Diesel prices are the warning sign

Wholesale diesel crack spreads have climbed steeply and without pause, and energy analysts and industrial economists think they matter more than the headline Brent price that most commentators watch. With Brent sitting above $100 a barrel, wholesale diesel has reached prices that point to real strain in supply chains.

What the crack spread measures

A crack spread is the margin between the price of crude oil and the price of a product refined from it. When the diesel crack widens faster than crude rises, the shortage lies in refining capacity rather than in oil in the ground, and that is the harder kind to fix. Wells can be drilled in months, whereas refineries take years to build, and refiners in Europe and North America have closed or converted a string of plants over the past decade. The Brent price says how scarce oil is; the diesel crack says how scarce the fuel that moves goods has become.

Europe is the weak point. Until 2023 it bought a large share of its imported diesel from Russia, and when the European Union banned seaborne imports of Russian refined products in February of that year, it replaced them largely with cargoes from the Middle East, India and America. The big export refineries of the Persian Gulf became a pillar of Atlantic diesel supply. Losing their output removes barrels from the one region with the least spare refining of its own, and Europe then bids for American cargoes, which pulls American prices up with it.

Everything moves on diesel

Diesel is no consumer luxury. Freight locomotives, container ships, long-haul lorries, combine harvesters and mining excavators all run on diesel and other middle distillates, and nothing else. The loss of output from the big Persian Gulf refineries has made supply tight, and when diesel is scarce the cost of moving every physical good in the economy climbs quickly.

Demand for it also bends less than demand for petrol. A household can drive less when prices rise, but a haulier with contracted deliveries, or a farmer in planting season, cannot. That makes the price of diesel swing further for any given shortfall, and it explains why distillate markets tend to tighten first and loosen last in an oil shock.

How a surcharge becomes a price

The pass-through is faster than for most costs because it is written into contracts. American trucking fuel surcharges are commonly reset every week against the government's published average diesel price, so a jump at the pump reaches shippers' invoices within days rather than at the next annual negotiation. Railways and parcel carriers run fuel surcharges of their own, so freight acts as a transmission belt with very little slack in it. Jet fuel comes from the same middle-distillate cut of the barrel, which means airfares, a component of core services inflation, respond to the same shortage.

Refiners sit on the other side of that belt. Plants that can still buy crude from outside the Gulf, on the American Gulf Coast in particular, earn a wide margin on every barrel of diesel they make and will run as hard as maintenance schedules allow. Their windfall is the haulier's cost, and it tends to persist until new supply arrives or demand gives way.

The losers are those who buy diesel without a surcharge clause to pass it on. Small owner-operators in trucking often pay at the pump before they can bill for it, and farmers buying fuel for spring planting cannot add a line to the price of a crop sold forward months ago. Airlines can raise fares on new bookings, but seats already sold at the old price must still be flown on dearer fuel, so the squeeze lands on their margins first.

Eight to twelve weeks' notice

Time-series studies suggest that jumps in diesel prices run ahead of core, non-energy inflation by roughly eight to twelve weeks. Hauliers respond to dearer fuel with steep surcharges, and wholesalers pass those on in the price of groceries, building materials and other goods.

The 2022 episode offers the obvious comparison. After Russia invaded Ukraine, diesel cracks hit records and the average American retail price of diesel went above $5 a gallon for the first time; headline consumer-price inflation peaked at 9.1 per cent in June and core inflation kept climbing until September. Fuel was one force among several then, alongside reopening demand and generous fiscal support, so the episode cannot isolate diesel's effect. It does show that a distillate shortage can feed through to underlying prices rather than staying in the energy line.

Why the Fed should care

Central banks are taught to look through energy shocks, on the grounds that a one-off rise in oil prices lifts the price level once and then fades from the inflation rate. That advice rests on the shock staying in the energy line. Diesel is the route by which it escapes, since freight costs are embedded in almost every core good and in services such as air travel. A Fed that waits for core inflation to confirm the damage will be responding two or three months after the diesel market has already told it.

The seasonal calendar makes the timing worse. Distillate inventories normally rebuild through the summer ahead of winter heating demand in the northeastern United States and Europe. If stocks cannot be rebuilt because refineries are running flat out merely to meet current demand, the tightness carries into the autumn rather than easing, and the pass-through to core prices runs on for longer.

The case for a milder pass-through

The counterargument is that fuel is a small share of the final price of most goods, and that a sharp oil shock tends to slow spending enough to offset the cost push. Retailers facing cautious customers may absorb surcharges in their margins rather than pass them on. That is plausible for discretionary goods and much less so for groceries and building materials, where margins are thin and demand is steady. The indicators that would settle it are the weekly government diesel price and distillate inventory data, the trucking component of producer prices, and the prices-paid measures in the purchasing managers' surveys. Energy costs are already working their way into the domestic supply chain through diesel, and core price indices will very probably be rising faster by mid-summer.