What Goes Up...

Yesterday I looked at the risks hanging over the oil market; today I want to look at the fundamentals, particularly for gasoline. The news is again full of reports of higher gasoline prices and irate consumers. Prices certainly seem to be headed back up, and almost everyone blames higher crude oil prices. Is that right, or is the story more complicated? Answering that requires looking at the supply and demand for both crude oil and for gasoline, and their connection via refining.

Let's start with crude oil. Global production for January-April was up from the same period in 2005 by about 200,000 barrels per day (bpd,) as reported by the Energy Information Agency, on total production of over 84 million bpd. However, US production is down by more than half a million bpd, due to lingering effects of last year's hurricanes, combined with existing depletion trends. Consumption for the first three months of the year appears to have been down, at least in the developed world, though this may have been due more to weather than price-related conservation. US refinery throughput for the first half of the year was down, as well. Taken together, this suggests that global crude inventories should be higher, and we certainly see that in US commercial inventories, which are about 5% above their level in June 2005 and still well above the average of the last five years.

Now let's turn to gasoline. The EIA's latest update shows that gasoline production for the first half of the year was about the same as for the first half of 2005, while demand was up by a bit less than 1%. Despite this, gasoline inventories appear quite normal for this time of year. That's because gasoline imports have risen by about 25% in the same period. The part of the inventory story that has changed, though, is the breakdown between gasoline that is already blended and ready to ship immediately, vs. gasoline that still needs further blending, either at a refinery or a distribution terminal. The former has dropped and the latter increased significantly, as a result of the shift toward ethanol and away from MTBE as a gasoline additive. This correlates with a 60% increase in imported gasoline blending components.

So what does all this tell us? The difference between the crude oil and gasoline market fundamentals suggests a market that is still being driven by growing product demand and a strained refining system, rather than a shortage of crude oil--but with an enormous risk premium overlaid on both. For the first half of this year, US refineries were still dealing with the consequences of the 2005 hurricane season, either in terms of lingering damage or maintenance that had been deferred into the 1st and 2nd quarters of 2006. At the same time, crude oil prices were up by $14.50/barrel, this June vs. last June, driven by the proliferation of risks I discussed yesterday.

If you're looking for signs of just how difficult the refined product end of the market has become, I can't think of a better indicator than an announcement by Citgo, the US subsidiary of Venezuela's state oil company, that it is phasing out supply to 1,900 mid-western service stations, about 15% of its US network, because it can't produce enough gasoline to supply them and can't afford to cover the shortfall by buying the product from others. Geopolitical experts will scrutinize this news for signs of growing US/Venezuelan tension, but I think it could well be exactly what Citgo claims: the result of a very tight market. Most of the major oil companies are in a similar situation, needing to supplement their equity refining output with purchased product. It will be interesting to see if any of them follow Citgo's lead, in trimming marginal parts of their marketing networks.

Even if crude oil looks a bit oversupplied at the moment, with the futures market in contango, the lack of cushion in the downstream quickly translates every dollar increase in the price of crude oil into a comparable bump in gas prices. At the end of the day, although I have consistently looked for signs that the market might be poised to weaken, the combination of international petroleum risk factors and a stretched refined products market could forestall that for some time. It looks to be a long, expensive summer for motorists.