High Gas Prices … No Easy AnswersPosted on February 27, 2012 by Christopher Henwood in Crude Oil, Energy, Gasoline, Geopolitical risk, Iran, North Sea Brent, Refining, Regulations, WTI
Why is the price of gasoline so high? In the past week I was asked that question by a couple of the world’s largest news services looking for me to explain why it was so high and going higher. In each case they were looking for that simple, single element that could be turned into a quick blurb for their consumer news audience. Everyone is looking for the sound bite that will render an extremely complex process into a twenty-second news clip. The nature of the gasoline market is complex and does not lend itself to an easy explanation but as I flip across the television dial and the internet, I am struck by how many supposedly authoritative voices have some very simple reasons for why the price of gasoline is so high and moving higher.
Let’s start with President Obama. Last week he spoke at the University of Miami about the high price of gas. During his speech he said some interesting things. On the one hand he spoke of his commitment to “new sources of American-made energy”, while on the other hand dismissed the Republican plan that he characterized as consisting of three parts: Drill, drill and more drilling. Did I miss something? Isn’t drilling for US oil “American-made energy”? Obama also touted the increase in oil production under his administration. What he neglected to mention was approval rates for new shallow and deep water drilling are much lower than in the past and the amount of time from application to approval is also much longer than under the previous administration. While increased production from states like North Dakota have contributed to that increase, how much more oil could be produced if the Obama administration were truly committed to developing our own domestic resources? This is not a political statement, but one that relies on common sense and a deep understanding of the energy market.
President Obama correctly stated, “the single biggest thing causing oil to spike right now is instability in the middle east, this time around, Iran”, but instability sort of minimizes the potential for disruption the current turmoil represents. Consider that Iran is determined in its quest to develop nuclear weapons. Consider also that Iran has publicly avowed to “wipe Israel off the map”. Many security analysts forecast that Iran will be nuclear capable within one to two years and they also predict that Israel will likely strike Iran as early as this spring. This is more than instability; this has the potential to explode into all out war. And all out war means sky-high energy prices, as the disruption to the world’s oil supplies would be significant. It is only prudent business for anyone involved in the energy market to start planning for a potential disruption and that means an increase in buying in the oil market. President Obama sees it differently, “when instability increases, speculative trading on Wall Street increases and that drives the price up even more.” The nature of all trading is speculative, whether you are hedging production or supply needs, or placing a bet on which direction the price of oil will take, you are taking a risk that you could be wrong and lose money in the process. There are no guaranteed trades in the financial world and right now I think you will be hard pressed to find someone in the energy market who is not concerned that the situation in Iran could lead to a major disruption in the world’s oil markets.
Jim Cramer of CNBC had an interesting way to explain the high price of gasoline: “the hoarders are in charge,” he said in an interview with The Street. While giving the nod to the current Iran / Israel tensions, he chose to lay the blame at the feet of “hoarders.” Did I miss something? Did a cable channel start a new program on “Oil Hoarders of the US and how they single handedly raised the price of Gasoline?” What Cramer is describing is called oil trading. When there is a fear that the price of any commodity will go up due to any number of factors, players in the market will buy or go long that commodity, in this case oil. But I guess common sense trading based on solid economic factors doesn’t play well to those looking for a scapegoat. Oil and gas cargoes, whether on barges in NY Harbor or on ULCC’s traversing the world’s oceans, more often than not, will change hands multiple times as buyers and sellers try to satisfy the needs of their customers as well as make a profit. The last time I checked that is a basic principle of capitalism. To hear Cramer describe oil trading as “hoarding” is a cheap populist shot that doesn’t even begin to explain why gas prices are so high.
Even Bill O’Reilly on the Fox News Channel is hung up on finding a quick fix to high gas prices. In a discussion with Lou Dobbs, he wants the President to step in and do something to lower prices. Really? I had to watch the segment twice. O’Reilly doesn’t like high gas prices because it hurts the regular folks but he thinks the Obama administration is the answer? While I don’t like high gas prices either, I understand why they are high and I don’t believe that further action by the US government will lower gasoline prices in the short term and I am a bigger skeptic that the Obama administration is the answer to the problem.
The reasons gasoline prices are high and will climb even higher are complex and varied. Many factors go into determining the price of any product and gasoline is no exception. I will break it down into four major areas: input costs, supply and demand, government and regulation, and the financial markets.
Let’s start with what gasoline is made from, crude oil. The crude oil market is an international market and events that impact the oil market anywhere in the world, impact it everywhere in the world. While the US does not get any of its oil from Iran, the countries that do buy their oil from Iran need to find another source because of the sanctions placed on Iran due to its nuclear weapons ambitions. As former Iranian customers compete for oil on the world’s markets to meet their needs, they drive the price of oil up in the process. There are many grades of crude oil in the world, but we will focus on the two main types, sweet and sour. In the energy world the best crude oil for making gasoline is light sweet crude. This also happens to be the more expensive grade of crude oil and the type most sought after by refineries. About 80% of the price of gasoline is determined by the price of the crude used to make it. Therefore if the price of crude goes up, the price of gas goes up with it. It’s basic economics. Most of the refineries in the US and the rest of the world require the expensive, light sweet crude to make gas, this increases demand and raises the price. Some refineries can make gasoline from lower quality or sour crude, thus lowering the input cost for gasoline. Many of the refineries in Texas and along the Gulf Coast have the capacity to run this cheaper crude. However, given that the price of all oil has been rising, even the cheaper sour grades have become much more expensive, resulting in higher gasoline prices.
In the post-holiday winter months the demand for gasoline in the US usually reaches its low point for the year and this year it at its lowest level since 2008. Lower demand usually means lower prices, but there are new factors at work here as well. Late in 2011, for the first time, the US became a net exporter of petroleum products. What that means is that we exported more refined products like gasoline, heating oil, diesel fuel, etc. than we imported. Most of those exports are heading to South and Central America, where the price is much higher than here in the US. The US refineries have found a fertile marketplace with increasing demand for US refined gasoline when demand is decreasing here at home. As any rational businessperson would, the refiners are shipping their products to where they can make the most money. Again, we are talking about basic economics and open global markets. Turning to the supply side of the equation, in the past year we have seen a decrease in the number of refineries in the northeastern US. Two major refineries were shut because their reliance on high priced, imported light sweet crude made them uneconomical to run. There has also been talk of two more refineries shutting down for the same reason. These closings have reduced the refining capacity and lowered the amount of refined products being made in the northeastern US. When you combine reduced supply (refining capacity) with increased demand (from exports) you have a recipe for higher prices. Again these are basic economic principles.
Complicating the picture is federal government and is regulatory apparatus. The Keystone Pipeline has been blocked by the Obama administration due to environmental concerns. The completion of that pipeline would increase imports of crude oil from Canada and reduce our imports from other, less friendly nations. While this would not lower gasoline prices, it could serve to marginally lower the price of crude for refineries in the future. The EPA played a large role in killing the pipeline. The BP/ Deepwater Horizon disaster was a horrible tragedy that rightly caused a closer look at how drilling operations are conducted. But the Obama Administration’s delay and pace of approvals for drilling permits since that time, has severely limited the number and amount of new oil and gas being brought to market. Again, this is domestic supply that will create a more stable supply picture for the US well into the future. And stable supply can contribute to lower prices. Keep in mind that there are also a number of different types of gasoline mandated by various state governments. There is a California blend, a midwest blend, a blend for the northeast, summer blends, winter blends, ethanol mixes. Each type needs to be produced for its region, further reducing the efficiency of refiners to deliver a consistent grade of gasoline to the entire nation. Government regulation and action can impact the price of oil and refined products in many different ways. So far all of the major steps taken by the Obama administration are supportive of higher not lower prices for gasoline, but again this is just one piece of the puzzle.
This finally brings us to the financial markets. There are two major exchanges that trade the world’s oil, the Chicago Mercantile Exchange (CME) and the Inter-Continental Exchange (ICE). These exchanges bring together all of the entities with an interest in the price of oil. The players consist of oil producing nations, oil companies large and small, banks and financial institutions, oil drillers and developers, refiners, pipeline and storage companies, speculators, and most recently, algorithmic trading programs. Each of these market participants use the markets to hedge or manage their risk, protect against price spikes or dips, manage financial risk or exposure, speculate on price direction or trade on small price moves to make a profit. The exchanges also trade two different crude oil contracts. The CME trades the US based West Texas Intermediate contract (WTI) and the ICE trades the London based North Sea Brent (Brent) contract. The price of crude oil as determined by the trading on these two exchanges, will serve as the reference price or benchmark for all of the world’s oil. The sheer volume of oil contracts traded and the large number of players in the market limit any one entity from disproportionately affecting the price.
There is an old saying in the market that “No one is bigger than the market”. I believe that still holds true today. The oil and gas markets are too big, too complex, with too many players each with their own interests to be boiled down to a quick sound bite. While we may not like the results of a market-determined price, it is the result of a complex relationship between input costs, supply and demand, government and regulation, and the financial markets. The high price of gasoline is the direct result of all of those factors and can’t be easily explained or changed. It will take a major shift in most of the areas outlined to reverse the current price trajectory of gasoline and the bad news for consumers is that nothing is pointing toward a reversal and as a result, the price of gasoline is still going higher, much higher.