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Oil Prices Will Continue to Rocket

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.

Join the conversation. Click here to jump to comments…

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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  1. R Wilson | June 22, 2014

    Hello while what you say is correct, however there is no new oil shortage in north America it is my belief ( as I work in Oil and gas) it is just the greedy hand of the suppliers. With the oil coming from Canada and the new Bakken shield in the north western oil plays in the US. I comes down to speculation and the greedy hand of those in charge. The cost of producing one barrel of oil from the Canadian tar sands is $12.00 leaving the rest as pure profit for the producer at the current level. The oil in the north west US is considerably easier to produce seeing it is not locked in to sand so please tell us why it coast so much in my opinion it doesn't reflect to oil in Iraq or Saudi or any where else it is just the greedy hand at work making all of us pay.

  2. susan | June 22, 2014

    "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."

    That is a lie!!!

  3. EdInvests | June 22, 2014

    The more you explain, the more confused I get. For instance, What is the % of oil produced in the US to US consumption? Is that consumption our real use, or does it incllude oil only imported to be refined and shipped back out? While I understand refineries changing mix to maintain profit, it makes zero sense to me why refined products made and consumed in the US would go up just because of reduced refined capacity outside of the US. It is as if the refineries are saying "I can get a better margin by selling all of my product outside the US, so if you want any more our product here, you must pay us dearly to so we can keep this huge profit margin we lucked into". I can somewhat understand that world supply/demand determines the price of Oil, being a resouce, but we have had a law that we can't export oil. Surely there is a policy of some kind that prevents us from exporting all of that refined oil, or the other law makes no sense. In general, it makes no sense that the price of refinded oil would be a worldwide standard under any conditions. It is particularly wrong that we would allow gas prices to go up on an arbitrary basis when it has such a negative impact on our economy. In other words, set a maximum margin for refiners for domestic demand and let them get the higher margins on the extra capacity to be shipped overseas. Sometimes your explanations only prove to me that common sense seems to be absent in how all oil related products end up getting priced. We seem to let speculators determine everything and we seem to be unable to do anything but whine about it.

  4. Sgt York | June 23, 2014

    We get maby 10% of our oil from Iraq and our costs will go up by 20%. Guess who is getting the ol obummer stick in the butt?

  5. Richard | June 23, 2014

    Every time I see these kinds of reports all I can say is: This is definitely time for Electric cars. The more they are purchased and used the greater the technological advances will be made. Just like the first automobile like the Model "T". Another example is the cell phone, look what it started out as and look at them now!

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