Making

Sense of Diesel Prices

Inthiscasestudy,weexaminecloselythehighwayretailprice($/Gallon)forNo.2UltraLowSulfur(0 15ppm)DieselintheEIAnine(9)PADDregions.Wecarryonprincipalcomponentanalysisinan attempttofindaminimalsubsetoftheprincipalcomponentsthatcapture(orexplains)thevariationin pricesbetweenregionswithaminimallossofinformation. Next,wewillusetheweeklyaveragehighwayretailprice($/Gallon)forNo.2UltraLowSulfur(015 ppm)DieselintheEIAnine(9)PADDregions.ThesampledatastartonFebruary5th,2007andendon May6th,2013(327observations).Eachobservationrepresentstheweeklyaveragepricesinnine regions: 1. 2. 3. 4. 5. 6. 7. 8. 9. EastCoast NewEngland CentralAtlantic(PADD1B) LowerAtlantic(PADD1C) Midwest GulfCoast RockyMountain WestCoast California

Theweeklypricesacrossthedifferentregionsarehighlycorrelated:

MakingSenseofDieselPrices 1 SpiderFinancialCorp,2013

Inthistutorial,wellinvestigatethedriversbehindthepricevariationamongthedifferentregions,and attempttoimplythephysicalrepresentationofthosecomponentsusingtheeachregionsprice loadings.

Process
Nowwearereadytoconductourprincipalcomponentanalysis.First,selectanemptycellinyour worksheetwhereyouwishtheoutputtobegenerated,thenlocateandclickontheprincipal component(PCA)iconintheNumXLtab(ortoolbar).

Theprincipalcomponentanalysiswizardappears.

MakingSenseofDieselPrices

SpiderFinancialCorp,2013

Selectthecellsrangeforthefiveinputvariablevalues. Notes: 1. Leaveoutthelastthreeobservations,soourinputdataendsonApril15th,2013.Theremaining threepointswillbeusedforcomparingtheforecastvalueslateron. 2. LeavetheVariablesMaskfieldblankfornow.Wewillrevisitthisfieldinlaterentries. Next,selecttheOptionstab.

MakingSenseofDieselPrices

SpiderFinancialCorp,2013

Initially,thetabissettothefollowingvalues: StandardizeInputsischecked.Leavethisoptionchecked. PrincipalComponentOutputischecked.Leaveitchecked. Thesignificancelevel(aka. )issetto5%. Underprincipalcomponent,checktheValuesoption,sothegeneratedoutputtables includetheprincipalcomponentvaluesfordifferentdates. InputVariablesisunchecked.Leaveitunchecked.

Now,clicktheMissingValuestab.

Inthistab,youcanselectanapproachtohandlemissingvaluesinthedataset(X).Bydefault,any missingvaluefoundinanyobservationwouldexcludetheobservationfromtheanalysis. Thistreatmentisagoodapproachforouranalysis,soletsleaveitunchanged. Now,clickOKtogeneratetheoutputtables.

MakingSenseofDieselPrices

SpiderFinancialCorp,2013

Analysis
1. Statistics

Inthetableabove,weshowthevarianceofeachprincipalcomponentandtheproportionoftheinput (standardized)datasetstotalvariancevariablethatitaccountsfor.Examiningthetablecloser,the1st twocomponentscapture99.8%ofthedatasetvariation.

MakingSenseofDieselPrices

SpiderFinancialCorp,2013

2. Loadings
Intheloadingstable,weoutlinetheweightsoftheprincipalcomponentineachinputvariable:

. Examiningtheinputvariables(i.e.regionprice)loadingsforthefirstcomponentshowsauniform loadingforallvariables.Thiscanbeinterpretedasthelevelfactor(pricethatislocaleneutral). Forthesecondfactor,thepictureisabitdifferent: ForallPADDregionsintheeast,theloadingisnegative. ForPADDregionsinthewest,theloadingispositive. Gulfcoastsloadingisslightlynegative. Midwestloadingisslightlypositive.

Thisfactorsloadingcanbeviewedasproximityto(oravailabilityof)refinerycapacityorimportports (example:NewYorkharbor).Thesecondfactorreflectsthecostoftransportationandtaxofthefuel.

MakingSenseofDieselPrices 6 SpiderFinancialCorp,2013

Note:Theloadingsoftheinputvariablesforthe1stcomponentareverycomparable,so,ineffect,the secondcomponent(factor)iswhatdrivesthepricedifferentialbetweenthedifferentPADDregions. 3. Principal Component Values Letsexaminethevaluesofthefirsttwoprincipalcomponents.

MakingSenseofDieselPrices

SpiderFinancialCorp,2013

Thetwotimeseriesexhibitsomeseasonality,althoughitismoreapparentinthesecondfactor. Furthermore,thefirstprincipalcomponentexhibitsapatternclosetocrudeoilprices.

NOTE:ThelackofanexactmatchmaybeattributedtoothercostsincurredinthemakingofNo.2Ultra LowSulfurDiesel:labor,energyprices,rawmaterial,etc.Furthermore,refineriesbuildupinventoryof products(e.g.diesel)inanticipationoftheseasonaldemandpeaks,sotheremaybealag. 4. Adding WTI Spot Prices AsalastthoughtontheWTIspotprice,wewillincludetheWTIspotpriceinourinputdatasetandre examinetheinputloadings.Intuitively,addinganinputvariableforrawmaterialprice(i.e.crudeoil) withthefinishedproductspricesinthesamedatasetwilllikelyrevealanotherdriver:costof production.

MakingSenseofDieselPrices 8 SpiderFinancialCorp,2013

Now,wedneedthreedriverstoaccountfor99.8%ofthepricevariation.

IMPORTANT:Theprincipalcomponentsofthenewdatasetarenotnecessarilythesameastheones wecomputedearlierwithonlythedieselprices. Letslookattheinputvariablesloadingsineachprincipalcomponent(i.e.driver):

Notes: 1. Theloadingsforthefirstcomponentaresimilartooneswecalculatedearlierwithonlythe dieselprices.NotethattheWTIloadingsareslightlylowerthantheirdieselcounterparts.Again, welldesignatethisfactorasthegeneralpricelevel(regionneutral). 2. Theloadingsforthesecondfactorareverydifferentnow,andtheloadingforWTIisnegative( %94.5)whilealltherestarepositive.Wecandesignatethisfactorasthecostofcrackingdiesel ofcrude. 3. Theloadingforthe3rdfactorisverysimilartotheloadingofthesecondcomponentinthe earlierdatasets.Again,theloadingvariesbasedonthelocation(eastvs.west).TheWTI,Gulf Coast,andMidwestarealmostneutral. Letsnowplotthefactorstimeseries.

MakingSenseofDieselPrices

SpiderFinancialCorp,2013

Ingeneralterms,thefirstandthethirdcomponentareverysimilartothefirsttwocomponentswe calculatedearlier(w/oWTIinthedataset). Forthesecondcomponent,wehypothesizethisoneastheproxyofthedieselcrackingcost.

MakingSenseofDieselPrices

10

SpiderFinancialCorp,2013

Conclusion
Inthistutorial,weexaminedanontrivialapplicationforPCA.Weattemptedtoexplaintheprice variationamongdifferentPADDregionsbyuncoveringthedrivingforcesbehindtheprices. Whatsnext? Wementionedearlierthatrefineriesbuildupinventoryofproducts(e.g.diesel)inanticipationofthe seasonaldemandpeaks,sotheremaybealag.Howdowecapturethisvariable?Futures:wecan includethefuturepricesofthedieselandcrudeoil. Why? Intuitively,futurespricesreflectmarketanticipationof(1)futuredemand(2)futurestoragecost,and possiblyapremiumforsupplyscarcity. ThisapplicationisintendedtogiveyouasampleofhowtoapplyPCAandtimeseries,aswellashowto useorinterpretthevariablesloadingsinderivingapracticalproxyforthem. Insum,PCAisamathematicalprocedurethatNumXLcanhelpyouexecute.Makingsenseofand interpretingtheresultsiswhereyourexpertiseandintuitionareindispensable.

MakingSenseofDieselPrices

11

SpiderFinancialCorp,2013