The Brexit vote caused a spike in volatility by creating an instant, “risk off” trade. The ensuing sell-off appears to have created a buying opportunity in unleaded gas futures that should continue to be supported by growing domestic demand through the summer vacation season.
The price of gasoline is holding above $3.00 per gallon and bouncing its way higher. This is happening even though the price of crude oil remains fairly well capped technically at $90 per barrel in spite of the Egyptian conflict and concern over control of the Suez canal. The price of crude oil is also showing fundamental weakness at these levels. The weekly commitment of traders report shows a record net short position by commercial traders who are expecting the market to decline from these prices. Furthermore, the gap in prices between current crude oil and crude for future delivery continues to widen. This is called, “contango.” The wider the spread becomes, the more economic incentive there is to sit on and store the oil. In the face of bearish fundamentals, why is the price of gasoline so stubbornly high?
I believe that gasoline demand as a finished product will outpace demand for raw crude over the coming months. A barrel of crude oil equals 42 U.S. gallons. The refined barrel produces 2/3 gasoline and 1/3 heating oil depending on the quality of the crude oil input. The difference in price between the combined value of the heating oil and unleaded gasoline produced versus the crude oil input is called the, “crack spread.”
The first part of the answer to our question lies in the global dynamics of this spread. Refineries are currently making about $17.20 per barrel that they refine. This is significantly higher than the $6.50 or, so they averaged throughout 2010. This added profit margin should incentivize greater refinery capacity utilization. This is where the first disconnect becomes clear. Refineries in the U.S. are only operating at 85% of capacity. Our main foreign suppliers are operating at lower levels than that. China, however, ran at record levels of refinery operation throughout 2010.
The Chinese position demands recognition. China sold approximately 18 million cars in 2010 while the U.S. sold just over 12 million. More importantly, the China Association of Auto Manufacturers claims that 2010’s sales pushed Chinese vehicle ownership up to about 6% of the total Chinese population. By contrast there are approximately 80 cars for every 100 Americans. China’s crude oil imports for January have increased by 33% over last year’s and their 2011 projection is for 5.27 million barrels per day. The Chinese are building a wealth of strategic reserves. It won’t take long for them to compete head to head on the open market for the 8.9 million barrels per day the United States currently consumes.
The second primary contributor to stubbornly high domestic gas prices is the mandatory edition of ethanol to the fuel we use. The government mandate is to increase the ethanol per gallon of fuel to 11% from 8.5% for 2011. U.S. ethanol production is uncompetitive because it is based on corn. Sugar based ethanol, like Brazil’s is more efficiently produced. The government’s energy plan currently imposes a $.54 per gallon tariff on imports while subsidizing the creation of ethanol plants and the corn that goes into them. Gas prices topped $4 per gallon in 2008 and corn is 20% higher now than it was at this time in 2008.
Asian refineries continue to soak up the global supply of crude oil while our refineries enjoy the profits of the crack spread foreign demand is generating. We are sitting near the seasonal lows in petroleum products and the corn market has yet to build in weather related planting premium. Our low operating capacity combined with higher ethanol content and the rising price of corn could create quite a domestic price shock.
This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.