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Old 02-19-2009, 09:53 AM   #1  
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Default Gasoline and Oil Prices

Things Explained: Gasoline Prices
The mysteries behind oil and gas prices

The question I’m most often asked may be, "How is it that the price of oil can fall and yet the price of gasoline rises?" Somewhere along the way, most reporters covering the energy industry have convinced Americans that the price of oil and gasoline pump prices are somehow directly connected. Well, the connection is there, but it is a weak one; and certainly over the past few years, misinformation has confused the effect of oil prices on the price of gasoline and diesel.

As covered in this column, oil is traded on numerous futures markets; the New York Mercantile Exchange is the best known and allegedly regulated. Oil is also traded on futures "look-alike" markets, which are fundamentally unregulated. The concept long taken for granted in this market is that supply and demand alone should determine the price of oil. And the prices represented typically show delivery of crude six or so weeks out, although oil contracts can be placed for far in the future.

Of course, as we have found out in the last three years, speculators in the market can drive the price of oil sky high. Worse, they do so without ever intending to take delivery of the crude oil specified in their contracts. Put another way, just as new home prices were driven through the roof in places such as California – unrealistic asset prices covered by overextended mortgages – the same thing happened in the oil market. And as happened in those bad mortgages, many speculators borrowed heavily on margin to finance their upward push on oil prices.

$14.70 a Gallon Gas?

The U.S. oil inventories hit their recent low of 290,287,000 barrels the week of September 19, 2008, and today we have 338,881,000 barrels – with an untold amount of oil stored in leased supertankers offshore. Keep in mind that there was no justification for the price of oil rising the way it did last year, because there was no supply problem with crude; one year ago today the U.S. had "only" 292,000,000 barrels of crude on hand for processing. We are far better off today.

In early 1999, when gas was selling for just 99 cents a gallon, we had about as much crude oil in our inventories as we do today, but the price of oil had collapsed to around $10 a barrel. That’s what started confusing the media and the public into seeing a direct connection between oil and gasoline prices. After all, using the 1999 oil and gasoline prices for a ratio, it looked like one gallon of gas should cost around 1/10 the price of a barrel of oil. Using that same fractional retail cost, today with oil at just over $40 a barrel, 1/10 of that would come to $4 per gallon for gasoline. And remember last summer, when oil hit $147 per barrel? If the 1999 ratio held true gasoline should have sold for $14.70 a gallon.

But it didn’t, and there’s a reason why. Gasoline is also sold on the futures market, and in this case the buyers tend to be the end retailers. Not all gasoline is sold that way, but when it is bid and purchased that way the price is determined by the retail demand for the product. Unlike oil, which is a near to long-term purchase, the gasoline futures market sells the finished product in the very near future. Meaning: That market responds quickly to our using less or more fuel.

Profit Taking

Just like OPEC can cut oil production to try and move the market price upward, refiners can cut back on refinery production to tighten the retail supply of gasoline (or diesel, heating oil or aviation fuel). By cutting the amount of gasoline that can be retailed, they can theoretically raise the price of gas on the market. And they do. I notice with some amusement that Americans loudly vent their anger at OPEC for cutting production, tightening oil supplies and bumping the price of oil. But nobody seems even mildly upset when an American refiner – say, Valero’s Texas City refinery – shuts down production to create a gas shortage and lift the retail price.

Similarly, it is always amusing to watch the TV news cover the fact that the price of gasoline has dropped by one or two cents a gallon in any given week when the futures market price for it is moving in a different direction – leading to what the price of gasoline at your local station will be 10 days out. But there is a good rule of thumb for figuring out what the price of gasoline will be 10 days to two weeks in the future: Look* at the futures price for gasoline today and add 63 cents (50 cents in Texas) to that figure, and in two weeks that will be the national price for gasoline. That’s not a perfect formula, but over the past five years it’s been fairly on target.

So, because gasoline sold for $1.255 on the futures market this past Monday, that means that the price of gas at retail should be around $1.88 a gallon by next weekend, or $1.75 in Texas. Now, should that calculation not prove to be accurate, then local stations might be improving their profits per gallon sold.

Certainly we are seeing that profit-taking happening today in the retail price for diesel. In most periods gas station owners are typically the one group that doesn’t benefit from the oil field-to-gas tank profit equation. But the price of diesel is within pennies of the wholesale price of gasoline today, which almost assuredly points to an improved diesel profit margin for station owners.

Good for them; there is nothing wrong with making a profit.

Fair Question

Now, the most thoughtful question I’m asked is, "What is a fair price for oil?" The answer to that question differs greatly from what you’d have heard 40 years ago.

In the sixties the world’s known oil fields held far more easy to extract oil than the then current demand for oil or the anticipated demand 10 years out. So, knowing that supplies could easily fill any worldwide demand for crude, you could do the financial math for operations to get oil from the ground to the refiner and tag a reasonable profit onto each barrel, and everyone — from the governments that controlled the oil to the oil companies — was fairly happy with the returns.

But that is not the case today. Now we have to factor in the profit that must be made on each barrel of oil based on what the replacement costs for that same barrel of oil might be 10 years from now.

Let’s assume, for example, that it costs Saudi Aramco and their partners $2.50 a barrel to extract it out of the ground. It would seem that adding $2.50 to each gallon would give that oil company a 100 percent return on their investment immediately. That sounds fair, and that concept is how the oil industry has operated for many decades. Only today we know that outside of Iraq, there are no major new oil fields left to discover where the costs of extraction will ever be that inexpensive again.

Where the Smart Money Looks

Today the smart money in oil understands that their best chance of success in the future will be to find oil deep under the sea or in places like Canada’s oil sands, or even in truly unconventional sources such as shale. You need super oil profits today to show a corporate profit and have the massive amounts of excess funds you need to put aside for exploration and extraction in the future, when the oil might have to be brought up from 30,000 feet below the surface of the ocean.

Likewise, if oil sells for $40 today but oil from your next offshore platform will cost $60 a barrel just to bring to market, then you are far less likely to invest in that new offshore drilling platform today. Again, that doesn’t always hold true – but it is the guideline for smart future planning. There’s no sense finding and pumping $60-a-barrel oil if the market is only going to pay you $40 for it.

You often hear the complaint today that American corporations are so short-sighted that they care only about their stated profits for the next fiscal quarter. But our ever-growing world of motorists demands that oil companies plan their futures decades in advance.

Summing up, in the futures market oil is traded on one contract, but gasoline is a completely separate bidding process. The only connection between the prices of oil and gasoline is that when oil’s price is high and gasoline demand low, refiners dial back on their production to short the supply and raise the price of gasoline. But if you are trying to figure out what gasoline will cost based on the selling price for oil, don’t bother. That direct equation stopped being accurate decades ago.

And if you want to know what oil will sell for in another 10 years, start looking at the cost of production for offshore oil, tar sand crude and shale — and apply the "supply against demand" equation to that model. Then thank your lucky stars that it’s only $40.00 today.

(*Oil and gas futures prices are updated daily at Ed Wallace's Inside Automotive)

© 2009 Ed Wallace

Ed Wallace is a recipient of the Gerald R. Loeb Award for business journalism, given by the Anderson School of Business at UCLA, and is a member of the American Historical Society.
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