High Gas Prices Got You Down? Beat the Oil Industry at its Own Game...

As the price of crude oil moves above $80 a barrel, consumers are wondering just how high gas prices can go.

Now is the time for such questions.

It's during the month of March that the market begins to readjust inventory and production in advance of the summer driving season. This usually means that production shifts from heating oil to gasoline.

Actually, the real issue is what refined products will be emphasized in the production process. To put it bluntly, U.S. refineries have insufficient capacity to handle all needs.

And that could make you some serious money.

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Where the Real Oil Profits Are

The oil majors - the big boys who own everything from oil fields to refineries to retail outlets - do not make most of their money drilling for oil or even selling gasoline. The real profits are in the refinery margin, the difference between what crude oil costs and what they can charge for the refined product. To expand profits, all they have to do is improve the refinery margin.

Welcome to the paradoxical world of cutting refinery capacity while demand increases. That's bad news for consumers but potentially very good for investors.

Refinery margins have taken a hit recently. The financial crisis caused a protracted cut in demand for oil. However, as demand returns, expect to also see an escalation in profitability from the refinery margin.

And there are now multiple indications that it is coming back. As demand increases for all manner of refined products, gasoline and diesel will head the list. Available refinery capacity will be hard-pressed to meet it.

Yet, for some time, U.S. refiners have employed less than 80% of capacity in a concerted attempt to keep prices high. Now the likes of Chevron Corp. (NYSE: CVX), Royal Dutch Shell PLC (NYSE ADR: RDS.A, RDS.B), Valero Energy Corp. (NYSE: VLO), ConocoPhillips (NYSE: COP), BP PLC (NYSE ADR: BP), and TOTAL S.A. (NYSE ADR: TOT) have closed, sold, or reduced capacity at facilities both here and in Europe.

The European scene is important for the U.S. market: First, because what happens to majors there has an impact here . And second, because 25% of the gasoline produced in Europe is exported to America.

In short, as we continue to reduce domestic capacity, we rely more heavily on oil product imports when demand increases. And that is where trade-offs among the three distillate categories becomes a major factor.

The three kinds are distinguished by heaviness, with heavier product usually having a lower value.

  • Light distillates include gasoline and naphtha, a product used in all kinds of petrochemical applications and as feeder stock for high-octane fuels.
  • Middle distillates are diesel, kerosene, high-end kerosene (jet fuel), and low-sulfur-content heating oil.
  • Heavy distillates include lower grades of heating oil all the way down to asphalt and residuum, the sludge that remains when just about everything else is taken out.

In reality, valuation is a marketing judgment that varies throughout the world.

In the United States, we put a greater emphasis on light distillates - such as gasoline. The price at the pump has become a major political issue. As one of my colleagues in the industry is fond of saying: "Light distillates vote." Higher gas prices and shortages are a guaranteed ticket (one among many these days) to get thrown out of office.

But fading supply also compels refineries to prioritize available capacity. For this reason, U.S. diesel prices have been higher than gasoline for some time. Middle distillates are short-changed to produce more gasoline.

In Europe, the focus is in the other direction. The major western European countries consume far more diesel each day than we do. That is because Europe has made a choice to tax gasoline to discourage auto travel, while increasing reliance on diesel.

As refinery capacity comes under pressure, choices must be made as to which market-demand sectors are met. To put it simply, we will need to choose between gasoline and diesel.

And once demand comes back online, refineries in the United States will not be able to satisfy both. Reliance on European gasoline imports will also come under pressure. Refinery closures there, combined with increasing exports to Asia and western Africa, will force the United States to look elsewhere for imported product. That will drive prices up further.

Here is where the moneymaking opportunity comes into play.

Turning a Profit with Two Medium-Term Market Moves

There are two medium-term moves developing for the average investor, both extending as we move into the next three to four months.

The first bridges the European and U.S. markets as a whole. Here we are interested in those companies that can best navigate the production and import/export dimensions of the relationships between the two regions. You need the big guys who control a percentage of both markets. Three fit the bill: BP, Shell and Chevron.

The second allows a play between the availability of gasoline and diesel. Since 2007, the New York Mercantile Exchange, or NYMEX (Nasdaq: CME), has allowed the trading of low-sulfur diesel fuel futures, priced at a stable market premium to low-sulfur heating oil. This makes sense because both are produced together. However, the average investor is not likely to be dealing heavily in futures contracts, which tend to emphasize the shorter end of the curve. You also need to be able to profit from longer market trends.

What we can do here instead is employ a series of exchange-traded funds (ETFs) to replicate the spread between crude oil prices moving into the refinery process and the products coming out.

That means holding puts and calls on the following:

  • The United States Oil Fund (NYSE: USO), which approximates spot crude sales in next ("near")-month contracts.
  • The traditional iPath GSCI Crude Oil Total Return (NYSE: OIL), which does virtually the same thing, but with some hedging in U.S. Treasuries.
  • The United States Gasoline Fund (NYSE: UGA), which approximates near-month gasoline sales.
  • And the United States 12 Month Oil Fund (NYSE: USL), which provides a longer-term view. (USL, by the way, has had the best tracking success of the actual underlying market of any oil-based ETF.)

While there are proprietary and privately traded diesel-only investment vehicles, there are no sufficiently liquid ETFs. However, two other funds provide exposure and sufficient flexibility to allow for diesel plays off of gasoline and general crude movement.

One is the United States Heating Oil Fund LP (NYSE: UHN), which acts as a discount clone to actual diesel pricing. The second is the PowerShares DB Energy Fund (NYSE: DBE), one of my favorite energy ETF exposures.

DBE is based on the Deutsche Bank Liquid Commodity Index-Optimum Yield Energy Excess Return. It allows investors to participate in futures contracts movements in West Texas Intermediate Light Crude (the NYMEX base), dated Brent (the London and European base), heating oil, natural gas, and RBOB gasoline ("reformulated gasoline blend stock for oxygen blending," the new NYMEX benchmark gasoline contract).

In other investment strategies, such as offsetting funds pegged to hydrocarbons with those reflecting alternative energies, DBE becomes a very useful balancing position. It is also based on a European-U.S. energy index.

The key is to be able to move as the commodity prices move. Combining (pairing) ETFs allows such movement.

You still need to decide which direction the underlying commodity market is likely to move, and these positions will require attention, but an initial entry would be long positions in OIL and USL and short-term exposure in USO and UGA, while holding DBE and UNH as your hedging vehicles.

[Editor's Note: For 31 years, Dr. Kent Moors has been advising the energy "majors," including six of the world's Top 10 oil companies and leading natural gas producers throughout Russia, the Caspian Basin, the Persian Gulf and North Africa. He also edits  The Oil & Energy Investor , a free energy opportunity letter for individual investors. Moors just released his latest special report, The Global "Big-Oil Bailout." Just click here to get it... and find out why this "bailout" is different. For the smaller companies involved, the profit potential is staggering.]

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