Oil Prices Will Continue to Rocket

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Here's a question that never seems to die. In fact, with the chaos going on in Iraq, it's on everybody's mind again this morning.

Everyone wants to know why the price at the pump just keeps going higher.

The last time I discussed this issue was in late April. Since then, pump prices in the United States have jumped more than 12%, with the spike accelerating over the past week.

Now, understand this is not shaping up to be a repeat of the summer of 2008. Prices in certain sections of the country will exceed $4 a gallon, but for different reasons.

Five years ago, the global oil market hit "panic" prices that ultimately exceeded $147 a barrel, while domestic gasoline prices actually increased at a faster rate than crude.

There were two reasons for this...

CYA: Pricing in Uncertainty

The first relates to oil trading psychology. In normal times (what does that even mean these days?), a trader will peg the price of oil to the cost of the next available barrel of crude.

However, during times of increasing uncertainty, that same peg will be based on the expected cost of the most expensive next available barrel.

In short, to provide a cushion for the anticipated pricing instability, traders peg the rate higher than the market would usually demand, covering themselves on the high side.

They also increase the number of options used to mitigate what they can of their risk while introducing additional derivative issuances to deal with the problem of paper barrels (futures) and wet barrels (actual consignments of oil) not converging at the expiration of the futures contract.

The second reason is more directly related to the retail gasoline market.

Given the nature of the refinery-to-wholesale-to retail product chain, refiners have always been able to maintain a price that's better for their bottom lines than the actual cost of the crude.

This is because, while the single largest component in refining costs remains the crude, the actual source of processing profits is something called the refinery margin. This is the difference between processing expenses and the "rack price" (the price commanded at the first level of wholesale).

There is a whole range of factors in play here, but the bottom line is the ability of a refiner to pass on higher costs to consumers while shielding their profit margins from downward pressure.

As an example, during the collapse of oil prices in late 2008 (which was caused by the onset of the recession), crude prices declined by more than 82%, while gasoline prices declined by less than 69%.

Moves like these translate into changes in how a refinery calculates its refining "cuts," or how much of each product (gasoline, diesel fuel, jet fuel, etc.) a refinery produces for each barrel of crude. As the profit margins for different petroleum products move up and down, refineries can adjust their product mix.

These moves, in turn, translate into trading what are called "crack spreads." Those spreads influence what the refinery actually produces, which refiners call the "crack ratio." Both the spread and the ratio reflect the volume of products produced and the relative prices of gasoline, heating oil, and other petroleum products.

The equation is complicated, but by adjusting the product mix and volume, a refiner can maximize profits.

Both of these elements - rising crude oil price pegs and crack spreads/ratios - are present today. But the panic of 2008 is not.

The "New Normal" for Gasoline Prices

Nonetheless, there is one major new factor pushing prices up that was simply not present five years ago. And it magnifies the effect of crises such as events in Iraq.

Now, one would assume that concerns over Persian Gulf oil would translate into higher crude prices because of the interconnected global market. Yet, if the United States is poised to become essentially independent thanks to the new abundance of energy, it raises the question: Why would gasoline prices keep rising at home?

It's because American refineries have become the largest exporters of processed oil products in the world. So the price you pay at the pump is now increasingly determined by events elsewhere.

The United States may no longer be importing as much oil as it had previously, but prices in the U.S. for products like gasoline are now more influenced by the wider global market than in the past.

That is why the status of the largest Iraqi refinery becomes a factor in determining American domestic gasoline prices. The Baiji refinery in Iraq is some 130 miles north of Baghdad near Tikrit. It produces about 25% of all the gasoline refined in the country. But that entire product is for consumption inside Iraq.

In prior times, that would have some modest knock-on effect for prices elsewhere. But these days, the pricing pressure will be greater. Should this single refinery in Iraq reduce production, it will cause higher prices in the United States as a result of the American position in the gasoline exporting market.

In this case, there is no need to export directly to meet Iraqi domestic demand. Instead, the situation is about balance. When prices rise in Iraq, the Iraqis first import gasoline from other countries in the region, and then from broader areas to maintain supply-demand balances. The result is a domino effect that quickly impacts markets that are regularly serviced by American exports. In a global market, this balance pushes prices higher.

Welcome to the new world order...

Once again, we are reminded that how secure the supply of oil is and how much it will cost are two very different issues.

It seems energy independence, a good thing from the standpoint of being less reliant on others, does not necessarily translate into lower prices at the pump.

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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