Tuesday, April 29, 2008

Price Ripples

American consumers have just dodged a bullet at the gas pump, and they don't even know it. This news would surely perplex anyone who has filled up in the last few days, as the national average retail gasoline price has zoomed to another new record of $3.60/gallon. Yet it is no less true, involving an event that has received scant media attention here. For two days, a major pipeline delivering North Sea crude oil to Scotland was shut down by what the British refer to as an "industrial action" that idled the 200,000 barrel per day Grangemouth Refinery near Edinburgh. Had the strike continued, we might have seen US refining margins break out of the unusual doldrums they are experiencing. As it is, we may yet see some ripples from this event on our side of the "pond", as the global fuel market adjusts to the lost refinery output.

It is a reflection of the degree to which US fuel supplies are integrated into the global market--and of how stretched those supplies have become as a result of sustained high global demand growth--that a problem at a medium-sized refinery in Europe might affect what US consumers pay for gasoline and diesel fuel. Because our refinery capacity has not kept pace with demand growth, the US imports an average of over a million barrels per day (bpd) of gasoline and gasoline blending components, and another 300,000 bpd of diesel and heating oil. That means our prices must be high enough to compete for those supplies against other fuel importers. When a refinery shuts down in the UK, drawing in imports from the Continent, there is less gasoline available to export to us, and the EU's rising imports of diesel increase even more. With "gas oil" on the London exchange selling for the equivalent of $3.50/gal., compared to $3.27/gal. for diesel fuel in New York Harbor, I wouldn't be surprised to see traders export a few cargoes of diesel to capitalize on that arbitrage opportunity, exacerbating tight US diesel supplies.

The one break that US consumers have caught this spring is that weaker gasoline demand has pushed down refining margins, reducing the difference between crude oil and gasoline prices to historic lows and providing a bit of insulation against the full impact of $115 oil. Comparing March-April of 2008 to the same period in 2006 and 2007, the NYMEX "gas crack"--the spread between gasoline and crude oil prices on the New York oil futures market--has averaged about 35 cents per gallon lower in a portion of the year when refinery output is usually constrained by annual maintenance, and demand is building towards its summer peak. The first-quarter results of companies with a large exposure to the US refining sector, including Valero and ConocoPhillips, tell the same story.

With crude oil as high as it is, the last thing standing between us and $4-average gasoline is unusually weak refining margins. It wouldn't take a very large disturbance to shift margins back into a more typical seasonal pattern. We should thank the management and workers of the Grangemouth refinery for resolving their dispute quickly and helping to forestall that outcome, at least for now.

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