The diesel price has broken away from oil — and that is bad news for Australia

For most motorists, the relationship between oil and fuel seems straightforward.

Oil becomes expensive.

Diesel and petrol become expensive.

Oil falls.

Eventually fuel should become cheaper.

The Iran war is demonstrating why that assumption does not always work.

International crude oil is trading at around US$90 a barrel — substantially below the extreme levels reached during earlier stages of the conflict.

Yet the economics of producing diesel have moved in the opposite direction.

The US diesel crack spread — an important measure of the difference between the price of crude and the value of the diesel produced from it — has exceeded US$100 a barrel for the first time, reaching a record US$102.20.

That is an extraordinary number.

And for Australia it may be more important than another movement in Brent crude.

Because Australia's economy does not run on barrels of crude oil.

It runs on finished fuel.

And diesel is becoming extraordinarily valuable.

What is a diesel crack spread?

The terminology sounds complicated.

The concept is not.

A refinery buys crude oil and converts it into products including petrol, diesel and aviation fuel.

The difference between the cost of crude and the market value of the refined product is broadly represented by what the industry calls a crack spread.

It is not the same thing as a refinery's final profit.

Refineries still have operating costs, transport costs and many other expenses.

But the spread is an important indication of the value the market is placing on refinery output.

When the diesel crack spread rises sharply, the market is effectively saying:

We need more diesel.

When it exceeds US$100 a barrel, something extraordinary is occurring.

Oil is not the principal shortage anymore

This distinction is central to understanding the present energy crisis.

The world has crude oil.

Alternative suppliers have emerged as Middle Eastern production and shipping have been disrupted.

American crude is travelling to Asia.

West African crude is travelling to Asia.

Saudi Arabia and the UAE have developed alternative arrangements to get some supplies around the Hormuz bottleneck.

The international market has adapted remarkably well.

But crude oil is only useful to a diesel-powered truck after somebody refines it.

And that is increasingly where the constraint lies.

Reuters reports global refinery output in July was approximately 5 million barrels per day below the level a year earlier.

That is an enormous reduction in the system responsible for producing the fuels the global economy actually consumes.

The Middle East disruption is hitting refineries

The Strait of Hormuz crisis affects both sides of the petroleum equation.

It disrupts crude exports.

But it also disrupts refined-product exports.

Middle Eastern refineries normally supply substantial quantities of diesel and other fuels to international markets.

When refinery operations are reduced and ships cannot move normally through Hormuz, those products disappear from the available global pool.

The market then has to replace them.

That is becoming increasingly difficult.

Russia has made the problem worse

The Middle East is not the only source of disruption.

Russian refining has also been affected by Ukrainian attacks.

Russia has curtailed international diesel sales as it attempts to protect domestic supply.

That means the global fuel market is simultaneously dealing with reduced availability from two important sources.

Middle Eastern diesel is constrained.

Russian diesel is constrained.

The rest of the refining system has to compensate.

That helps explain why diesel itself can become extraordinarily expensive even when the world is still capable of finding barrels of crude oil.

China adds another uncertainty

China could potentially provide additional refined products to international markets.

And there is some encouraging news.

Chinese refined-oil exports increased 6.7 per cent in July from June as Beijing eased restrictions introduced after the Hormuz disruption. Diesel exports rose particularly strongly month-on-month.

That could provide some relief to tight international markets.

But Chinese crude processing was also substantially below year-earlier levels in July, and China's export policies can change according to domestic priorities.

The international market therefore cannot simply assume China will fill every gap.

Why this matters more to Australia than many people realise

Australia imports a large proportion of the refined petroleum it consumes.

That means Australia does not merely import exposure to the international crude price.

We import exposure to the international refining market.

If diesel itself becomes scarce internationally, Australia competes with other countries for available cargoes.

The relevant price is therefore not simply what the crude originally cost.

It is what somebody is prepared to pay for the finished diesel.

That distinction is now becoming extremely important.

Diesel is not just another motor fuel

Petrol is the fuel Australians see.

Diesel is the fuel Australians often do not see.

A family fills a petrol car and immediately notices the price.

The diesel consumed by the truck delivering groceries is largely invisible.

So is the diesel powering an excavator.

Or a combine harvester.

Or mining equipment.

Or a refrigerated freight vehicle.

But those costs still exist.

And eventually they become somebody's bill.

Australia's freight system cannot simply stop

Road freight is one of the clearest examples.

Australia is enormous.

Products move vast distances between ports, distribution centres, warehouses, supermarkets, factories, farms and regional communities.

Much of that freight travels by diesel-powered truck.

Transport businesses can improve efficiency.

They can optimise routes.

They can reduce unnecessary kilometres.

They can operate newer equipment.

But there is a limit.

A truck still needs energy to move freight from Melbourne to Adelaide.

Or Brisbane to Cairns.

Or Sydney into regional New South Wales.

When diesel becomes structurally more expensive, the economics of those journeys change.

Freight operators eventually have to recover the cost

A trucking company can absorb a temporary fuel increase.

Perhaps for a week.

Perhaps longer if margins permit.

But no business can permanently purchase an essential input at dramatically higher prices while pretending its costs have not changed.

Eventually something happens.

Fuel surcharges increase.

Freight rates rise.

Margins fall.

Contracts are renegotiated.

Or less profitable work is abandoned.

When freight rates rise, the next business in the chain receives a higher bill.

That is how diesel moves through the economy.

Food is particularly exposed

Australia's food system involves enormous amounts of transport.

Farm inputs have to reach farms.

Produce has to leave them.

Animals are transported.

Food travels to processors.

Processed products travel to distribution centres.

Supermarkets receive deliveries.

Restaurants receive supplies.

Some products are refrigerated throughout the journey.

Diesel is embedded throughout that process.

A consumer can therefore pay for expensive diesel without ever owning a diesel vehicle.

It can appear in the price of dinner.

Farmers face the problem directly

Agriculture has an additional exposure.

Farmers frequently consume diesel themselves.

Tractors.

Harvesters.

Pumps.

Generators.

Utes.

Earthmoving equipment.

Contractors.

Then they can pay again when inputs arrive.

And again when produce leaves.

The difficulty is that farmers frequently sell into commodity markets.

They cannot necessarily increase the price they receive simply because their diesel bill increased.

That can turn higher fuel prices directly into lower margins.

Mining has enormous exposure

Australia's mining industry is another substantial diesel consumer.

Huge haul trucks and mobile equipment require enormous quantities of energy.

Mining companies are progressively examining electrification and alternative technologies.

Some operations will eventually reduce their diesel dependence substantially.

But the existing mining industry cannot transform its equipment fleet overnight.

For now, expensive diesel remains an additional cost for one of Australia's most important export industries.

Construction does not escape either

Australia is simultaneously trying to overcome a housing shortage.

That requires construction.

Construction requires trucks.

Excavators.

Loaders.

Cranes.

Generators.

Tradespeople travelling between sites.

Materials moving from manufacturers and ports to projects.

Many of those activities involve diesel.

Higher diesel costs do not explain Australia's housing affordability problem.

But they are another input pushing in the wrong direction.

Regional Australia carries more exposure

Distance magnifies everything.

A metropolitan business may serve customers within a relatively compact area.

A regional business can cover hundreds of kilometres.

A rural family may travel substantial distances simply to access services.

Farm products travel from remote properties.

Goods travel from metropolitan distribution centres into regional communities.

Tradespeople cover large service territories.

The more kilometres required, the greater the exposure to transport costs.

That makes a prolonged diesel-price shock particularly important outside the capital cities.

Why doesn't high diesel profitability solve the problem?

At first glance, a US$100 diesel crack spread appears to offer an obvious solution.

If refiners can make enormous margins producing diesel, why don't they simply make much more?

They are trying.

High margins encourage refineries to maximise production.

But refining capacity is physical infrastructure.

A refinery cannot simply double its size because today's market price is attractive.

Existing plants have maximum capacities.

They require maintenance.

Different refineries are configured to process different crude grades and produce different mixes of products.

New refining capacity takes years and billions of dollars to develop.

Price can encourage greater production.

It cannot instantly create industrial infrastructure.

This is a capacity problem

That makes the present crisis fundamentally different from a simple crude shortage.

If the problem were merely insufficient crude oil, higher prices could encourage producers with spare capacity to pump more.

When the bottleneck is refinery capacity, the response is slower.

The world needs facilities capable of turning available crude into the particular products consumers require.

Reuters Breakingviews notes that new refinery capacity is being added, but not quickly enough to eliminate the immediate mismatch between product demand and available output.

That means high refining margins can persist even while crude itself remains relatively plentiful.

The service-station price can therefore disappoint

Australian motorists may watch Brent fall and reasonably expect diesel prices to follow.

Eventually they often do.

But not necessarily at the same speed.

The Australian pump price reflects several components.

International refined-fuel prices.

The Australian dollar.

Freight.

Wholesale costs.

Taxes.

Retail costs and margins.

If the international price of diesel remains high because diesel itself is scarce, cheaper crude does not automatically translate into equivalent relief at the pump.

The crude is only the raw material.

Australians purchase the finished product.

There is an inflation problem hiding inside this

This matters enormously for inflation.

A spike in petrol prices is visible and relatively easy to identify in inflation data.

Diesel creates a more dispersed effect.

It increases freight costs.

Agricultural costs.

Mining costs.

Construction costs.

Delivery costs.

Some of those increases eventually reach consumers through other prices.

The diesel shock becomes embedded in the cost of goods and services.

By the time it appears on a supermarket shelf, the word "diesel" is nowhere on the price tag.

But it may still be part of the reason the product costs more.

The RBA cannot refine diesel

This creates the familiar monetary-policy problem.

The Reserve Bank cannot build a refinery by increasing interest rates.

It cannot reopen Hormuz.

It cannot stop attacks on Russian refining infrastructure.

It cannot order China to export more diesel.

But the RBA is responsible for Australian inflation.

A temporary fuel shock can sometimes be looked through.

A persistent shock spreading through freight, wages and prices becomes more difficult.

Duration therefore remains critical.

Australia is already strengthening its buffer

The Federal Government has recognised the strategic importance of diesel.

Its fuel-security measures include plans for a $3.2 billion Australian Fuel Security Reserve and increased diesel and jet-fuel holdings towards 50 days.

That becomes increasingly significant as the nature of the international crisis changes.

A strategic reserve does not make diesel cheaper.

It does something potentially more important during a severe disruption.

It reduces the risk that expensive diesel becomes unavailable diesel.

Those are very different problems.

Price and availability must be separated

Australians should distinguish between two questions.

Can Australia obtain enough diesel?

And:

What will Australia have to pay for it?

A functioning international market can solve the first problem while making the second considerably worse.

At a sufficiently high price, cargoes will generally move towards buyers prepared to pay.

Australia is a wealthy advanced economy and therefore has considerable purchasing power.

But paying more for essential fuel still reduces national income.

The fuel arrives.

The economy keeps functioning.

The cost appears elsewhere.

There is some encouraging news

The situation is not entirely negative.

Chinese fuel exports are recovering.

US refiners have strong financial incentives to maximise output.

Alternative crude supplies continue reaching Asia.

Governments are strengthening inventories.

Australia is building greater strategic resilience.

Markets are doing what markets do during shortages: high prices are encouraging additional supply and reducing demand.

Those mechanisms should eventually bring the system towards balance.

The question is how long that takes.

Hormuz remains central

Ultimately, the Strait of Hormuz still matters.

Normalising Middle Eastern crude and refined-product exports would remove a major source of pressure.

It would increase available supply.

Reduce shipping disruption.

Help rebuild inventories.

Allow refinery systems to operate more normally.

And potentially reduce some of the extraordinary margins now appearing in diesel markets.

But the oil market is increasingly pricing a prolonged crisis rather than a brief interruption. Reuters analysis notes that Hormuz oil flows remain dramatically below pre-war levels and that refined-fuel inventories are exceptionally tight.

Until that changes, Australia should not assume that a moderate Brent price means the fuel crisis is over.

Businesses should watch diesel, not just crude

For Australian businesses exposed to transport, the lesson is practical.

Watching Brent alone is no longer enough.

Freight companies should watch diesel prices.

Farmers should watch diesel.

Construction businesses should watch diesel.

Mining companies already do.

Retailers should understand transport surcharges.

Businesses with large vehicle fleets should examine fuel assumptions in contracts and quotations.

A US$10 movement in crude matters.

But right now, the extraordinary movement in the value of the finished fuel may matter more.

The Times View

For much of the Iran conflict, the world asked whether it could find enough oil.

Increasingly, that is not the right question.

The world has found alternative crude.

American oil is moving to Asia.

West African oil is moving east.

Saudi and UAE supply chains are adapting.

Brent remains around US$90 rather than the extraordinary peaks reached earlier in the war.

Yet diesel refining economics have reached unprecedented levels.

The US diesel crack spread has exceeded US$100 a barrel for the first time.

That tells us where the pressure has moved.

From the oil well to the refinery.

For Australia, that distinction matters enormously.

We do not put crude oil into trucks, tractors, excavators or mining equipment.

We put diesel into them.

And Australia depends heavily upon international markets to provide that finished fuel.

The government can build reserves.

Businesses can become more efficient.

Markets can find alternative suppliers.

Eventually additional refining capacity can emerge.

But none of those responses changes the immediate reality.

The price of diesel has begun breaking away from the price of oil.

For an economy built across enormous distances and dependent upon trucks, farms, mines and construction equipment, that is not merely an energy-market curiosity.

It is an Australian economic warning.