Forget the Kneejerk Reactions, Oil Prices Are Going Higher

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With all of the concern exhibited over Cyprus' problems with banks and China's high-profile billion-dollar solar implosion, the doomsayers are once again predicting an oil price crash.

These guys must really need your money!

Each new geopolitical event is cast as the end of the world as we know it.

The fact is there is nothing on the horizon that will collapse oil prices for one very simple reason.

The prospects for oil prices are increasing, and elevating oil products along with them. Most sections of the U.S. will be testing 2008 gasoline price highs at the pump well before mid-summer.

Yes, we did see a swing down in crude futures during the initial stages of the Cypriot crisis, augmented by some short-lived negative comments on Chinese industrial prospects.

But by last Friday morning, stabilization had occurred and an oversold crude oil futures market began to move back up.

The perception is that this remains driven by demand expectations. Now I have discussed several times the essential shortcomings of what the pundits regularly do with demand. Whenever a negative appears, most of the initial reactions witnessed in the market are overdone.

These negative reactions also come without a justification in data.

Remember, the tangible figures supporting a reduction in futures contract prices, the data that actually provides an indication of a decline in demand, takes at least three months.

And even then, the indicators are very provisional.

As a result, knee-jerk reactions drive the initial investment response.

But it usually results in an oversold condition. As we have also noted in the past, such an immediate read says nothing of the genuine value about crack spreads - the difference between futures contracts in crude oil and those in gasoline and heating oil.

On this score, consider the current situation in crude versus RBOB ("Reformulated Blendstock for Oxygenate Blending," the NYMEX futures contract in gasoline). Both have performed about the same this month, with NYMEX prices up 0.3% for WTI (West Texas Intermediate benchmark grade), while RBOB posted a 1% gain.

However, the price of gasoline will be spiking for three reasons that have nothing to do with projected demand.

What's Actually Driving Demand?

First, the main driving season of the year is approaching.

Second for most of the populated areas of the country, a required switch from winter to the more expensive summer blend of gasoline is approaching.

And third, there is the ethanol situation.

This last consideration is the new wrinkle. Admittedly, it is the result from a political (though still largely bipartisan) decision. Washington mandates that a certain percentage of the retail gasoline mix sold must be ethanol. In fact, the credits refiners have to buy, called RINs (short for "Reusable Identification Numbers"), to fill in the gallons processors are required to buy.

Each year since 2007, the number of gallons of gasoline sold in the U.S. has declined. That will be the case again this year. With the ethanol mandate remaining, however, the overall volume of ethanol in fuel will be increasing just to maintain the 10% level.

But the legislation states that the number of RINs (that is, ethanol gallons) purchased must increase each year for the next decade. And that is where the pricing pressure hits.

Corn Futures, Weather a Major Concern

Last year's drought brought about a huge rise in corn prices. With more than 40% of the corn grown in the country now going to ethanol production and the price of that corn rising over 60% in less than a year, the situation has translated into a rapid increase in the cost of the ethanol component in gasoline.

Normally, an open market would compensate for this by reducing the percentage of biofuels in gasoline. Unfortunately, that is not possible, given federal statute.

This is not a demand-push scenario. It is one dictated by an attempt to rebalance motor fuel to require a greater domestic (and diversified) composition. Yes, there will be a guaranteed market for American-produced biofuels in the new energy mix emerging.

In addition, the problem now experienced was caused by Mother Nature's decision to preserve rainfall. I normal times, the cost of the ethanol in gasoline was counted in pennies to the gallon. Nonetheless, this is another example of politics messing up the normal market pricing mechanisms and costing the consumer.

Now we are all consumers and we will all have to pay until the ethanol situation is resolved. Certainly, the interests of corn growers in Nebraska and Ohio must be considered right along with the drillers of oil in Texas and Oklahoma.

Before too long, with the advent of a push to use natural gas as a vehicle fuel, we will also have to throw the interests of gas producers in Pennsylvania and Colorado into the mix.

All of which leads us to a very clear conclusion. There are always elements other than simple supply and demand that are influencing the ultimate price of an oil product.

Remember, we may complain about external pricing pressures that are human in origin. But as investors, they are also likely to make us some money.

As this pricing swing moves into full gear, I will be talking right here about how to gain from the dynamics unfolding.

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About the Author

Dr. Kent Moors is an internationally recognized expert in oil and natural gas policy, risk assessment, and emerging market economic development. He serves as an advisor to many U.S. governors and foreign governments. Kent details his latest global travels in his free Oil & Energy Investor e-letter. He makes specific investment recommendations in his newsletter, the Energy Advantage. For more active investors, he issues shorter-term trades in his Energy Inner Circle

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