Why Gas Prices Are Outrunning Oil Prices
As we take a holiday break from what will continue to be a very unstable energy market, it seems like a good time to draw from the many questions and comments I’ve gotten from your fellow Oil & Energy subscribers. I appreciate all of your emails, as always, even if I can answer only a few.
Today, I am actually answering only one. It introduces a very important element – and one we need to watch carefully in the coming months.
Q: Oil is now at about $113 per barrel, and gasoline prices are approaching more than $4.00 per gallon in some areas. Two years ago, gas prices were indeed $4.00 – and then some – but oil prices were over $140 per barrel. With oil prices now 22% to 25% less than they were then, why are we already “enjoying” $4.00-plus gasoline? ~ Pete
A: Pete, while it is true that crude oil prices remain the single highest component in calculating the resulting retail price of refined products like gasoline, they do not tell the entire story.
We need to do a little detective work here, my dear Watson…
Traditionally, a $1 increase in a barrel of crude would result in a 2.5-cent increase at the pumps.
On January 3, the first trading day of 2011, NYMEX WTI (West Texas Intermediate) next-month (near-month) futures closed at $91.55 a barrel, while RBOB futures closed at $2.43 a gallon.
RBOB, which stands for “Reformulated Blendstock for Oxygenate Blending,” is the futures standard for gasoline in New York trading.
The corresponding figures on July 1, 2010, were $72.95 and $2. That means, on average, a 2.3-cent rise per RBOB gallon for each $1 rise in crude price per barrel over the second half of 2010 – or just about where the historical averages would conclude we should be.
However, something significantly different takes place when we move further into 2011.
Yesterday, the WTI price closed at $112.29 and RBOB at $3.31 – a $20.74 rise in price per barrel since the January 3 close, but an 88-cent rise in the price of a gallon of RBOB. That works out to an increase of 4.2 cents per gallon for each $1 in barrel price
The spread has widened quickly this year. By January 31, the year to date ratio had spiked to an increase of more than 9 cent per gallon for each $1 in oil. By February 18, the price of crude had actually decreased, but the price of gasoline continued to climb. By March 1, it was still over 6 cents; and by April 1, it had settled into a differential of 4.4 cents, essentially the spread we’ve experienced since.
So what happened?
Many pundits blame the rise in MENA (Middle East / North Africa) tension and the disaster in Japan. This certainly may have something to do with the rise in prices globally, but explaining this away as a risk factor means nothing in the actual calculations. Such a “fur ball” explanation cannot be plotted.
It also becomes a hard sell in the U.S., wherewe have historically high surpluses of crude oil at Cushing, Okla.Cushing is the confluence of pipeline systems, one of the primary storage locations and the place where the NYMEX WTI contract prices are actually set.
One cannot explain away a price hike like this when there is excess supply over demand in the market served.
Something else is afoot (a little Sherlock Holmes paraphrase for the real detective fans among us).
The answer begins by searching elsewhere – in the widening spread between WTI trading in New York and Brent trading in London (as well as globally on ICE). Both are denominated in dollars.
Until recently, WTI would usually be priced higher than Brent because, while both are lower sulfur-content crude than what is traded in most consignments worldwide (“sweeter” oil, in market parlance), WTI is of slightly higher overall quality. That would normally translate into a premium over Brent.
Indeed, this is what we witnessed until August 16, 2010.
Yet from that point onward, Brent has traded higher than WTI for 174 consecutive trading days. Some of this results from that glut forming in Cushing. But the deeper reason reflects the actual usage of the two benchmark prices.
Taken together, WTI and Brent represent a grade of oil used in less than 15% of all the daily trades across the globe. Brent, however, serves as the benchmark for more markets than does WTI. It also feels the impact more immediately to the MENA unrest.
On January 3, Brent priced higher than WTI by $3.29, or 3.6% of WTI. By January 27, those figures had increased to $11.75 and 13.7%. By February 16, they stood at $18.79 and 22.1%, respectively; on March 1, $16.04 and 16%; at close yesterday, $11.70 and 10.4%.
There is a marginal decline in the spread as we have moved forward over the last two months. Yet the difference has remained, on average, the same for all of April (the April 1 figures were actually a bit lower – $10.76 and 10%). We have also witnessed a slight tightening of WTI to Brent.
A more complicated algorithm will provide us with part of the answer.
Using a progression of times-series equations as an overlay of the WTI-Brent spread onto the futures price/RBOB relationship – for all of 2011 – results in the spread between the two benchmarks accounting for, on average, an effective daily incremental factor of 77 cents.
Combining this increment and the traditional $1 rise per barrel equaling a 2.5-cent increase in gasoline prices, we are at 3.2 cents, or 76% of the 4.2-cent average already mentioned for the year to date.
This clearly tells us that the markets for both crude oil and gasoline are global, not local.
Now, most of the gasoline purchased daily in the U.S. comes from local refineries. I say “most”because, as with crude, we are importing a greater amount of daily oil product needs from refineries elsewhere. Those imports, along with the distribution of crude internationally to begin with, mean that pricing anywhere is no longer simply an exercise in local costs and profit margins.
Nonetheless, profit margins are also coming into it – or refinery margins, to be more precise. (See “In Oil Refining, It’s All About the Margins,” March 22, 2010).
While crude oil is the single greatest cost for a refinery, the margin between costs and wholesale levels are the primary source of profits.
Here, compare the continuing high crude oil surpluses against the drawdowns in gasoline inventories and the refinery usage figures (in the low 80% range). That tells us the market uncertainty is allowing the opportunity for an unusual relative rise in refinery margins.
Both of these factors – the WTI-Brent spreads and the acceleration in refinery margins – speak to the underlying environment of high volatility. This will be with us for some time.
It may seem unsettling. But the previous market dynamics are now impossible to maintain, and something previously regarded as “improbable” has taken over.
As Holmes reminded Watson in The Sign of the Four: “How often have I said to you that when you have eliminated the impossible, whatever remains, however improbable, must be the truth?”