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Soaring Gasoline, Diesel, and Crude Oil Prices

Commodities / Energy Resources May 09, 2008 - 12:16 PM GMT

By: Zeal_LLC

Commodities

Best Financial Markets Analysis ArticleGasoline, usually taken for granted, is weighing heavily on consumer sentiment today. In the States, the AAA just reported that retail gas soared to an average of $3.65 per gallon nationwide! This all-time record high is motivating Americans to drive less, drive slower, and migrate to more efficient cars to save fuel.

As a student of the markets, I find gasoline fascinating. The impact of its pricing creates far-reaching ripples throughout the entire economy. And since transportation is such a basic necessity of life, everyone monitors gas prices on a regular basis. It is fun to watch and analyze such a widely-followed market.


Like every other American, I've marveled at prices at the pumps in recent weeks. It is hard to believe that retail gas briefly edged under $1.00 a gallon in late 1998! That idyllic world, driven by $11 oil, is never going to return. Quite the contrary, odds are gasoline prices are heading considerably higher soon.

Refined from crude oil, gasoline prices have been lagging their progenitor for the better part of a year now. This is just killing oil refiners, who can't even hope to earn profits in such a hostile environment. Many of their stocks are trading near 52-week lows, they've just been slaughtered. The carnage in this sector is amazing. This is rather ironic since retarded politicians are blaming oil companies for high gas prices.

In the free markets, if something can't be produced for a reasonable profit then soon it will no longer be produced. This truism of capitalism even applies to such a capital-intensive industry as oil refining. Refiners will cut back on zero-margin gasoline production, which will reduce gasoline supplies, which will then drive gasoline prices higher to catch up with crude oil. Gas prices have only begun their march higher!

As a consumer, I'm sure this really irritates you. I don't like it either. But as investors and speculators we must strive for total neutrality on all prices. We shouldn't care one bit if a price is likely to rise or fall. Instead of wasting effort fretting, all our energy should go into figuring out how to game the trend for profits. The low-gasoline-relative-to-oil anomaly we see today will likely prove to be a great trading opportunity.

Understanding the historical relationship between oil and gasoline prices is the key. As I studied this, I decided to throw in diesel too. Boiled out of raw crude oil lower and hotter in the fractionating column than gasoline, the broad economic impact of rising diesel prices may ultimately rival that of gas prices. In both cases, the new $100+ oil world will radically change longstanding notions of “normal” fuel prices.

This first chart compares wholesale gas and diesel with oil over the past decade to establish a baseline. Today's low-gas-price anomaly is difficult to perceive until you understand how gas and oil have interacted in the past. The ratios between oil and gas, and oil and diesel, are also rendered in the background.

Gas and diesel are so highly correlated with crude oil that the latter's black line is nearly covered in this chart. Over this decade-long span encompassing the entire secular oil bull, the correlation r-squares are stupendously high. Gasoline's r-square with oil ran 95.7% on a daily basis while diesel's was even better at 98.6%. This means that 95.7% of daily gas-price action and 98.6% of diesel's was directly attributable to oil price action.

This is crucial to understand, that motor fuels always eventually follow oil. There can be short-term supply-demand differentials that drive temporary decouplings, but in the end oil is king. So if oil doesn't correct sharply soon, then gasoline will inevitably climb until it adequately reflects the expenses of producing and delivering it in a $100+ crude world. There is simply no other economic option.

The best example of a temporary decoupling was the legendary Katrina spike in gasoline in late August 2005. As that wicked storm ripped through the heart of oil refining in the US , refineries responsible for 10% of national gasoline consumption went offline. It was an unprecedented gasoline supply disruption.

In the 5 trading days ending September 1st, 2005 , wholesale gas soared 65.7%! But in the 5 days after, it plunged 34.6%. The net 10-day gain surrounding Katrina was just 8.4% to $2.05 wholesale. Since oil prices didn't rise anywhere near sharply enough to support such a gas parabola, this gas spike quickly collapsed.

But today, despite what American consumers and our brain-dead politicians want to believe, the opposite has happened. Oil has been over $100 continuously since late February, 49 trading days! With such a long duration, this is far more than a speculative spike. Real global fundamentals are driving the lion's share of it. World oil demand is growing faster than global supplies, and oil is being bid up as a result.

So far gasoline prices haven't fully reflected this oil surge, but they will. The tight Oil/Gas Ratio rendered in these charts makes this crystal clear. Regardless of where oil went between $11 and $124, the OGR didn't break. And it is not going to break today either. You just can't have finished goods priced lower than their feedstock input costs. Other than the goofy airlines, industries will not operate at losses forever.

This chart zooms in on the Oil/Gas Ratio, with the Oil/Diesel Ratio added in the background for good measure. Over one of the most volatile oil and gasoline decades ever witnessed, the OGR remained solidly locked within a tight range. It averaged 35.7, which means a barrel of crude oil cost 35.7x as much as a gallon of wholesale gasoline since 1998 on average. Diesel's average ODR came in very close at 35.5.

The horizontal trend channel of the OGR ran from 27 on the low side to 42 on the high side, with few extra-trend anomalies. I find this 42 resistance number very intriguing. A barrel of crude oil contains 42 gallons. Is there some chemical or economic logic explaining why the top of the OGR range should also be 42? Or is this pure coincidence? Gasoline certainly isn't the only distillate cracked out of a 42-gallon barrel of crude. My woefully rudimentary refining knowledge offers no insights here.

At the top of this OGR trend channel near 42, profits for refining oil are nonexistent. When this happens, refiners will cut back on producing gasoline. They can't do this quickly as refining is very complex, but they can gradually idle parts of their operations for maintenance or switch their focus to other distillates like heating oil or kerosene (jet fuel). This helps to work the temporary gasoline oversupply out of the system until gas prices rise again.

Since 2001, the OGR has challenged this 42 resistance over a half-dozen times. Such economically-irrational levels never persist through. After short-lived forays near resistance, the OGR soon plunges sharply lower before reversing again well under the 36 average near 27 support. Around 27 of course, the opposite is true. Refining gasoline is very profitable so refiners gradually accelerate gas production which drives down gas prices.

Due to the economics of oil refining, I doubt this flat trend will ever materially change. Since oil is distilled and cracked to produce gasoline, gasoline always has to reflect oil prices over the long term. This principle helps illuminate the trading opportunity today. Note above that the OGR soared to 45.8x in mid-March! This was its highest level in at least a decade. And it would not surprise me if it was the highest ever.

With a barrel of oil costing 45.8x as much as a gallon of gasoline, every refiner was operating at a steep loss. In the business, they call the difference between input oil costs and output gasoline (and other petroleum products) prices the “crack spread”. Cracking is the process where heavier raw hydrocarbons in oil are separated from the lighter simpler molecules used in gasoline. The crack spread measures the profit per barrel in refining oil.

Average crack spreads over the last 5 years have run between $4 and $18 per barrel with a heavy seasonal component. Generally gasoline refining is the most profitable, crack spreads are highest, in the spring leading into the summer driving season's high demand. Crack spreads are usually the lowest in November and December when gasoline demand wanes due to winter arriving.

Around this time last year, crack spreads were incredibly profitable running between $30 to $40 per barrel. Gasoline prices stretched well ahead of crude oil prices, as the next chart will show. But this year, crack spreads ran around $5 until March when they plunged to zero. The low gasoline prices (relative to crude) we saw in recent months made gasoline refining an impossible business. Why refine to lose money?

This gasoline pricing anomaly was driven by higher-than-normal supplies in the States. Typically this nation has about 23 days worth of total consumption in refined gasoline supplies heading into April. In 2007 when crack spreads were stellar, this fell to 22 days. But in 2008 US gasoline supplies had ballooned to 26 days, very high. American drivers were already cutting back leading to higher supplies.

The refiners obviously watch gasoline supplies like hawks. They will adjust their throughput rates and output distillates to maximize profits for their shareholders. If gasoline isn't profitable to refine, they'll simply produce less. This will drive gasoline prices higher again and restore reasonable profits to the crucial refining industry. It is the only possible outcome in a free market hit by temporary oversupply.

Back to the OGR chart above, whenever an extreme OGR high is hit the ratio starts falling. Over the next 3 to 8 months, this ratio declines as gasoline-refining economics are brought back into line with oil-price realities. This usually leads to support approaches, the ratio briefly hitting 27 or so. Today after recently witnessing a decade-plus OGR high, odds are we'll again see a massive OGR contraction to support in the coming months.

This has crazy implications for gasoline prices. If oil can consolidate near $120 like it did near $100 between November and February, then we are looking at seriously higher gasoline prices approaching. $120 oil divided by just the average OGR yields wholesale gasoline of $3.36. This is 7.7% higher than this week, a move that will be passed on to retail. This scenario would drive average retail prices near $3.90.

But it is not merely this ratio's average that an extremely high OGR tends to revert to, but its support near 27. At $120 oil, a long-overdue OGR support approach would mean $4.44 wholesale gasoline! This is 42.3% higher than this week's price. This would translate into a $4.99 average retail gasoline price across the United States ! If today's gasoline prices bother consumers, imagine sentiment at $5+! Ouch.

Of course oil may very well correct too, Wall Street is sweating bullets praying for such an eventuality. But since gasoline prices are so far behind crude oil, even a correction doesn't offer much relief. Bull to date, oil's average major correction is 21.8% over 2 months. This would take us to $97 or so, which is incidentally just about where oil's 200-day moving average would be by then. 200dmas usually offer strong support in ongoing secular bull markets.

Anyway, at $97 oil after a major correction if the OGR still contracts to 27 support as it ought to, a barrel of crude will cost 27x as much as a gallon of wholesale gasoline. This works out to $3.59, or 15.1% higher than today's gas prices. This would translate into $4.12 or so at the retail pumps! So probabilities favor higher gasoline prices even if oil corrects hard . And if crude oil instead continues powering higher, then all these numbers are far too conservative!

In this election year where Republican socialists compete with Democrat socialists to see who can bribe the most voters, retail gas taxes are a big issue. But even if by some miracle they are repealed, they are still largely irrelevant to this analysis. The federal gas tax is only 18.4 ¢ per gallon (state taxes average another 28.6 ¢ ). Percentage-wise the federal tax alone is fairly immaterial at $4 to $5 gasoline.

So we haven't seen anything yet in terms of retail gas prices. Gasoline just has to rise until it is reasonably profitable to produce again, or else less and less will be refined. And lower supplies drive up prices. This final chart, which is what started me down this thread of research in the first place, highlights the recent low-gas-relative-to-oil anomaly. Its axes are zeroed to ensure no visual distortion of the data relationships.

Around this time last year, gasoline prices got ahead of oil on lower supplies relative to demand. This is when the refiners were enjoying the stellar $30+ per barrel crack spreads. The post-Katrina OGR low, 26.7, was actually hit a year ago this week. But such a hyper-profitable situation for gas refining couldn't persist, as refiners rushed to distill out gasoline in order to reap the unsustainably fat profit margins.

So gasoline prices started grinding lower despite rising crude in the late spring and summer of 2007. In early September, when oil surged, gasoline remained flat. This is when it started to lag crude oil. By late February 2008, the gap between gas and crude oil grew wider. This is what drove the zero crack spread in mid-March, when the costs of producing gasoline exceeded the price it could fetch in the US markets.

Now if this final chart was the sole one in this essay, we could wonder whether this anomaly could last for a long time. But after looking at a decade of the OGR relationship in the previous charts, it is clear that such extremes never persist for long. And this makes sense too. Refiners are not going to produce gasoline at a loss for a long time. They'll reduce production which will drive up prices and their profits will return.

Provocatively, diesel's relationship with oil over the past year has remained far tighter than gasoline's. I suspect this is because diesel consumption for commercial transportation is less discretionary than consumer transportation. Consumers can carpool and reduce their driving a bit if necessary. But the goods transported by diesel, literally everything physical we consume, can never stop flowing.

Over this much shorter span since early 2007, diesel's correlation r-square with crude still ran 95.5%. But gasoline's has plummeted to 74.6%. This is vastly lower than its decade-long r-square of 95.7%. And this anomaly is even more pronounced when compared to gasoline's 1998 to 2006 r-square of 96.2%. Due to the economics of refining, this extreme disconnect between gasoline and oil isn't sustainable.

And gasoline returning to its normal relationship of following crude tightly has all kinds of implications for investors and speculators. If you trade futures, the odds are high that gasoline prices will rise in the coming months. Despite perceptions that gasoline is already too expensive today, the long-side trade is very appealing until gasoline once again truly reflects its crude-oil input costs plus a reasonable profit.

On the stock side of the game, the oil refiners struggling near 52-week lows are very attractive. Oil-refining profits are cyclical and the refiners will come back as gasoline starts to catch up with crude. At Zeal we are studying the various refiners today to find the highest-potential stock picks in this sector for our upcoming weekly and monthly newsletters . Not only are refiners technically trashed today, but their profits are likely to rise even if oil falls considerably. Wall Street is irrationally discounting terrible profits persisting forever.

On the consumer sentiment front, higher gasoline prices will radically ramp up inflationary expectations. In a strict sense, supply-and-demand driven price increases are never “inflation”. True inflation is rising general prices driven by an increasing money supply . And we do have relatively more money chasing after relatively fewer goods today thanks to the Fed's scary and irresponsible 16.5% absolute growth in MZM money over this past year. But in most folks' minds, all rising prices are inflation.

Gasoline is almost certain to head over $4 at the pumps, and will probably exceed $5 by late summer if oil can stay above $120. This is going to get investors worrying about inflation like nothing else ever could. And the high diesel prices that do reflect crude oil are going to filter into everything tangible that we consume, since it is all hauled by diesel-fueled trucks and trains. This summer we may see the biggest inflation scare since the late 1970s.

And when people get scared about inflation, what is the first investment that comes to mind? Gold, baby! Sure, gold has been beaten up since the Fed's “restrained” 75bp cut in mid-March on dollar-rally-fear sentiment. But it is investment demand that drove gold from the $250s to over $1000 over the last 7 years. And surging inflation fears ought to drive new mainstream investment demand at a pace that hasn't been witnessed in decades. Rising gasoline sparking inflationary fears should lead to surging gold demand.

Thus while soaring gasoline prices at the pumps are no fun, investors and speculators have plenty of opportunities to ride this trend. We've recently recommended neat new leveraged gold vehicles for stock traders in our newsletters and we're looking to add some refining stocks soon. Subscribe to our acclaimed monthly newsletter today and mirror our trades for a shot at big profits in the challenging summer to come.

The bottom line is gasoline and diesel are naturally heavily correlated with the crude oil that produces them. While diesel has dutifully reflected oil's advance over the past several months, gasoline has not. History clearly shows that this low-gas-price anomaly cannot persist. Gasoline prices will have to be bid up to reflect the economic realities of producing this crucial commodity sooner or later. There is no other option.

Sadly, Americans worried about high gasoline prices today ain't seen nothin' yet. $4+ is all but certain and $5+ later this year is a growing possibility. It's going to get ugly. But although we're at the mercy of global oil production and consumption trends hopelessly out of our control, as traders we may as well ride these trends. As good stewards of our hard-earned capital, we need to make the best of prevailing conditions.

By Adam Hamilton, CPA

So how can you profit from this information? We publish an acclaimed monthly newsletter, Zeal Intelligence , that details exactly what we are doing in terms of actual stock and options trading based on all the lessons we have learned in our market research. Please consider joining us each month for tactical trading details and more in our premium Zeal Intelligence service at … www.zealllc.com/subscribe.htm

Questions for Adam? I would be more than happy to address them through my private consulting business. Please visit www.zealllc.com/adam.htm for more information.

Thoughts, comments, or flames? Fire away at zelotes@zealllc.com . Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!

Copyright 2000 - 2008 Zeal Research ( www.ZealLLC.com )

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