Oil Upside Down

Anyone thinking that oil would remain impervious to the financial uncertainties sweeping the globe received two wake-up calls in yesterday's energy futures market. It wasn't just that oil closed down by over $6 per barrel; the November gasoline futures contract actually settled below November light sweet crude. You don't have to know anything about the economics of oil refining or pipeline transportation to see that as unusual. It is even more remarkable, considering that for the last two weeks, US gasoline inventories have been at their lowest level since at least the 1980s. I'd hate to read too much into one data point, but it is consistent with the notion that the oil industry, like many other sectors of the US economy, is entering an extremely unsettled period.

When I saw yesterday's NYMEX closing prices, I had to do the math a couple of times to convince myself that gasoline had really ended the day below crude oil. I couldn't recall seeing that in the 10 years that I traded oil commodities, and a review of the futures price history at the Energy Information Agency website turned up only two other such instances in the last 28 years: once during Iraq's occupation of Kuwait in 1990, and again this September 22nd, as a consequence of a squeeze on the expiring October crude futures contract. Year-to-date through September, the differential between crude oil and gasoline futures, or "gas crack"--a proxy for refining margins--has averaged around $7 per barrel. That's half its average for 2006-7, when standalone refining companies such as Valero and Tesoro were the darlings of the stock market, but still enough to cover variable expenses. Anything below $1.50/bbl doesn't even cover the pipeline tariff from the Gulf Coast to New York. This looks unsustainable, and it is, but the normal mechanisms of self-correction are complicated by strong demand for diesel fuel and by the continuing penetration of ethanol into the gasoline market.

In 2007 US monthly gasoline demand was still growing, year-on-year, and ethanol accounted for just under 5% of the total. Since then, gasoline demand has fallen by 3-4%, while ethanol output has risen by more than 40%. As of July, ethanol accounted for 7% of finished US gasoline supply. This trend looks set to continue, with ethanol blending driven by a federal mandate based on ethanol volume, rather than a targeted fraction of gasoline sales. In other words, as a result of federal policy and a weak market, ethanol is squeezing out petroleum-based gasoline, precisely as the government intends. I believe this also explains part of the apparent inventory paradox: current gasoline inventories can't be compared to historical levels without adjusting for the growing share of ethanol, which isn't counted in gasoline inventory until it is blended in at the distribution terminal. While this situation doesn't contradict my comment yesterday that annual ethanol additions are still modest, relative to total US oil imports, they are certainly large enough to put pressure on refining margins, at a time when several companies are undertaking enormous refinery expansions.

Moreover, rising biofuel production is only one of the factors that have altered the environment oil companies face, as the global economy weakens. As this morning's Wall St. Journal notes, sub-$100/bbl prices and the credit crunch are disproportionately affecting smaller, exploration-oriented independent oil companies. Cash is king, and if you need it to drill and can't borrow, the choices look ugly. Big, cash-rich companies will find M&A opportunities more attractive than some of their expensive internal projects, and that will lead to more consolidation and slower production growth within a few years. So while slumping demand and the output inertia from projects undertaken after prices started rising earlier this decade may provide global spare capacity a chance to recover from its near-total depletion a few years ago, this will probably be a temporary respite.

Factor in a dollar that has appreciated by 17% vs. the Euro since July, along with the prospect of strong climate change regulations in the next administration--plus a possible windfall profits tax--and the oil company planners are in no better position to assess the next couple of years than their counterparts in any other manufacturing or consumer-products businesses. The same holds true for anyone investing in the sector. Will the long-term prospects of Peak Oil outweigh the patience-testing volatility that lies ahead?