The One Time it's Good to Be Crude

By William Patalon III
Managing Editor

Gasoline prices have fallen sharply in recent weeks and are now about 23 cents a gallon below an all-time record high set in May.
But crude oil prices steamed their way to a 10-month high on Monday.

After 23 years as a finance journalist and author, I understand very well the market forces at play here. Even so, I still find it fascinating – and even a little jarring – that the prices of two such closely related products can move opposite one another.

This paradox in pricing will soon disappear.  And then we’ll get to watch as the prices of these two such seemingly closely related products begin to move in tandem once again.
Indeed, the long list of catalysts that will induce these two commodities to move in lockstep are already piled up like players in a rugby scrum – except that these forces are all facing in one direction.

And, unfortunately for U.S. consumers, that direction is “up.”
If you’re among the group of investors who were expecting gasoline prices to continue their recent decline, you’d better give your forecast a fast-but-major makeover.

Let me explain …

The Trend is Your Friend

As Money Morning readers have quickly come to know, I’ll often dust off a tried-and-true investing axiom to make my point. Here, there are actually two that perfectly illustrate the key to the investment play I’m outlining for you here:

• The first is the just-mentioned wisdom snippet, “The Trend is Your Friend.”
• And the second is, “Don’t Fight the Tape.”

They both mean roughly the same thing: Investors make most of their money by finding a trend, and then riding along for all it is worth.¹ Bucking the trend (a.k.a. “investing against the tape”) not only creates a ton of frustration as you repeatedly watch one well-crafted investment thesis after another head straight for the netherworld in a small, hand-carried container made of woven cane – it also creates losses.Lots of losses. (Easily enough, in fact, to fill your afore-mentioned “handbasket” many times over).

As for “the tape,” well, that’s merely a physical reading, or illustration, of the trend you’ve identified as your profit vehicle – manifested through price, volume and other important information you can use to confirm that the “trend” is playing out as you expected.
In this case, the trend is oil and gasoline prices. But because of the short-term disparity that I mentioned, identifying the trend is initially a bit tricky.

Oil prices hit a 10-month high on Monday. London Brent Crude – a closely watched proxy for worldwide oil prices – hit $72.77 a barrel, its highest level since Aug. 25 . But as we said earlier, gasoline prices have fallen of late.

That’s merely a short-term disparity, however, for the catalysts are lined up and are poised to push oil-and-gasoline prices in one direction…up.

How powerful and well-positioned are these catalysts? Well, if these catalysts were a baseball lineup, its power would cause folks to (temporarily) forget² the vaunted “Murder’s Row” of the 1927 New York Yankees – with Combs, Gehrig, Ruth, Meusel and Lazzeri. This “Murder’s Row” will certainly kill a consumer’s wallet. Consider:

• The U.S. market has moved into the first of the two summer months where gasoline demand is at its highest – a factor that tends to push up gas prices at the pump even in the best of times.
• Domestic production is flat, crude imports are down, and the demand for refinery-grade crude oil will spike because of the peak driving season – these three alone representing a trifecta of catalysts for higher crude prices.
• The weak U.S. dollar, which hit a 26-year low against the British pound sterling on Monday, will magnify the costs of crude imports, which were already on the rise.
• Demand from such fast-growing, emerging-markets rivals as China will continue to escalate, causing prices to rise even more. Just as it’s been doing in the commodities sector, China is locking up exploration-and-production capacity in the energy sector, which over the long haul can only exacerbate the already-nettlesome supply problem for U.S. consumers.
• Terrorist fears – stoked by the attempted bombings in London last week and an attack on Glasgow airport – have boosted oil prices even more, with traders demanding a “risk premium” to compensate them for the higher loss potential some of their trades carry.

Clearly, oil prices are heading higher. But the question that remains is …

Just How Much Higher is “High?”

The analyst team at Barclays Capital – which does a pretty decent job covering the oil and commodities markets – said in a research note that Brent crude oil “has started July with a bang … indicating that its uptrend has resumed toward $76.95.”

Lawrence Poole, an analyst with Global Insight, is forecasting gasoline prices at the pump to surge back up to – and probably over – the $3 per gallon level.
When I say “back up to,” I mean just that….for gasoline prices have already been there as part of the wild ride they had this year.

Pinning down precise prices is always tough, even with the many surveys out there, for prices vary widely from region to region, the surveys themselves are “averages” and are of limited breadth and scope, and the manner in which the results are calculated can differ greatly from one study to the next.
Even so, the numbers I present will at least convey the magnitude of the mind-numbing upswings and volatility in gas prices that we’ve seen – especially this spring and summer.

According to AAA, gasoline is currently averaging $2.975 a gallon nationwide. That’s down about 23.7 cents a gallon from one month ago, although a gallon of gas was 10 cents a gallon cheaper at this time last year, according to the AAA survey.

Earlier this spring, fuel prices experienced a scorching upswing: Prices achieved the first of several record highs. During a two-week stretch that ended May 7, prices at the pump had soared by 20 cents a gallon, reaching a then-nationwide record high of $3.07 a gallon – and eclipsing the recent prior high of $3.03, which had been reached last Aug. 11.

And there was still plenty of wind beneath its wings. Prices soared even higher, climbing to equal another “all-time record high” – at $3.22 a gallon – on May 21.
This matched the inflation-adjusted record high for U.S. gasoline prices, which was achieved in March 1981.³ Since then, of course, gas prices gradually dropped back down to their current level at just under $3 per gallon.

I’ve Seen the Future, and it’s….Expensive

Although U.S. crude-oil stores are at a nine-year peak, a number of refineries are down for maintenance. Once these facilities go back on line, it’s likely that a decent portion of these reserves will be drawn down somewhat quickly.
For the week that ended June 22, the U.S. Energy Department’s Energy Information Administration, or EIA, reported that fuel inventories dropped by about 700,000 barrels. Analysts had projected a gain of 1.1 million barrels, according to a survey by Dow Jones.

The EIA report also showed that crude oil supplies rose by 1.6 million barrels to reach a total of 350.9 million barrels, eclipsing the consensus estimate of a 1 million barrel increase. Refinery utilization was 89.4%, an improvement of 1.8 percentage points and a gain that bettered the consensus Wall Street prediction of a gain of 0.8 percentage points, according to published reports.

According to a poll by the Reuters news service, there’s been a reduction of 700,000 barrels in crude-oil inventories, at the same time that refinery utilization increased by 0.9% — changes that will feed any price-increase trends.

The next snapshot of U.S. fuel stocks is due out today – a day later than usual, due to yesterday’s Independence Day holiday.

Although these statistics are always closely watched, they’ve been even more so since the start of this spring. The reason: An unusually large number of refinery outages have forced gasoline futures prices higher, and have also translated into record gasoline prices for consumers.

The latest example of the slew of refinery problems that have afflicted the American oil market this year: The Coffeyville, Kansas-based Coffeyville Resources refinery – which has a daily capacity of 108,000 barrels – had to shut down following some flooding.

One analyst wrote that the end of the peak refinery maintenance period – usually the middle part of June – should lead to “a significant reduction of planned maintenance in the [United States market] in the third quarter.” With those refineries up and running, however, demand for the crude oil needed to put them through their paces will cause prices to spike.

The International Energy Agency, which represents 26 nations of consumers, on Monday once again called for OPEC to boost its production output. But OPEC, which pumps about a third of the world’s oil, has resisted so far: It has argued that current crude supplies are ample and that the shortages in actual refined products are outside its purview and would not be materially affected by an increase in its output.

But the Reuters survey found that OPEC had kept a lid on its output in June, pumping 30.19 million barrels per day, or BPD. The 10 OPEC members subject to production limits produced about 26.64 million BPD, an increase of 50,000 from May.

According to Poole, the Global Insight analyst, “because domestic gasoline production is broadly flat, imports are down slightly and demand is expected to pick up in the next six to eight weeks, we can expect price rises in retail gasoline going forward.”