Gas Prices Are Heading Up (and the Sector That Will Benefit)

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The price of gasoline in the U.S. is on the rise again.

Futures prices for RBOB ("Reformulated Blendstock for Oxygenate Blending"), the NYMEX futures contract for gasoline, are up over 11% for the year, and a full 6.6% of that increase has come in the past month.

In fact, gas is up 2.4% over the past week alone. Today, the average retail price is 4 cents higher per gallon than a year ago.

And you can bet that as we move into the "official" start of the summer driving season, the worst is yet to come. Prices will be headed even higher.

So with all the hoopla surrounding our newfound oil wealth and our legitimate move to become energy self-sufficient in as little as a decade, why are gas prices still climbing?

Let me explain...

More Oil Doesn't Necessarily Mean Lower Prices

But first I need to clear the record about what this new largess in unconventional oil actually means. Then I'll identify the two primary causes of higher gas prices, along with a third catalyst that is waiting in the wings.

Now it is quite true that the main element in the cost of refined products remains the price of crude oil. However, the reason America became so dependent upon foreign imports in the first place is that they were cheaper.

It was simply less expensive to produce abroad and transport than it was to extract from the declining conventional oil base inside the U.S.

By the time we reached the point where 68% of our daily oil needs were being met by imports, U.S. domestic production was largely coming from mature fields in what was rapidly becoming one of the most expensive places in the world to extract oil.

At the time, more than 60% of all daily U.S. production was coming from stripper wells. On average, these wells provide fewer than 10 barrels of oil a day while bringing up 15 to 20 barrels of water for each barrel of the crude.

Shale and tight oil is now completely changing that dynamic, although there are indications the cost of production is beginning to move up. Nonetheless, the financial attraction of importing has appreciably declined (along with a welcome rise in the security of supply).

By 2025, the U.S. is now projected to have cut its daily import needs by more than half from the highpoint only a few years ago. Only about 30% of that requirement will need to be imported. Additionally, just about all of the volume sourced will be coming in from Canada.

So that should allow us to parlay the newfound subsurface wealth into lower overall refiner product prices, right?

Well, in a single word, no.

First, while one side of the trading scale (imports) may be declining, the other (exports) is rising... and fast. Today, American refineries are now leading the world in the export of oil products, especially when it comes to gasoline and diesel.

Now, it's true. We do have fewer refineries than we had 20 years ago, but the aggregate production capacity has actually improved thanks to technological advances and increases in refining capacity at the remaining plants.

These refineries are also processing a larger cut of crude passing through them, and in many cases have been refurbished to process heavier grades of crude. This latter point becomes especially important with the oil sands product moving down from Canada.

Refinery capacity is stretched but is still within manageable limits.

However, the profitable move these days is for refineries to export product to parts of the world prepared to pay a hefty premium over U.S. consumers. This is not creating any shortage of gasoline in the U.S., but it does put an upward pressure on prices.

And yes, some pundits are already calling for an "America first" strategy in this case, with the cost as the deciding factor. They are calling for a cut in exports of gasoline - not because we have a dearth of volume available domestically - but because it costs a few cents more a gallon at the pump. But attacks like this on a free market system will always result in remedies that are far worse than the disease.

Second, we are finally starting to see a rise in U.S. demand, matching increases already experienced elsewhere in the world. This global acceleration has been the main reason why exports have become more profitable for American refineries.

The demand improvement itself is a result of two primary factors.

One is an improving economy. The other is that the U.S. is now working through the last vestiges of downward pressures brought on by the recession. Finally, pent up industrial and commercial demand is kicking in, matching the steady improvement in retail consumer usage levels.

But this demand is still not close to the levels experienced before the credit crunch hit. That means there will be additional increases headed our way and further rounds of upward pressures on gasoline prices.

Biting the Bullet on Higher Gas Prices

So we are likely to be flirting with $4 a gallon gasoline again by midsummer. But this time, it's going to be different. Most Americans are going to bite the bullet and pay it.

The reason is simple: Employment prospects for most people have improved. That wasn't the case not too long ago.

In late 2008 and early 2009, the collapse in the price of gasoline was the result of a significant contraction in economic opportunity. Then, a guy could finally afford to put gas in his SUV, but he no longer had a job to drive to.

And what of that third lingering cause?

It's simple. The rise in domestic crude oil production is outstripping the ability of the infrastructure to store and process it.

That's why you shouldn't be surprised if the government begins to approve exports of the oil itself. Currently, that is essentially only allowed for the California heavy crude that does not have a sufficient domestic market.

But, as we have discussed previously, the use of tolling is likely to be phased in. This is the process of providing raw material (in this case crude oil) for processing elsewhere and then importing it back in as a processed product.

This is how the trading cycle, now centered on the export of oil products, will expand to include the export of oil itself. It is also how American refineries will cope with a double whammy -wanting to export but needing to satisfy an expanding domestic market. Refined products imported from one region will then figure in the export of the same products to others.

Refinery margins (the difference between the cost of production and the wholesale price; the actual source of refinery profits) will decide the direction of this trade flow.

In the end, this will support higher gas prices.

But it's not all bad news. It will also provide a better return for investors in the pivotal refining sector.

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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