Thursday, September 14, 2006

Mood Swings

The steady drop in gasoline prices, week after week, must come as a great relief to most Americans, after a seven-month stretch in which the market seemed to know only one direction. The latest weekly figures from the Energy Information Agency of the Department of Energy show regular gasoline averaging $2.62/gallon, 42 below its summer high. If the futures market is any indication, prices could slide another 15-20 cents in the weeks ahead. It's worth remembering, however, that seasonal variations and a period of better news haven't changed the long-term fundamentals. Every year, the US grows more dependent on imported crude oil and more reliant on the willingness of foreign refineries to produce fuels meeting our stringent specifications. Unfortunately, while we obsess about gasoline prices, we tend to ignore their underlying drivers.

The oil and product market fundamentals have been moving in a bearish direction for a while, at least in the US. The latest EIA report shows inventories of crude oil, gasoline and diesel all well above last year's levels, and above the average range of the last several years. With Iran at least temporarily making nice, the peak of the summer driving season behind us, and the winter heating season still several months off, it was time for some of the air to come out of this balloon. You may not want to buy that new Tahoe or Expedition just yet, however.

Even if crude prices stay where they are or go a bit lower, refining margins are unlikely to remain this low. If you look at the difference between the wholesale prices of gasoline and crude oil on the New York Mercantile Exchange, it's currently below 4 cents/gallon, and it rarely stays that small very long--20 cents has been more typical for the last couple of years, and 14 cents historically. At the same time, the futures contracts for gasoline and crude are both in contango, i.e. prices for future months are higher than next month's, and that condition rarely persists long, either. Essentially the market believes that we are oversupplied for the time being, but it doesn't expect that situation to persist. Without a collapse in oil prices--which OPEC is apparently beginning to worry about--we could see $3 again, before we see anything below $2.

All of this leaves policy makers and politicians in a quandary. Those who have denounced high gasoline prices as an affront to consumers--and possibly the result of oil company collusion--must either switch messages or risk appearing churlish. Those who were merely waiting for prices to fall, in order to propose higher gasoline taxes to reduce consumption and put more of the high price of fuel in the pockets of Uncle Sam, rather than OPEC or Big Oil, have their opportunity, along with an endorsement from the head of the International Monetary Fund. Will they dare, with mid-term elections less than two months away? My best advice to both camps is to focus less on volatile prices that are the outcome of a very complex set of interactions, and more on the underlying factors.

There are a host of energy issues that merit serious discussion at the highest levels, even if they seem more esoteric and of less immediate interest to consumers/voters than gasoline prices:
  • How can the US reduce oil imports, when we put so much of our unexploited domestic oil resources out of reach for development?
  • Can the production of ethanol and other alternative motor fuels ramp up fast enough to fill this gap--or to prepare us for the day when the European refineries upon which we depend for a good chunk of our imported gasoline finally redress the fundamental imbalance caused by the shift of new cars in Europe to diesel?
  • Who will absorb the burden of the carbon emission cuts that the transportation sector must inevitably make?

This is just a sampling of the serious problems stemming from current trends in US petroleum supply and demand. As long as our attention span waxes and wanes with the up-again, down-again price of gasoline, how likely is it that we'll solve any of them?

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