Tags: Gas | Prices | the | Edge?

Gas Prices On the Edge?

Friday, 28 April 2006 12:00 AM

Dear MoneyNews Reader:

At gas stations around the nation the price of a gallon of gas hit $3.00 this week, setting off mental alarm bells in consumers' minds.

Economists have always cited the changes in the price of oil as having a negative impact on consumer spending. Each time we go to the gas station you can't help but notice how much more it costs to fill the tank.

What you spend to fill the tank by definition comes out of either spending or out of your savings.

According to analysts at investment bank Credit Suisse, oil and gas prices will cost consumers a record $65 billion this quarter, up from $52 billion in the third quarter when oil last exceeded $70, strategists wrote in an April 18 report.

The list of conventional rationale for the rising cost of oil is straightforward.

Recent changes to environmental controls have caused a switch from MTBE to ethanol. As a result, a shortage of ethanol occurred, which left us with a ready-made disaster plan for surging nationwide gasoline costs. 


MTBE has been proven to leak from underground gas storage facilities and contaminate aquifers. However, making the move has proven a little trickier as gas refiners locate sufficient supplies of ethanol.

According to Department of Energy Secretary Sam Bodman, this change to ethanol may disrupt gas supplies for several months. The department noted that the lack of domestic ethanol means that producers would have to rely on imports to blend with richer grades of fuel.

The outcome is a surge in prices. However, are we confusing either a lack of supply or strengthening demand with other bottlenecks in the system?

While G7 leaders met to discuss global growth, OPEC ministers held an informal meeting in Doha, Qatar to discuss the surging price of crude oil and commented on the supply situation.

Kuwaiti oil minister, Sheikh Ahmad Fahd al-Sabah told reporters, in light of the record high price set at $75.35 the day before, that the Iran conflict has added as much as $15 to the price of crude.

According to another, oil would settle back to the high fifties. Some months ago, OPEC abandoned official price bands for crude oil.

OPEC member Kuwait even offered to pump more oil, yet the cartel has already urged them not to increase production.

OPEC's Nigerian President Edmond Daukoru said, "We are giving them all they ask for and what they can process."

The Algerian minister, Chakib Khelil added that, "There is nothing OPEC can do to alleviate high oil prices." 

The fact that Saudi Arabia offered to release its stockpile of spare capacity in the fourth quarter of last year only to find no takers bares testimony to that fact.

So let's take a look at three charts that the Department of Energy releases each week. They show U.S. inventories or crude, motor gas and distillates. In each of the following charts, I have plotted weekly data along with a 90-day average. First up are crude inventories.

Average inventories of unleaded gasoline between 2002-2005 ran at 206 million barrels. Motor gas inventories have slumped recently as refineries just can't refine crude oil quick enough.

But the latest reading of 202 million barrels is within spitting distance of that four-year average.

This week the Energy Information Agency reported a further decline in both crude and motor gas inventories, but a rise in distillate inventories.

I often hear the comment from oil experts that it's not necessarily the volume of crude oil that counts, rather it's the quality. While Saudi Arabia has the world's largest proven reserves of crude, it's nowhere near the quality of nations such as Venezuela or Nigeria.

You'll hear the terms ‘light-sweet' and ‘heavy' or ‘sour' crude used. The former is the better quality and just what the refiners want.

But apart from whether or not the refiners have the right grade of oil, let's take a look at the level of refinery output.

In the aftermath of Hurricane Katrina,several oil rigs went ‘missing' in the Gulf of Mexico and even shore-based ones were knocked offline.

Gradually, rigs were relocated and switches were flicked as refiners got back to business. But as you can see from the chart, the present 86.5% utilization rate (red line) is low by historic standards. Indeed you can easily count the nine occasions during which capacity utilization dropped below the current value.

Focus on the green line, which shows the three-month average. Since 2001 the average capacity utilization rate has not been below today's level. That should confirm to us that the nature of the problem lies in refiners' ability to perform their role.

Looking forward, the chances are that we'll see capacity output normalize. Of course the caveat here is that the situation could worsen if the pending hurricane season steps up to compete with last year's.

But remember, it would take comparable and above winds to knock capacity offline. I'm not saying that Katrina and her ugly sister Rita were flukes, merely that a rerun would have to occur for the situation to worsen.

We've been repeatedly warned that omnipresent population growth is straining fossil fuels, which will create a one-way path for fuel prices.

Recently Houston's billionaire energy trader T. Boone Pickens stated that it's unlikely that we'll see oil prices decline to $50 per barrel during the remainder of his lifetime.

President Bush recently stated that the United States aims to replace 75% of its imports from the Middle East by 2025.

But other leaderships have realized the nature of the beast much earlier than this. It was in the 1980s that the Brazilian military-run government determined that the 1970s oil shock shouldn't be repeated, and set about to develop biofuels.

Farmers were given subsidies to grow sugarcane, from which ethanol is produced. Prices at the pump were raised to induce flexi-car purchases. And it worked, too. By 1985 and 1986, 75% of all motor vehicles and 90% of all cars in Brazil were able to run on biofuel.

However, the environment changed when a new civilian government took power with less ambition to pursue interests of national security over social reform. Rising sugar prices sent subsidies sky-high and state-owned oil company Petrobras discovered major offshore oil fields.

By 1997, less than 1% of domestic cars sold were capable of running on both types of fuel. The slide in the price of oil made it hard to argue for biofuel at that time.

In the recent few years, the government has introduced tax incentives to promote sales of cleaner-fuel burning vehicles. Similarly, tax breaks and technological advancements have made it more appealing for ethanol producers to convert sugar to fuel.

Now, more than 80% of all cars on Brazil's roads are capable of using both ethanol and gasoline. The sugar industry claims that this switch to biofuels has reduced imports by a staggering $400 billion.

And on the export side, there remains talk that Japan will buy six billion liters of Brazilian ethanol by 2008. Producers will have opened 70 new mills by 2012.

Last week, President Luiz Inacio da Silva opened a vast new oilrig, which will enable the country to be self-sufficient in oil production.

Brazil spent $600 million on the platform, which will produce 180,000 barrels per day. The additional output means that production of oil exceeds the nations needs.

Back in the 1970's when the nation was fully dependent of importing oil, the twin oil-price shocks caused Brazil to become heavily indebted, leading to a debt and inflationary spiral with disastrous consequences.

In the span of your author's lifetime, the Brazilian nation is set to shift from playing the role of the pauper to that of the prince. Today, Brazil boasts some of the best deep-sea drilling technology that will allow it to become a net exporter of oil.

For a nation with almost four times the population of the United States, India doesn't sell many cars.

In August 2005, annualized passenger car sales surpassed one million for the first time and have maintained that pace ever since.

The culprits here are strong economic growth and rising salaries.

South Korea's Hyundai names India as its top growth market since cars are rapidly becoming status symbols in the nation's biggest cities.

The 7-8% economic growth rate coupled with the increased availability of inexpensive auto-loans is driving spending too, shifting India from a nation of savers to a modern-day consumer society.

But add together 10% growth in demand for cars and surging industrial demand, and energy use is through the roof.

Currently 75% of India's energy is imported, and it's estimated that by 2020, it will need to import all of it.

India is in talks with Pakistan and Iran over plans to build a $17 billion natural gas pipeline, which could form the platform of India's next growth phase.

Right now, India's government subsidizes both oil and kerosene used by most individuals. If they didn't, the nation could not manage the growth rate it does.

The country's oil needs form just 3% of global demand. If demand pressures India's needs to 10% of global oil use by 2030, subsidies are going to be an unjustifiable expense on the road to economic strength.

Rather, the way forward for Indian energy needs will come from nuclear sources. Currently, the nation has 14 reactors and a further nine under construction.

Nuclear fuel accounts for just 3% of electric output. That will rise to 25% by 2050 despite the fact that India has little or no uranium required in the nuclear process. India is currently reaching agreements with Russia to secure uranium supplies.

Any discussion over high oil prices invariably includes the topic of China, as if the 1.3 billion Chinese were to blame.

The 9% compounded rate of economic growth over the last decade has turned China from oil provider to the world's second largest oil importer. Still it only uses 4% of the world's daily output.

As with Indian middle class, so to is China's population gravitating to a more affluent lifestyle. Each day a thousand new private cars hit the street, adding to the current three million vehicles.

It's estimated that by 2020 China will have 140 million private cars on its roads.

Clearly, the strains on the global oil situation won't rectify themselves, and China will have to rely on other fuel sources. Already, China is the world's largest producer and consumer of coal.

In 2005, its 30,000 mines produced two billion tones of the dirty black rock. One in three lumps of coal were produced in China.

Coal is renowned for the fact it's not clean burning. However, several huge new projects are set to clean up that act and will turn dirty coal into clean gas.

As was the case with Brazil's ethanol industry, when oil prices decline, the appeal of investing in the process diminishes. The process by which coal is cleaned up is called coal gasification and until now has been considered economically unviable. But with $60-$75 per barrel oil, that's rapidly changing.

According to experts, several new Chinese mega-plants will turn sulphur-rich coal into sulphur-free methane ready to be liquefied and put into the tanks of its three million vehicles or burned at its power stations.

The Chinese government has mandated that by 2020 15% of its energy will come from renewable sources from solar, wind-power and biomass. For China, the way forward is hydro-power.

China wants to dam its five arterial rivers. In three years time when the work on the middle reaches of the Yangtze River is done, the world's biggest turbines will pump out 25 gigawatts of electricity equivalent to one third of the U.K.'s total energy output.

Plans are in place for other mega-dam projects further up the river in one of the world's most spectacular gorges. Another series of dams is planned for close to the Burmese border.

If you don't think differently, you won't solve the age-old problems. It took my existing lifespan for Brazil to change into the powerhouse it's become today, throwing off the shackles of reliance in the Middle East and it's oil.

Chinese ambitions to build a sustainable platform for its heady pace of growth has seen its industrial and political leaders strike supply-chain deals in the darkest corners of the earth from the Sudan and Iran to Brazil and Australia.

The Chinese know that there is no simple solution to long-run energy needs, and despite attempting to corner many existing supplies, they are taking steps to address the problem with home-grown solutions.

China's government knows that without aiding its population and its businesses it could scarcely afford the growth it's witnessed. Call it a barrier to entering the modern world. Creative financing in a sense has allowed them to leap the hurdle.

But with such growth comes a different class of citizen and a variety of consumer needs. Having bravely started a 110-meter hurdle race, China needs to find marathon-style solutions instead.

The world's major oil producers are essentially home-grown here in the United States and are increasingly coming under the hammer for causing the sky high prices at the pump.

However, the reality is that these companies have not just a great business model, but essentially monopolistic powers. The higher the price of crude goes, the bigger profits they make.

Whether this week's announcement by President Bush about using strategic reserves to supply the market or talk over windfall taxes on oil producers' profits will be fruitful, remains to be seen.

But one clue about the future price of oil can be seen within the futures market for oil this week. Recently, the large commercial producers took the view that the price of crude wouldn't stray above $70 per barrel.

Data from the CFTC based upon the net positions of commercial traders in the crude oil futures markets revealed pessimism over crude in the coming weeks.

In the chart, the blue line plots the price of a barrel of oil on the right-hand scale, while the green line maps the net commercial position in futures contracts.

The horizontal red line represents a net-zero position. In general, these commercial traders remain net long of crude oil positions, most likely because of the usual reasons. They recognize prices are more likely to rise because of the tensions listed at the top of this article.

The flip-flop to such a convincing short position is unusual. On the other side of the coin, the net speculative position held by professional traders at banks and hedge funds went extremely long.

But looking at the chart, I'm not convinced that the commercials always get it right. Between July and September 2005 they remained net short, while the price of oil rose from $58 to $67 per barrel.

Perhaps they have a better knowledge of the timeline of refineries coming back on line. While hurricane season is only five weeks away, don't forget that last year the first storm wasn't until the end of August. That's four months from now.

Who's your money on??

Have a great week! 

Andrew Wilkinson

P.S. Get exclusive access to million-dollar hedge fund strategies for the price of a newsletter subscription with my new service, Wilkinson's Hedge Fund Investing. Join today.


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Dear MoneyNews Reader: At gas stations around the nation the price of a gallon of gas hit $3.00 this week, setting off mental alarm bells in consumers' minds. Economists have always cited the changes in the price of oil as having a negative impact on consumer spending....
Friday, 28 April 2006 12:00 AM
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