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?

Key Takeaways:

• 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.

PADDs

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.

The content of this document is for informational purposes only and is not being provided in the context of an offering of any securities described herein, nor is it a recommendation or solicitation to buy, hold or sell any security. The information is not investment advice, nor is it tailored to the needs or circumstances of any investor. Information contained in this document is not, and under no circumstances is it to be construed as, an offering memorandum, prospectus, advertisement or public offering of securities. No securities commission or similar regulatory authority has reviewed this document, and any representation to the contrary is an offence. Information contained in this document is believed to be accurate and reliable; however, we cannot guarantee that it is complete or current at all times. The information provided is subject to change without notice.

Commissions, trailing commissions, management fees and expenses may all be associated with investment funds. Please read the prospectus before investing. If the securities are purchased or sold on a stock exchange, you may pay more or receive less than the current net asset value. Investment funds are not guaranteed, their values change frequently, and past performance may not be repeated. Certain statements in this document are forward-looking. Forward-looking statements (“FLS”) are statements that are predictive in nature, depend on or refer to future events or conditions, or that include words such as “may,” “will,” “should,” “could,” “expect,” “anticipate,” intend,” “plan,” “believe,” “estimate” or other similar expressions. Statements that look forward in time or include anything other than historical information are subject to risks and uncertainties, and actual results, actions or events could differ materially from those set forth in the FLS. FLS are not guarantees of future performance and are, by their nature, based on numerous assumptions. Although the FLS contained in this document are based upon what Purpose Investments and the portfolio manager believe to be reasonable assumptions, Purpose Investments and the portfolio manager cannot assure that actual results will be consistent with these FLS. The reader is cautioned to consider the FLS carefully and not to place undue reliance on the FLS. Unless required by applicable law, it is not undertaken, and specifically disclaimed, that there is any intention or obligation to update or revise FLS, whether as a result of new information, future events or otherwise.