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Ways of the World

Carol Stone, business economist & active Episcopalian, brings you "Ways of the World". Exploring business & consumers & stewardship, we'll discuss everyday issues: kids & finances, gas prices, & some larger issues: what if foreigners start dumping our debt? And so on. We can provide answers & seek out sources for others. We'll talk about current events & perhaps get different perspectives from what the media says. Write to Carol. Let her know what's important to you:

Friday, March 30, 2012

High Gas Prices Again?!

Filling your gas-tank has gotten expensive again, as we all know only too well. The national average price of a gallon of regular was $3.92 last week. Prices got almost exactly this high last year, but that was in May, in the build-up to the most intense driving season. So having the price surge as much as they have during the winter and early spring – it was only $3.25 back at Christmastime – is really disturbing. Where can we possibly go from here?

It's easy to want to blame someone for this – surely it's somebody's fault, and price gouging, profiteering oil companies and greedy speculators pop right up as possibilities. But it's hard to think that, with the world economy in such tenuous status, those players would have reason to try to push high-price strategies. Demand and the outlook for demand growth are just too uncertain. They might be shooting themselves in the foot to make prices too high.

We've looked at some reports from the U.S. Department of Energy and a couple of independent consultants to try to fathom an answer. Where this leads is not at all clear, but we can at least get a better feel for why it has happened. Here are three factors.

The first one is Iran and the sanctions against them. If you absolutely have to have someone to blame for the gas price surge, it might be their leaders and their potential nuclear weapons production. They have also periodically threatened to block the Strait of Hormuz, through which much Middle Eastern oil is transported on the way to the West. These developments have led the European Union to impose an embargo on importing oil from there to try to starve the Iranians' revenue stream. Europe imports about 700,000 barrels of oil a day from Iran, about 20% of Iran's total production. Some Asian countries are also starting to restrict their imports from Iran, in line with international sanctions. Iran is the second largest OPEC producer, with about 3.5 million barrels of crude per day (b/d) and the world's third largest. The restriction of Iran's oil flow will tighten an already tight world oil production system, in which there is little flexibility for any country except Saudi Arabia to expand output meaningfully. Some of the recent pressure on prices has come from a build-up of inventories in the U.S. and other major countries in anticipation of the loss of some of Iran's supply.

Emerging Market Demand
Second, while petroleum demand in North America and Europe has been sluggish – indeed, declining noticeably – demand in the so-called Emerging Market countries is gaining significantly. Recent Energy Department estimates show advanced country consumption down just over 1% in the quarter just ending compared to a year ago, and emerging market use up 3.8%. In fact, projections by the Energy Department show that petroleum consumption in the emerging markets may well surpass industrial country usage by the summer of next year. Thus, while we tend to focus on our own economies, it is the "rest of the world", especially China, India and Middle Eastern countries that are apparently driving world markets.

U.S. Distribution System Bottlenecked
Third, there is a regional disconnect in the U.S. production and refining system. This is a physical and geographic situation. Significant new shale oil production in North Dakota came online in 2007 and by last year had reached 500,000 b/d, obviously a large amount. However, the pipeline system was not previously geared up to handle this flow. So a large portion of it is sitting at terminals in the Midwest, especially the major facility at Cushing, Oklahoma. Ideally, this oil would go through pipelines to the Gulf Coast, where it would be transported to the East Coast. However, there is insufficient capacity to get the oil to the Coast, and the one major pipeline from that region to the East, the Colonial, which runs from the Houston area to New Jersey, is already operating at capacity. As a result, there is a relative shortage of gasoline in the Northeast, while the Midwest has something of a glut. Prices are rising everywhere, but a major spread developed between prices in that region and elsewhere. Regular gas in the Rocky Mountains cost virtually the same as in the Middle Atlantic region as recently as last autumn, but in February the difference was 60 cents a gallon; this spread has diminished recently, but is still somewhat wider than historical averages. Disruptions to refining operations have also occurred in the East, and two or three major refineries may be closed by midyear.

Role of Profits and Speculation
It is important in all of this to notice that profit margins in various oil products are not increasing. Last week (ended March 23), a gallon of gas retailed for $3.92 and a gallon of wholesale or "spot" gasoline cost $3.23, a margin of 69 cents. A gallon of crude oil cost $2.96, yielding a spread to the spot price of 27 cents. Over the last year, these spreads have averaged 17 cents for crude versus spot gasoline and 70 cents for retail over wholesale. Thus, there is no evidence here of "profiteering" by gas stations, and the latest widening by wholesale distributors followed five weeks of slimmer-than-average margins.

There are questions about the role of speculation in the financial markets. Can investors, putting money in futures markets, drive up the price of the product even though they have no intention of buying the quantities of gas and oil they bid for? This is a big question and there will be more to say about it at a later date. Research economists' analysis show mixed results in trying to explain price movements by movements in the financial futures market. One academic study for the Centre for Economic Policy Research, a European-based research network, indicates that the earlier episode of super-high energy prices in 2008 was a consequence of fundamental demand and basically not caused by speculators. Another report from the St. Louis Federal Reserve Bank seems to show that while world demand has been the key mover in prices, speculation has played a significant, though secondary role. Still another report from the widely respected energy expert and historian Daniel Yergin calls attention to the fact that new regulations under the Dodd-Frank law that attempt to reform the markets may well curb activity by independent oil producers. Those smaller companies depend on the futures market for the fundamental hedging of their operations, and his recent work concludes that they may be forced to cut back if financing from speculators is not as readily available as before.

So there are presently many forces on oil prices, some of which are brand new to this current high-price episode, and we didn't begin to deal with a number of them here. Earth Day is coming and that occasion will give us a logical time to consider more of these energy use and pricing issues. We wish we could promise that gas prices will soon decline, but there is little here that gives a reason to back up such an expectation. There are some more favorable developments which will eventually help, including the building of a spur of the Keystone Pipeline that will help oil get to the Gulf Coast. Also, Libyan production, restrained following the coup there a year ago, should be increasingly restored. Car companies are designing a wider variety of hybrid vehicles, contributing to further prospective reductions in gasoline use without constraining consumer welfare. But these projects are not coming on next month; later in the year, perhaps. As one writer explained, speculators might have quite sound reasons for speculating on rising prices. We hope not, but it's only a hope. The Energy Department's own forecast says regular gasoline will ease only to about $3.75 through this year and next.

Sources Cited:
Energy Information Administration of the U.S. Department of Energy. . There are recent reports on the regional disruptions we discussed. The Iranian issue is so important that EIA is required by the Fiscal Year 2012 National Defense Authorization Act to produce a bi-monthly report on the availability and cost of petroleum outside Iran. The first of those came on February 29. Our commentary also relied heavily on data and forecasts from the monthly publication, "Short-Term Energy Outlook."

The statement from Daniel Yergin come from a press release about a report his organization did as part of the public comment response to proposed Dodd-Frank regulations. Our source is Yergin concludes that the supply restraints he envisions from the regulations could actually raise energy prices.

The St. Louis Fed article is "Speculation in Oil Markets" by Juvenal and Petrella, and is one of the Bank's "Economic Synopses"; it is dated March 13. See .

The academic paper on speculation is "The Role of Speculation in Oil Markets: What Have We Learned So Far?" by Fattouh, Kilian and Mahadeva. Kilian is a professor at the University of Michigan and the others are affiliated with the Oxford Institute of Energy Studies. The paper is dated March 18, and we obtained it from Kilian's website at


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