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Most people think gas prices reflect oil prices, but they don't. Ed Wallace explains why—and why gas prices still go up when oil falls
"The price of gas is indeed tied to oil. It's just a matter of which oil." —Associated Press, Feb. 15, 2009
With statements like that, it's no wonder Americans don't understand how the energy industry really works. But that line appeared in an Associated Press story that ran Feb. 15 and was reprinted in virtually every major newspaper in America. The statement simply feeds and sustains the public's conviction that oil and gasoline costs are directly linked to one another—which they're not: There is an connection between oil prices and gas prices, but it is indirect— far less strong or predictable than most people understand.
The AP story concluded that gas prices are rising while the price of some oil is falling because American refineries are primarily using oil from overseas, not the U.S. benchmark crude West Texas Intermediate. No news there; there isn't enough WTI crude to supply this nation's fuel needs. Not even close.
Then the writers suggest that the cheaper WTI, which they incorrectly refer to as West Texas International, could play a bigger part in our oil system if only pipelines were built to transport this crude past "refineries in the Midwest." That statement could be true, but it's not. In fact, it reveals a deep unfamiliarity with WTI's NYMEX contracts, because they specifically state that anyone bidding for West Texas Intermediate must deliver that oil to the storage tanks at Cushing, Okla. Spot-cash prices for immediate delivery of WTI allows shipment elsewhere, but thats not the basis for the price discovery system.
Low-Tech Controls Still Work
The Cushing clause was designed to dampen wild swings in oil prices. If the tanks at Cushing were full, that would put downward pressure on the price for WTI; there would be no sense in purchasing that oil if storage space wasn't available, so the price would fall. Likewise, when Cushing's storage tanks were low, the price of oil could float upward to refill the space available. This may sound like an overly simplistic way to moderate the price of oil, and it is. And if you think this system needs to be updated or scrapped, fine. Change it if you want. But this was the original intent of WTI NYMEX contracts' demanding delivery at Cushing, and the contracts still specify that location. (Crude other than WTI can also be stored at Cushing.)
It should be noted that when British Petroleum (BP) purchased Arco in 2000, one of the Federal Trade Commission's conditions for approving that purchase was that BP would have to sell Arco's pipelines and storage tanks at Cushing, to remove the possibility of any manipulation of WTI contracts. That would also mark the last time the U.S. government expressed any concern about oil price manipulation.
The AP story suggests that the price of gasoline is going up because the futures market for oil is now weighted in favor of Brent Sea North, an oil contract that has traded for $7 to $10 higher than WTI. Here again, the article left a key factor out of the equation: Brent Sea oil's price was sitting around $44 per barrel, not far from where it was the first week of December, and yet the price of gasoline on the futures market has climbed from under 85¢ per gallon to over $1.24 at one point ($1.08 per gallon as of publication). So yes, Brent Sea North is higher than West Texas Intermediate, but it has been higher for months. If AP's theory were correct, gasoline prices would have remained static.
Don't Compare, Contrast
The AP story briefly mentions but doesn't make clear the real issue: The gasoline futures market is not the oil futures market. The real reason gas prices are moving upward is that gasoline is sold under a completely separate futures contract and to different buyers than oil is.
The published oil contracts for both WTI and Brent Sea North are for delivery to one set of end users, typically refineries—or are bought by people who will speculate on them for profit, as we've seen for the past three years. Those contracts specify delivery anywhere from the next month to years in the future. But the futures market for gasoline is most often driven by other end users—the gas station owners, chains, wholesalers—and prices bid are for much shorter delivery times from the date of contract.
Again, this market acts as the price discovery for gasoline. Other factors, such as shortages of gasoline in certain markets, can elicit still higher prices for spot purchases and immediate delivery to the needy region.
In short, gasoline is sold separately and priced according to short-term retail demand, which may or may not have any relation whatsoever to the current or future price of crude oil.
As an example, after the Asian Financial Crisis of the late 1990s, at one point in early 1999 the price of oil plummeted to around $10 a barrel, gasoline prices hitting 99¢ per gallon. That made the price ratio of a gallon of gasoline to a barrel of oil 1 to 10. If gasoline prices were directly tied to oil, that would mean we'd be paying $4.40 a gallon for gasoline today—and it would have hit $14.70 a gallon last July, when oil traded at $147 a barrel. That obviously isn't happening now and certainly didn't happen last summer.
Fair Profits Aren't Unethical
As of Jan. 30, we had 220,211,000 barrels of gasoline on hand. That's about 3 million barrels of gasoline more than we had at the end of January 1999, when gas sold for around a buck. Therefore, the recent suggestion that we are short of refined gasoline products is as patently untrue now as it was this time last year.
What we are seeing, however, is American refiners cutting back on their utilization capacity, producing less gasoline in order to reduce the retail supply so they can raise prices. Amazingly, Americans get hot under the collar when OPEC cuts production to intentionally raise oil prices on the market, but when refiners cut production to raise the prices of finished fuels that we buy every day, we ignore it.
To be fair, our refiners deserve a break in their profits, known in the industry as crack spreads. Because of the high prices oil hit last year, refiners took it on the chin and could have filed for reorganization as charities; they often made gasoline for little or no profit, and at one point, refiners were losing $7 for every barrel of oil they refined. The last figure I read for 2009 is that crack spreads are back up to nearly $18 a barrel for refiners, and that seems roughly accurate. When oil prices go high and there is still heavy demand destruction, or weakening of the market for gasoline (as we're seeing now because of the economic crisis), the refineries dial back production, thereby raising the price of their products on the futures market—and turn a profit based on their expenses, including what they paid for the oil. It is nothing more complicated than that.
It has been decades since we've had a truly integrated, contractually bound worldwide oil industry, with contracts for oil fields that specified the net price oil companies paid for each barrel. (True, there was some state regulation back then to level out the price of oil, but that ended in the early 1970s.) That oil then shipped most often to buyers' own refineries, adding small profits to each transaction along the way. Yes, once there was a much more direct connection between oil and gasoline prices, but the industry doesn't work that way anymore. (Just like the gold standard.)
At Least Someone's Still Hiring
The way oil buying works today is that you bid against others for crude tied to specific delivery dates based on perceived future demand, then you refine the products and let others bid for the fuels based on final retail demand. Oil can go high and gas can be cheap at the same time; that was the situation last year, although the average motorist won't believe it. Conversely, oil can drop like a rock and gasoline prices rise as refiners cut production to short supplies over demand.
There is one other little thing. Every once in a while, retailers of refined fuels make a little extra money. Again, nothing wrong here, profits are a desirable thing. Recently diesel was selling for 30¢ to 35¢ a gallon more than regular gas in Texas, although the local rack price for diesel was just pennies more than that of gas. When that happens, you know that local station owners are finally making more money selling fuel than they are selling Twinkies and Big Gulps. Considering how everything else in America is caught up in the meltdown, any company making money today and not laying people off is a desirable thing.
Watch the daily futures market for WTI, Brent Sea North and Gasoline here. .
Special thanks to Tom Knight at Truman and Arnold Energy for his input.