Should Uncle Sam Intervene In The Energy Markets?

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
October 18, 2005

IN THIS ISSUE:

1. Introduction – Government Should Stay Out

2. The Supply & Demand Factors For Oil

3. The Shortage Of Refineries In The US

4. Are Hedge Funds Driving Oil Prices Higher?

5. Are Gas Stations Price-Gouging Customers?

6. Conclusions & BCA’s Forecast For Oil Prices

Introduction

Dozens of Senators and Representatives are clamoring for new legislation that would lower energy prices, or at least keep them from going significantly higher. Several versions of energy “price controls” are being suggested by members of the House and Senate. It’s as if they have forgotten how disastrous price controls were in the 1970s!

Congressmen and women feel, for political reasons, that they must be seen as doing “something” to bring down energy costs, so they roll out ideas and suggest new legislation that they can show their constituents back home, who are clamoring over fuel prices and the news that the big oil companies are making record profits.

In my view, the government should stay out of the oil business. As I wrote in my August 2 E-Letter, the recent pork-laden energy bill accomplished very little in the way of solving any of our energy problems. The one big thing they could have done – opening up more areas for exploration – they didn’t do. So Uncle Sam should stay out of it.

There is no question that the big oil companies are raking it in. Exxon/Mobil, the largest, is on track to make unheard of profits of $30-$40 billion (yes, billion) this year alone. Its profits in 2005 are reportedly up 69% over this time last year. Many consumers believe that the big oil companies control the price of crude oil, which is not true.

Many consumers also believe that the oil and gasoline markets were driven to record highs recently because of speculators and large hedge funds. While trading in the energy markets by such groups is not insignificant, a breakdown of the participation in these futures markets does not suggest that hedge funds caused prices to rise as much as they have recently (more details below).

At the state level, virtually every Attorney General is looking into complaints by consumers of price-gouging at the gas pumps, especially during August and September when prices skyrocketed. While it is true that there were instances of price-gouging, many consumers do not understand that most service stations and convenience stores raised their prices during the recent surge the same way they have done for years. It’s just that the numbers were a lot larger in the latest run-up.

More than anything else, energy prices have surged to record highs due to supply/demand factors. It is not a conspiracy as many would have us believe.

This week, we will look at a host of factors affecting the energy industry, oil and gasoline prices and what, if anything, can or should be done about it.

The Supply & Demand Factors For Oil

The bullish case for oil is well-known. Currently, the world consumes 84 million barrels of oil per day. According to the US Energy Information Administration, that number is likely to increase to 103 million barrels per day by 2015, which could be low depending on the growth of the economies of China, India, etc.

America, alone, uses 25 million barrels of oil per day, or 29% of total daily world consumption. If our refineries are running at full capacity, we can refine about 17 million barrels per day. The balance must be imported from foreign countries.

Daily global oil production barely meets daily global oil consumption, and that is with many oil-producing countries running at flat out. Add to that the fact that oil producers are not discovering as much new oil as we are consuming. There is also growing evidence that global reserves of oil are nearing a peak, at a time when demand is estimated to increase for the foreseeable future.

Given these underlying fundamentals, we had a market that was ripe for a powerful run-up and continued high volatility. The only question was when.

Oil prices have been rising steadily since the beginning of 2003 when crude was at $30 per barrel. By late 2004, prices had topped $50 per barrel for the first time. Prices were still around $50 per barrel when we entered this year’s hurricane season.

Following Hurricane Katrina, crude oil soared to an all-time high of $70 per barrel. Regular unleaded gasoline hit a national average high of $3.06 per gallon on September 5 according to AAA. Prices were much higher in some parts of the country.

With an estimated 40% of offshore drilling rigs and oil platforms in the Gulf of Mexico damaged or destroyed by the hurricanes, we should be thankful that oil prices didn’t go even higher. Fortunately, oil prices have retreated to the $63 area as this is written, but we also have another hurricane brewing, Wilma, which is projected to make its way into the Gulf sometime next week. If that happens, oil and gasoline prices could go up again.

The Shortage Of Refineries In The US

Much has been said about the shortage of refineries in the US. Depending on which source you cite, there are either 144 or 148 refineries operating in the US, down from 324 in 1981. Much has also been written and said about why we have not built a new refinery in this country in almost 30 years. There are numerous arguments (and conspiracy theories) about why we don’t have more refineries, but I will leave that subject to others.

What you may not know is that despite the fall in the number of refineries to less than half from the peak in 1981, refining capacity has actually risen substantially over the last 20 years. Since 1985, refining capacity has risen from 12,500,000 barrels per day to over 17,000,000 barrels per day this year according to the American Petroleum Institute.

This significant increase, even as the number of refineries was cut by more than half, has been possible mainly because: 1) many existing refineries have been expanded and upgraded; and 2) major advances in technology.

What you also may not know is that refiners’ profits have risen dramatically in the last year as oil prices skyrocketed. According to a study released by the Denver Post, average refiners gross profits tripled from $7 per barrel in September 2004 to $22.77 per barrel as of last week.

Interestingly, that same study notes that 42% of all the refineries in the US are owned by the top five oil companies – Exxon/Mobil, British Petroleum, Royal Dutch Shell, Chevron and Conoco/Phillips. They own the oil, they have their own refineries - small wonder that their profit margins are soaring!

This substantial increase in refining margins is one reason why gasoline prices have risen by more than would have been expected from the rise in crude oil prices. In years past, refining costs were estimated to be 15-18% of the cost of a gallon of gasoline. Now, with the substantial increase in refining profit margins, a gallon of gasoline costs us more.

Rather than slapping on price controls, the government should strip away the bureaucratic maze of regulations that make it so difficult to build new refineries. The recent energy bill provided some incentives to build more refineries, but far more needs to be done to address this problem. Of course, the big oil companies had better be plowing some of those record profits into building more refineries.

The next new refinery to be built in the US is planned for Acna, Arizona, a small town about 100 miles west of Phoenix. The investor group that wants to build the new refinery has been working on the project for 10 years and they have spent over $33 million just in getting through the regulatory boondoggle.

Are Speculators Driving Oil Prices Higher?

Lots of people – including many in the oil and gas and related industries – believe that speculators and hedge funds have driven the prices of oil and gasoline far higher than they would have otherwise gone. As a 28-year veteran of the futures markets, I can tell you that if enough new money comes into a market, it can drive prices further in one direction or the other. However, such moves are usually temporary, and that same money has to come out at some point, which usually drives prices back in the other direction.

While I disagree, some people believe that buying by large speculators and hedge funds has resulted in a premium of $15-$20 per barrel in the case of crude oil. This is in addition to the so-called “terror premium” of $10-$15 per barrel. Actually, no one knows how much the threat of terror has added to the price of oil.

Some oil market analysts say that the large increase in trading volume in crude oil and heating oil futures at the NYMEX (New York Mercantile Exchange) in the last several years is a sure sign that hedge funds make up a big part of this market now, and that this has served to artificially raise prices. Daily trading volume in crude and heating oil futures has increased 61% and 36% respectively since 2000.

Yet this misses the point entirely. Trading volume in almost every futures market increases every year, and the volume increases in crude oil, heating oil and other energy futures are consistent with the increases in trading volume across the board. Interestingly, with all this talk about hedge funds driving up the price of oil, the NYMEX says that hedge funds account for less than 3% of trading in oil futures. Assuming this is true, hedge funds are not the culprits.

Fortune Magazine staff writer Jon Birger did some legwork on this very issue. Birger looked at public data that is published by the US Commodity Futures Trading Commission (CFTC) to see which groups of traders were “long” and which were “short” in oil futures in the week prior to Hurricane Katrina.

The CFTC’s “Commitments of Traders Report” for the week before Katrina hit showed that “non-commercial traders” – the subset of participants that includes hedge funds and banks – held only 16% of the open long positions. The same report showed that non-commercial traders held only 14% of the open short positions.

These are not unusually large positions for a market that has been red-hot for over two years. Furthermore, the fact that long and short positions are almost evenly split blows away the argument that hedge funds are driving the price of oil skyward. And remember, the figures above are for hedge funds and banks.

Many hedge funds (and futures funds) are struggling this year. Some hedge fund analysts believe returns have been disappointing because many funds have reportedly tried to short oil this year, hoping to pick the top. This differs 180 degrees from the perception out there that hedge funds have driven oil and gas prices significantly higher. Birger concludes that if hedge funds are trying to drive up oil prices, they’re doing a lousy job!

Are Gas Stations Price-Gouging Customers?

Many Americans believe that their local gas stations and convenience stores have engaged in price-gouging in recent months. As noted in the Introduction, state Attorney Generals around the country are scrambling to levee fines and even prosecute store owners (including several large oil companies) for price-gouging.

In cases where store owners added large premiums above their normal profit margins, those individuals or corporations should be fined and/or prosecuted. We all heard the stories of $5 gasoline in Georgia and other places. That deserves punishment, which should be determined on a case-by-case basis.

I happen to have some friends who own convenience stores, and they tell me that most convenience store owners did not change their gasoline pricing policies during the recent explosion in prices. I also have a friend who owns a trucking business here in Austin that delivers gasoline to convenience stores in this area. He agrees. Their comments seem to be consistent with the National Association of Convenience Stores (NACS).

According to NACS, convenience store profit margins on gasoline sales have been declining for the last 20 or so years. For 2004, profit margins on gasoline sales averaged just 10.5 cents per gallon nationwide, the lowest ever, according to NACS. With the likes of Wal-Mart, grocery chains and others getting into the gas station business in recent years, profit margins have dropped.

Many Americans are convinced that gas stations across the country raised their prices and profit margins unconscionably when oil prices skyrocketed before and after Hurricane Katrina. No doubt some did. But the facts suggest that most didn’t.

Here is how my friends who own convenience stores here in Texas describe the gasoline pricing practices at most service stations and convenience stores that sell fuel.

There is a wide variance in the size of the underground holding tanks for various fuels at different stores. As such, some may get a shipment of fuel every day, while others may only get a delivery once a week. Given that, the average cost per gallon of fuel in the ground varies from store to store. That would make you think that prices at the pump from store to store would vary much more than they do, especially recently.

However, my friends who own such stores tell me that the price at the pump is governed more by what the store, or stores, down the street are charging than what their actual cost of fuel in the ground is. In other words, the stores try to keep their prices competitive with each other because they know that consumers will drive a block or two extra to save a few pennies per gallon.

Many Americans howled when their nearby gas stations raised prices even before a new transport of higher priced fuel arrived. This was true in many (probably most) cases; it was certainly widely true here in Austin. But as my friends in the business explain, it was not unusual based on their historical pricing policies.

Here’s an example. Let’s say gas station “A” has underground tanks that are full of regular unleaded gas it can sell at normal profit margins for $2.50 per gallon at the pump. Gas station “B” just down the street receives a new shipment of regular unleaded two days later, that it must sell for $2.60 to maintain its normal profit margin. But station B knows customers will pass it up and go to station A to save 10¢ a gallon. So station B sets its price at $2.55 instead of $2.60. The next day, station A is likely to raise its price to $2.55 as well. So station A makes a little more on what’s left in its tanks, while station B makes a little less, at least until A has to refill its tanks at higher prices.

The point is, at least in this area, that gasoline prices at the pump are determined both by the underlying price of fuel and what the competition is charging. Because stations receive their fuel shipments on different days and at different prices – yet still keep their prices relatively close – this means there will be times when stores make additional profits. Yet there are also times when stores make little or no profit, especially when gasoline prices are dropping.

Because oil prices have been rising for the last two years, my friends tell me that their profit margins on fuel are up slightly over the normal level. Yet they are also concerned that the huge run-up in fuel prices will be followed by a large decline at some point, in which case their margins will be squeezed.

I hope this rudimentary explanation is helpful. Obviously, different service stations and convenience stores use different profit margins based on their individual circumstances, what additional services they offer, location, etc.

Conclusions & BCA’s Forecast For Oil Prices

The bottom line is, some gas stations were guilty of price-gouging in recent months, and those stores should be punished. This seems to be happening around the country. However, most of the price increases we have seen are simply the result of the huge increase in oil prices and increased refining margins.

For the most part, the gas stations and convenience stores where we fill our cars are making slightly higher profit margins on fuel, but well short of “highway robbery.” And they are likely to see those margins shrink if the price of oil continues to fall.

Speculators and hedge funds, generally speaking, certainly participated in the rise of oil and gas prices over the last two years, but their participation had a marginal effect on how high oil and gas prices went, in my opinion. The data from the CFTC which regulates the futures markets indicate that hedge funds were about evenly split – long versus short – in the week before Katrina hit.

As noted above, the underlying supply/demand fundamentals were already poised for a large move up. Add to that two devastating hurricanes in the Gulf, and you have the effect of tossing a lit match into a fireworks depot.

So, where are oil and gasoline prices going? Obviously, no one knows for sure. My astute friends at The Bank Credit Analyst have issued a guarded opinion in their latest October issue. Two years ago, BCA predicted that oil prices were headed for a big bull market, although (like other forecasters) they did not predict prices to rise to $60-$70 dollars per barrel.

Basically, Martin Barnes and his fellow editors at BCA believe that oil prices are going to remain high for the next several years due to continued increases in demand, especially from Asia. However, they also believe there is a good chance that oil prices will drop – temporarily – to below $50 a barrel next year, as a result of a slowdown in the economy.

Longer-term, they believe that oil prices will have to remain above $50 per barrel for at least the next five years in order to stimulate the necessary exploration, increased production and increased refining capacity that will have to occur to satisfy growing global demand. They say:

“This year’s spike in prices is leading to a demand response [lower consumption], setting the scene for over-supply and a [downward] price correction. It would be a mistake to assume that prices will keep moving up from current levels, even if one embraces an optimistic view of demand and a pessimistic view of production.

There could be occasional periods of excess supply, but they may not last long. A reasonable expectation is that prices will average at least $50 a barrel over the next five years. Any fallback in oil prices would presumably hurt the near-term performance of oil stocks. However, that would represent a strong buying opportunity. Even at $40 a barrel, most oil companies make tidy profits and valuations are reasonable.”

While I respect BCA more than any other source I read, I have to caution that their current view, as outlined just above, is pretty much the same as everyone else I read and talk to. Generally speaking, $50 a barrel is now considered a “floor” and most analysts feel that anything below $50 will be a good buy.

I must caution, however, that the futures markets are famous for NOT performing in line with the consensus expectation. Oil prices, in particular, are no exception. That’s why my personal participation in the energy markets is solely via funds that employ professional futures Trading Advisors who have the flexibility to be long, short or on the sidelines, depending on market conditions.

Unless you are a professional trader, I do not recommend that you trade in the energy futures markets or in options on futures – especially at the current price of oil and gas.

That’s all for this week. I hope the weather is nice where you are. It’s still hot in Central Texas.

Best Wishes,

Gary D. Halbert

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