With California about to enact yet another increase in its excise tax on motor fuels, and with fuel prices in the Golden State remaining well above the rest of the country, a driver filling a truck might ask the legendary question posed by Talking Heads: Well, how did I get here?
Here are some numbers to illustrate how the market has changed over time. The data series from the Energy Information Administration on ultra low sulfur diesel prices in California and the rest of the country goes back to early 2007. The first week it was published, California diesel was about 114% of the national price of ULSD. The start of the series in 2007 is tied to when ULSD became the standard diesel specification in the U.S., replacing fuel with a far higher sulfur percentage.
By the end of 2008, there actually were a few weeks when average U.S. diesel was more than the California price. But California generally stayed at about 110% of national diesel through the first half of 2015.
And then the state’s decision to increase excise taxes started kicking in. The percentages began climbing. In the first week of January 2017, the percentage was about 113%. By the end of that year, it was about 122%. It crossed 130% in 2019. It has yet to cross 140%, but has gotten as high as 136%. Recently, it slid back below 120%.
But with an excise tax increase of 2.8 cents per gallon that is slated for Friday — no change in the 2.25% sales tax rate — there will be new upward pressure on that differential between California diesel and the rest of the country.
Dave Hackett is a longtime California refining and marketing industry veteran who now is chairman of Stillwater Associates, one of the most knowledgeable firms on California fuels issues in the sector. FreightWaves spoke with him to hear his views, drawn from his many years of experience, on what have been the factors that have pushed California diesel prices so much higher than the rest of the country.
FREIGHTWAVES: When did California start becoming an outlier in fuel?
HACKETT: “The state has a long history of regulating fuel quality and this dates back to the ’50s, when it recognized it had to do something about smog and couldn’t get the federal government to recognize that. It has led to a carve-out in the area of regulation and it allowed the California Air Resources Board to do what it needs to do to clean up the air. That has included changes in the formulations of transportation fuels, and that is primarily gasoline and diesel. The whole auto and oil industry underwent a lot of big changes to accommodate these new restrictions and regulations. So not only does California have a unique gasoline formula, it has unique diesel too.”
FREIGHTWAVES: When was the most significant period of changes in California fuel quality?
HACKETT: “Other changes were made in the ’90s and in general the fuel quality has been different than the rest of the country since then. The specifications are still there but the quality of fuel in the world, especially the U.S., has come up to essentially the same quality as California. However, the specifications have not been harmonizing, so California remains a boutique fuel.”
FREIGHTWAVES: Is that difference a key reason why California diesel prices are so much higher than the rest of the country?
HACKETT: “The specifications do set the market off on its own. But when you look at the spot prices between California and the rest of the country, only a small piece of that can be laid to the fact that it’s a boutique fuel.”
(Benchmark price provider S&P Global Commodities Insights, which includes the legacy Platts business, assessed CARB-grade diesel in the Los Angeles spot market Tuesday at $4.1847 per gallon. Diesel that met just the specifications of the U.S. Environmental Protection Agency was one cent cheaper. In the active Gulf Coast market, ULSD was 6 cents cheaper than the CARB diesel price, supporting Hackett’s statement that price differences between California and the rest of the country are only minimally impacted by specification differences. Hackett later told FreightWaves that the EPA diesel–which gets shipped out to Arizona and Nevada–has generally been running a cent more than CARB diesel, as it is the boutique fuel in the West. )
FREIGHTWAVES: Then what has built this gigantic gap between California and the rest of the country?
HACKETT: “It’s the difference in taxes and fees imposed by the government. It’s the excise taxes, the higher sales taxes and then California has a couple of programs for reducing greenhouse gases, such as its cap and trade program and the Low Carbon Fuel Standard (LCFS).”
(This chart spells out the history of excise tax increases in California. When introduced in 2010, the rate was 18 cents per gallon. On Friday, it rises to 53.9 cents per gallon).
FREIGHTWAVES: Can you discuss how the cap and trade program impacts fuel prices?
HACKETT: “The cap and trade program goes up steadily over time. The value of the allowances that companies must buy to comply with the cap and trade program goes up at the rate of 5% per year, plus inflation. So it’s like compound interest. It got to be relatively serious in 2018. For 2021, the impact on the price of fuels was a bit more than 18 cents per gallon. Most recently, it was about 30 cents per gallon.”
FREIGHTWAVES: The LCFS is designed to incentivize the production of low-carbon fuels by generating credits if you sell energy, like a transportation fuel, that has a low-carbon footprint, like renewable diesel, and requires a company to buy LCFS credits if the carbon footprint of its output is higher in carbon. What has been the impact of that on the price of diesel?
HACKETT: “LCFS is probably on the order of 14 cents per gallon and that is down from where it had been. LCFS prices looked like they had bottomed last year when they got to $175 to $180 per ton, but it got to under $80 this spring. It seems to be rallying back from there. LCFS credits were going down because of a fair amount of renewable natural gas being converted to electricity. That renewable natural gas is mostly from dairy operations — in other words, cow poop. These projects have come on and created credits.”
FREIGHTWAVES: What has been the role of renewable diesel in this fuel mix? Would renewable diesel be successful in California if not for the various credits?
HACKETT: “Renewable diesel is a transportation fuel that has probably been one of the biggest successes in the LCFS program and the value of renewable diesel continues to grow. But the way to think about the feedstock for renewable diesel, which is mostly things like restaurant grease, vegetable oil and animal fats, is that it sells for more than the price of diesel. So yes, it takes these credits to make the economics work.”
FREIGHTWAVES: What has been the impact of lost refining capacity? I looked at data from the Energy Information Administration and it shows that refining capacity in PADD 5, which includes California, was 3.232 million barrels per day in 2010. It is now down to 2.65 million barrels per day and was 2.875 million barrels per day as recently as the start of 2020.
HACKETT: “California has lost more refining capacity relative to its size than the rest of the country. Marathon (NYSE: MPC) shut down its Martinez refinery, also known as Avon, in the Bay Area and transferred some of that capacity to making renewable diesel. They were going to need to spend more than $1 billion to bring it up to standards and they didn’t think it was going to be worth that. That’s similar for Phillips 66 in the Bay Area, (NYSE: PSX) which has not been happy with the California business for a long time. So when renewable diesel came around, it gave them an opportunity to transition to a green refinery and shut down that place and transition to renewable diesel.”
FREIGHTWAVES: But if they’re producing renewable diesel, doesn’t that mean for the diesel market that the supply replaces what was lost with the shutting of the refinery?
HACKETT: “With renewable diesel, first you strip the oxygen off the feedstocks and then they send it to another process called isomerization. That ultimately produces a superior diesel product. With the deoxygenation, you use hydrogen and that works with the oxygen to convert it to water. But it takes a lot of hydrogen to do that deoxidization step. So you are not going to be able to run as many barrels and you lose capacity at the same size refinery.”
FREIGHTWAVES: Are there other reasons for the big spread between California retail transportation fuel prices and that of the rest of the country?
HACKETT: “Some of it is the higher operating costs, taxes and fees that station owners incur for operating in California, but it isn’t material. There is what has been referred to as a ‘mystery gas surcharge,’ which is where California is higher than the U.S. average after accounting for the differences between taxes and fees. Nobody is alleging anything illicit or criminal. We’re just trying to get somebody to come up with an explanation.”
FREIGHTWAVES: Could it be related to the structure of the retail sector in the state?
HACKETT: “At the end of the day, it comes down to our analysis that points out there are twice as many licensed drivers per gas station in California than in the rest of the country. That means that drivers have fewer choices and therefore fewer competitors. The retailers know that and there can be less competition for retail gasoline consumers than in the rest of the country. The mystery gas surcharge goes mostly to retail margins.”