The octane rating that you get at the gas pumps is basically a measure of how much the fuel can be compressed in an internal combustion engine (ICE) before it ignites. An engine with a higher compression ratio means a higher combustion efficiency, requiring higher octane fuel. Depending on the car model, many mass-market ICE vehicles today will have negligible performance improvement with premium gas.
Interestingly enough, there’s a leading indicator of how the economy is doing if you look at the spread between premium gas and regular gas. Regardless of real-world impact, some consumers will still fill their tanks with premium gas when times are good despite the negligible impact on fuel economy and actual emissions. The opposite is also true when times are bad; we see a grade-down effect from consumers filling up with lower octanes to save on the total cost of filling up, on top of switching to lower octane-rated vehicles (put the Porsche away and go get the Honda Civic out).
So, depending on the public’s perception of economic wealth, are consumers grading up or down at the pump lately?
- Don’t discount gasoline demand just because the “R” word is being used more often in commentaries
- Gasoline demand is resilient going into the driving season
- The supply side of the equation is just as important as the demand side, with structural environmental and capacity shortages
In the wake of the 2007 financial crisis, the spread remained suppressed for years through 2010 until we saw a more meaningful recovery, and the S&P 500 has moved up since. 2022 was a weird year because gas prices (along with everything else) were high on an absolute basis, so we did see a bit of demand destruction on the premium front despite the constructive economic conditions.
The United States is divided into five Petroleum Administration for Defense Districts (PADDs):
What Are the PADDs Indicating?
If you take a closer look at the premium to regular gasoline spread across the PADD regions, it’s interesting to note that this spread has picked up noticeably in recent weeks. This may indicate that consumers are still paying up at the pump despite all the negative recession headlines these days, and economic conditions are perhaps better than expected.
This is also particularly noteworthy as we are not in driving season yet – that’s slated to start end of May. So, if we’re already short the premium products in the shoulder season, it’s possible we see gasoline prices hold up much better than diesel through the year.
Across all the PADDs, the octane spread has picked up with the exception of PADD 4 and, to a certain degree, PADD 5. Higher elevation areas do not require as high of an octane level due to less air density; a 93 octane in Florida is pretty much the same as a 91 octane in Colorado.
PADD 1 – East Coast
PADD 2 – Midwest
PADD 3 – Gulf Coast
PADD 4 – Rocky Mountain
PADD 5 – West Coast
What complicates this a bit is the supply side of the equation. Higher octane becomes expensive when the oxygenates, alkylates, and other “octane enhancing” molecules are either being pulled away by other markets (Asia) and/or their supply is low. This can occur because refiners and others are leaning towards producing other products or because there is simply not enough capacity to make enough of the ‘octane-rich’ products. During the pandemic, there was a 1.3 million barrels per day (BPD) refining capacity, which is leading to some scarcity.
Still, that trend is starting to reverse with refining supply coming online through 2023 in various parts of the world. On the environmental regulation front, the Environmental Protection Agency’s (EPA) Tier 3 gasoline sulphur standards are leading to more octane destruction from the hydrotreatment of naphtha, one of refiners’ key feedstock.
The Bottom Line
At the end of the day, the octane spread impact we’re seeing is likely a combination of both supply and demand factors, but the octane spread is one of many indicators that suggest that US consumers aren’t as weak going into recession this time around as suggested by many doom and gloomers.
— Jeremy Lin is a Portfolio Manager at Purpose Investments
Sources: Charts are sourced to Bloomberg L. P.
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