved fit and
accuracy, diesel and crude oil prices
still diverge in some instances, suggesting the influence of additional variables.
Refining the Model
More stringent environmental
regulations altered the composition
of diesel fuel and increased its cost
of production. In December 2000, the
U.S. Environmental Protection Agency
(EPA) mandated stricter controls on
diesel engines’ nitrogen oxide and
hydrocarbon emissions.
The new standards required manufacturers to develop emissions-control
equipment for diesel engines. Vehicle
producers met the requirements by
using a catalyst to reduce output of the
gases. However, the catalyst could be
damaged or rendered ineffective by
sulfur contamination, so it became critical to reduce diesel’s sulfur content.
EPA standards reduced the allowable sulfur content of on-highway
diesel fuel by 97 percent—from a limit
of 500 parts per million to 15.7 By June
2006, about 90 percent of U.S. production met the new standards for ultralow-sulfur diesel (ULSD).
Meeting the new regulations
imposed significant capital and operating costs on refineries because cutting
diesel fuel’s sulfur content required
further refining and new equipment to
remove sulfur. The EPA estimated the

Chart 3

Transportation’s Share of Distillate Demand Rising
End use, percent
80
70
60
50

Transportation
Other

40

Residential
Farms

30

Industrial

20
10
0

’84 ’85 ’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07

SOURCE: Energy Information Administration, Department of Energy.

Chart 4

Crack Ratio Shows Shifting Seasonality
Crack ratio
Winter
months
(Nov.–March)

1.28
1.26
1.24
1.22
1.20
1.18
1.16
1.14
1.12
1.10

Nonwinter
months
’93

’94

’95

’96

’97

’98

’99

’00

’01

’02

’03

’04

NOTE: The crack ratio is a measure of diesel prices relative to oil prices.
SOURCES: Wall Street Journal; calculations by the Dallas Fed.

F ederal Reserve Bank of Dall as

5 EconomicLetter

’05

’06

’07

’08

’09

In particular, the rate
and timing of the world
economy’s recovery from
recession could have a
substantial effect on
crude oil prices and,
therefore, the cost
of diesel fuel.

new regulations added 4 to 5 cents a
gallon to production costs.
To account for this increase, we
refined our diesel price model by adding a dummy variable, the standard
procedure for analyzing a one-time
shift in a series. In this case, we found
the new EPA regulations cause a onetime, 6.25 percent change in diesel
prices as they rise to offset the higher
production costs.
Seasonality and regulation don’t
exhaust the potential influences on
diesel fuel prices. A variety of events
can cause deviations from seasonal
norms. Abnormal weather patterns, for
example, can disrupt refiners’ annual

cycles. Colder and longer winters
increase distillate demand.
Other unexpected shifts in consumption and production can cause
abnormal price movements. In mid2008, for example, Chinese diesel fuel
imports rose sharply ahead of the
Olympics. China attempted to improve
Beijing’s air quality by using diesel
instead of coal to generate electricity.
China also increased its diesel stockpiles to guard against shortages during
the Games. Increasing Chinese imports
reduced the foreign diesel available
to the U.S. market. Diesel prices rose
relative to gasoline and oil at a time
when they had previously exhibited
seasonal weakness.
Another notable example occurred
when hurricanes Katrina and Rita
ravaged the U.S. Gulf Coast in 2005,
shutting down a large share of U.S.
refinery capacity. Diesel supplies
fell sharply while demand remained
steady. Prices shot up at a time when
seasonality dictated only a moderate
increase.
These examples show how nonseasonal factors may play an important
role in diesel prices. To improve our
model and benefit from the additional
information contained in these variables, we added nonseasonal fluctuations in consumption, inventories, production and imports.
Our final model includes a broad
and comprehensive range of variables
that shape U.S. diesel prices—the price
of WTI crude oil, seasonal variations in
the crack ratio, a one-time shift in
prices from implementation of ULSD
standards, and nonseasonal movements in consumption, production,
inventories and imports.
The variables are represented in
natural logs, consistent with standard
econometric practice. An error-correction process was used to reflect the
long-run link between crude oil and
diesel spot prices. Not surprisingly, the
final model shows that higher oil prices drive up diesel prices. Normal seasonal diesel prices respond positively
to increases in demand and negatively

EconomicLetter 6

F edera l Re serve Bank of Dall as

to increases in production, imports and
inventories.
In its final form, the model
explains 80.9 percent of the changes
in diesel prices, up from 75 percent
in the model using only crude oil
and 76.3 percent in the model using
crude oil and normal seasonality. We
lowered the root mean square error
to 4.83 cents a gallon, compared with
8.08 cents per gallon and 5.23 cents
per gallon in the earlier versions.
The initial deviations between spot
diesel prices and our fitted values
are reduced (Chart 5, compared with
Chart 2B).
Diesel Price Outlook
Combining crude oil prices, seasonal shifts, regulatory changes and
other factors produces a model that
does a fairly good job of explaining
past diesel prices. Now, we use it to
estimate the conditional outlook for
U.S. diesel prices and determine how
well it fits with futures market prices
(Chart 6).
Using current WTI futures as a
proxy for future spot oil prices, we
generate a short-term outlook by
assuming that nonseasonal fluctuations
in consumption, inventories, production and imports will persist. For the
long-term outlook, we assume that all
nonseasonal fluctuations will revert to
their long run-averages and that normal seasonal patterns will prevail.
The futures market shows crude
oil prices rising from the current $77
a barrel to $85 a barrel by the winter
of 2010. Using these prices, our model
suggests that spot diesel should rise
25 cents a gallon over the next six
months and 41 cents a gallon over the
next 18 months.
The model predicts a spot-market
diesel price of $2.15 a gallon in June
2010, an outlook consistent with the
futures markets. Historical relationships
between spot and retail diesel prices
suggest a pump price of around $2.92
a gallon.
The outlook is likely to change
as market conditions evolve and the

pressure on diesel prices, raising costs
in shipping and other transportation
industries.

Chart 5

Price Discrepancies Reduced in Final Model

Thies is a research analyst in the Research
Department of the Federal Reserve Bank of Dallas
and Brown is a nonresident fellow at the nonprofit research organization Resources for the Future.

Diesel, dollars per gallon
4.5
Spot diesel
4

Highlighted variations are
smaller than previous model.

3.5

Notes

3

The views expressed are those of the authors and
should not be attributed to the Federal Reserve

2.5
Diesel, final fit

Bank of Dallas, the Federal Reserve System or

2

Resources for the Future.

1.5

1

We examine spot prices to eliminate the

fluctuations in diesel prices due to frictional costs

1

arising from distribution, retailing and marketing.

.5

Frictional costs affect the prices charged at the
pump and vary among retailers. For instance,

0
2008

2009

diesel on the West Coast cost $2.72 a gallon at

NOTE: Fitted value using oil prices, seasonal fluctuations and other significant factors as explanatory variables.

the end of June, compared with $2.58 a gallon in

SOURCES: Wall Street Journal; Energy Information Administration, Department of Energy; calculations by the Dallas Fed.

the Midwest.
2

The percentage is calculated using the average

weekly New York Harbor spot price from Jan. 7,
1994, to Oct. 30, 2009. The total sample spanned
826 weeks.

Chart 6

3

Outlook Calls for Rising Prices

See Energy Information Administration (EIA)

official statistics at http://tonto.eia.doe.gov/dnav/
pet/pet_pnp_pct_dc_nus_pct_m.htm.
4

Diesel, dollars per gallon

See the EIA’s statistics on sales of distillate

fuel oil at http://tonto.eia.doe.gov/dnav/pet/

4.5

pet_cons_821dst_dcu_nus_a.htm.

4

5

For an explanation of diesel fuel basics, see

the EIA’s Energy Kids website at http://tonto.eia.

3.5

doe.gov/kids/ energy.cfm?page=diesel_home-

3
Futures
2.5

basics.
6

Conditional
estimate

2
Spot diesel

1.5

See “What’s Drving Gasoline Prices?” by

Stephen P. A. Brown and Raghav Virmani, Federal
Reserve Bank of Dallas Economic Letter, vol. 2,

Fitted diesel

no. 10, 2007. Like Brown and Virmani, we found

1

that the crack ratio is more stable than the more

.50

commonly used crack spread. The crack spread
is created by multiplying the spot price of diesel

0
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’95

’96

’97

’98

’99

’00

’01

’02

’03

’04

’05

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’08

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’10

by 42 and subtracting the spot price of crude oil.
7

SOURCES: Wall Street Journal, calculations by the Dallas Fed.

In 1997, the EPA also set new engine standards

designed to reduce emissions of nitrogen oxides
and hydrocarbons from heavy-duty diesel engines built in 2004 and subsequent years.

price of crude oil changes. In particular, the rate and timing of the world
economy’s recovery from recession
could have a substantial effect on

crude oil prices and, therefore, the
cost of diesel fuel. A sluggish rebound
will hold down diesel prices, and a
faster bounce back will put upward

F ederal Reserve Bank of Dall as

7 EconomicLetter

Window into the Economy
Researchers at the Federal Reserve Bank of Dallas continually check the pulse of
the economy and share findings through a range of reports and statistical releases.
Keep current on the trends with regional, national and international Economic
Update reports, posted at http://dallasfed.org/research/updates.cfm. For analyses
and data resources covering energy, manufacturing, agriculture, exports,
immigration and other subjects of interest to the Fed’s Eleventh District,
visit http://dallasfed.org/research/economy/index.cfm.

EconomicLetter

is published by the
Federal Reserve Bank of Dallas. The views expressed
are those of the authors and should not be attributed
to the Federal Reserve Bank of Dallas or the Federal
Reserve System.
Articles may be reprinted on the condition that
the source is credited and a copy is provided to the
Research Department of the Federal Reserve Bank of
Dallas.
Economic Letter is available free of charge
by writing the Public Affairs Department, Federal
Reserve Bank of Dallas, P.O. Box 655906, Dallas, TX
75265-5906; by fax at 214-922-5268; or by telephone
at 214-922-5254. This publication is available on the
Dallas Fed website, www.dallasfed.org.

Stay plugged into the Dallas Fed home page,
www.dallasfed.org, for up-to-date
economic information.

Richard W. Fisher
President and Chief Executive Officer
Helen E. Holcomb
First Vice President and Chief Operating Officer
Harvey Rosenblum
Executive Vice President and Director of Research
Robert D. Hankins
Executive Vice President, Banking Supervision
Director of Research Publications
Mine Yücel
Executive Editor
Jim Dolmas
Editor
Richard Alm
Associate Editor
Kathy Thacker
Graphic Designer
Ellah Piña

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2200 N. Pearl St.
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