High Gasoline Prices Are Here to Stay

This Earth Day was a watershed moment.

I’ve never seen so many Earth Day pronouncements, celebrations and headlines. The world has never been so focused on energy and sustainability as it is now.

This Earth Day, benchmark West Texas Intermediate oil set a new all-time high over $119, and Tapis (the Malaysian benchmark price Far East crude) shot over $124.

Gasoline prices crossed $3.50 a gallon for the first time, and diesel set a new record over $4.20.

A front page story on the Wall Street Journal declared "the age of cheap and easily pumped oil is over," and followed up with several stories about a new crop of suburban farmers who are making their first forays into self-sufficiency. In my book, there’s really no better way to celebrate Earth Day than to plant some of your own food.

Best of all, I got the word that my new book about peak oil (and gas, coal, nuclear, and all renewables), Profit from the Peak with Brian Hicks, is flying up the Amazon charts—and it only just started shipping. The actual release date is still 10 days off, but it was already #1 in some subcategories and at one point was #792 of all sales-ranked books on Amazon.

Five years ago, I was one of the few lone voices out in the wilderness warning about peak oil, and all that it means. Oil had hit a new high around $35 and most traders were arguing that it would soon fall back to $20.

Peak oil was considered a fringe theory, and the financial media were absolutely sure that the market would sort everything out and let us all get back to our "Happy Motoring" fantasies. I had some spirited discussions with investment analysts back then, who basically thought that I just had an apocalyptic bent.

I stuck to my guns. I knew that oil had begun a relentless rise as we approached the global peak of production, and that the Street was in for a rude awakening. And at the end of last year, I predicted that 2008 would be the year that peak oil really hit the mainstream, and the dialogue about energy would start to come around to reality.

Now, as oil hits record high after record high, the Street’s own paper of record has admitted that the jig is up. The whole world is finally starting to recognize that we’ve got a serious problem on our hands, and no amount of "jaw-boning" the Saudis is gonna fix it.

The Oil Price Juggernaut

Maybe the change in attitude had to do with hearing it straight from King Abdullah himself, who said last week that he wasn’t interested in increasing Saudi production beyond its current level just to satisfy the rapacious demand of Western consumers.

He’s got his own country’s future to think about. "When there were some new finds, I told them, ‘no, leave it in the ground, with grace from god, our children need it,’" he said.

One week later, U.S. Energy Secretary Sam Bodman admitted that he was powerless to persuade them otherwise. "I have done everything that I know how to do with OPEC," he said. "I have a very good relationship with (Saudi oil minister A) Naimi and all the people that work at OPEC. I wish they would open it up and issue more oil. That’s my wish but I can’t order them to."

Bodman’s admission comes about a month after the White House admitted that it, too, was powerless over the situation. On March 13, while being grilled about high gasoline prices, White House spokeswoman Dana Perino said "It would be wrong of the President to provide false hope to people to think that we are going to be able to have an immediate impact to reduce gas prices…This problem didn’t get started overnight, and it’s not going to be solved overnight… This is something we’re going to have to all work through."

Energy expert Frank Verrastro at the Center for Strategic and International Studies think tank in Washington agreed: "Clearly, there are no easy, near term fixes for higher gas prices."

I’d like to tell Mr. Verrastro that there are no easy long term fixes, either. But I suspect he already knows that. He’s just too polite to say so.

Myths About High Gas Prices

So why are gasoline prices so high?

Well, consider this: In general, a $1 rise in the price of a barrel of crude oil adds about 2.4 cents to the price of a gallon of gasoline. Since oil prices have doubled since the beginning of 2007, you had to expect gasoline prices to follow.

Of course, the story is a little more complex than that. As my readers know, the factors that weigh on gasoline and oil prices are many and interrelated. But you’d never know it from most of the media coverage. In fact, I have heard and read more myth than fact about gasoline prices.

It’s an annual phenomenon. Every year, as gasoline prices rise from their winter lows, we gather to wring our hands and wonder and worry what’s going on. As if we’d never seen this happen before.

I just realized that I was on exactly the same topic, talking about Congress doing the same stupid things, one year ago.

I even got the annual email petition to boycott gasoline purchases from Exxon. Yep, I wrote about that one year ago too.

The outrage over gas prices is as regular as Groundhog Day.

Let’s debunk this story and see if we can’t get it right, for once.

1. It’s Those Evil Oil Companies

Every time oil prices spike up into a new trading range, you can bet that some Congressman will haul Big Oil’s CEOs into a hearing and try to pin the blame on them. And this time is no different.

The lack of understanding of the oil markets demonstrated by our fearless leaders is truly appalling.

As ConocoPhillips Chief Executive James Mulva remarked one year ago, "Big Oil is not so big."

My readers know the real score: Big Oil controls only about 10% (at best) of the world’s remaining oil reserves, and their share of daily production is slowly eroding. They have reached the point where the oil they produce is coming out of their total reserves, because they can’t replenish it with new-found oil anymore.

As we have discussed in these pages previously, since the very basis for the valuation of their companies is the inexorably falling reserves, big oil companies are doing the smart thing and buying back their shares. Wouldn’t you, if the alternative was to continue investing skyrocketing amounts of money in order to drill dry holes in decreasingly interesting prospects?

Personally, I wish they’d be a little more up-front about that, but if you follow their actions and not their words, it’s clear enough.

But I digress…

Investigation after investigation into alleged oil company profiteering hasn’t resulted in one single prosecutable charge. It’s simply barking up the wrong tree.

Remember: Oil is highly fungible. Oil is traded on a global basis. And while Big Oil does benefit from higher prices for their diminishing barrels, they’re not setting prices.

Traders are, and speculation has been heavy. The amount of oil traded on paper far exceeds the amount of oil that’s actually being sold.

This has prompted more Congressional attention, and questions as to whether the rules for oil trading need to be tightened to keep out speculators.

That may be a good call actually, but for now, the increasing price of oil remains partly due to the flight to commodities, which I have written about in recent columns.

That said, I think that oil is still badly underpriced on the basis of its true value. So the speculation may in fact be a part of a normal market, functioning as it should to find the correct price.

So: speculators, a qualified yes; Big Oil, not really.

2. It’s the Low Refinery Output

Some have blamed high gasoline prices on low refinery output. After all, lower supply means higher prices, right?

Well…not exactly.

If you think gasoline prices are high now, consider this.

A year ago, the typical "crack spread," or the profit on refining a barrel of oil, was over $20 a barrel, and peaked at over $30. Today, it’s closer to $10 on average, and for the independent refiners, it’s absolutely dismal:

Source: PetroStrategies, using Oil & Gas Journal statistics

Consequently, refinery utilization has been even lower than usual for this time of year, the "turnaround season" when refiners typically idle some equipment in order to prepare to produce the summer blends of gasoline. Normally, refinery utilization in the turnaround season is in the range of 85-90%, but this year it’s barely above 80%.

So why have refining profits collapsed?

It’s a squeeze play: Crude prices have gone up much more than gasoline prices for domestic refiners, squeezing out their profit.

So why have gasoline prices not kept up with crude?

Part of the answer is reduced domestic demand. High gasoline prices are really starting to hurt American consumers, and they’re cutting back on their trips. Still, although gasoline consumption has fallen by a few percent year over year, total U.S. demand will still rise about a half a percent this year.

The problem here is that the elasticity of U.S. gasoline demand is really very low. Recent studies have suggested that a quadrupling of gasoline price only cuts demand by half, and that only 20% of the demand reduction is due to driving less—the rest owes to reduced vehicle ownership and better mpg.

But the bigger part of the answer owes to a new dynamic in the gasoline trade: Finished gasoline imports have increased dramatically in the last several years, which has pressured prices for the domestic refiners.

This is primarily because Europe is increasingly choosing diesel over gasoline. Their diesel-sipping vehicles are more efficient and generate less emissions. As their diesel demand rises, they have more finished gasoline to export to a hungry world market.

Were this not the case, gasoline prices in the U.S. would have risen as fast as diesel. Diesel prices have gone up twice as much as gasoline prices over the last year:

Source: EIA

You might be surprised to know where all that imported gasoline is coming from. It’s a very different list than our sources of crude:

Top 10 Sources U.S. Gasoline Imports, 2007 (million barrels)

Source: EIA

So instead of blaming domestic refining output for tight supply and high gasoline prices, we should be thanking Europe for reducing their gasoline demand!

As we head into the "summer driving season," with its higher demand and its requirements for specialized blends of gasoline, it seems likely to me that margins will head back into normal territory for this time of year.

If we revisit last year’s crack spread highs, gasoline prices could tack on another 48 to 72 cents per gallon!

That’s why I’ve been predicting $4 gas by summer.

3. It’s Our Failure to Develop Domestic Supply

This is one of my favorites: the claim that if only those damn environmentalists hadn’t made much of our offshore oil reserves off limits to drilling, that we’d be enjoying gas prices under $2 again.

These people demonstrate a severe lack of comprehension about the concept of flow rates.

This is a familiar concept to my regular readers. All together now: "It’s not the size of the tank which matters, but the size of the tap."

When you’re consuming 21 million barrels a day (mbpd) of oil, bringing on a few field, even a "huge" field producing a quarter million or a half million barrels a day is still a drop in the bucket. It might dampen the rate at which prices increase, but it can’t bring them down.

If you understand what Hubbert’s Peak is all about (and if you don’t, you definitely should read my book!), you know that there is no turning back the clock on the decline of U.S. oil output, which has been steadily falling for 37 years despite massive investment and the best technology in the world.

4. It’s Because They Won’t Open the SPR

Finally, we have the Strategic Petroleum Reserve (SPR), which was created as a supply buffer against disruptions like the oil shock of 1973-4. It was a fine idea. I remember sitting in line in a car for three hours in the hot summer Tucson sun, waiting to buy a maximum of five gallons of overpriced gas on an "even" or "odd" day. It sucked.

The SPR can’t buffer prices, though. It’s strictly an emergency supply. Right now, it’s got about 701 million barrels of oil in it, which sounds like a lot. But when you’re consuming 21 mbpd, that’s only a 33 day supply. More correctly, it’s a 58 day supply, since we import only 12 mbpd of the 21 we consume.

Two months isn’t much of a buffer against a serious emergency, and in today’s environment, we absolutely must be prepared for such an event. It’s an insurance policy against natural disasters and oil terrorism. We need look no further than what happened to oil after 9/11 and Katrina to know how quickly oil prices can spike up. To draw the SPR down below current levels would be irresponsible and reckless. That’s why I applauded the decision last year to increase the SPR’s capacity.

More to the point, the maximum flow rate of the SPR is only 4.4 mbpd, so at most it could only provide about 20% of our daily needs. That would dampen oil prices only a little, and only for a short while, until we had to start refilling it again. And when we did, it would add substantially to the already stretched global supply-demand balance, making price pressure even worse.

The Bottom Line on Gasoline Prices

I have written at length about why oil prices keep going higher. Some of it has to do with the usual factors cited in the press: speculation, geopolitical unrest, OPEC announcements, inventory levels, and so on.

But the most important reason usually goes unsaid: peak oil.

Even the IMF has obliquely admitted there is a problem. Recently, deputy director John Lipsky said, "While oil demand has remained robust, the supply side response to rising prices has been disappointing."

And that’s the bottom line right there.

You know the old saw: when you point the finger at somebody else, there are three pointing back at you.

While oil production has leveled off, demand has not, and the reduced demand from the OECD is being more than offset by the red-hot economies of the developing world.

For the first time this year, the combined oil consumption of China, India, Russia and the Middle East will exceed that of the U.S.. Even with all our efforts to curb domestic demand, worldwide oil demand will increase about 2 percent this year, according to the IEA.

Until global demand cools off, there’s no way out of the oil price trap.

And however we choose to characterize the reasons, oil supply isn’t increasing anymore. The tap is wide open.

As Scotty used to say on Star Trek, "She can’t take anymore cap’n! I’m givin’ ‘er all she’s got!"

The world is now perched precariously on the plateau at the top of the global peak in oil production. And it’s not a long plateau. We’ve been on it for about three years, and I’m giving it another two years, tops. After that, we head on down the other side of Hubbert’s Peak.

And I am increasingly doubtful that the world will be able to reduce its demand in time to prepare for the second half of the Age of Oil.

Oil will keep going higher, and gasoline and diesel prices will follow it up—not precisely, and not immediately, but they will follow. And for once, the White House seems to have told the truth about energy:

There’s really very little we can do about it.

Well, except for this: You can sign up for the $20 Trillion Report and learn how to profit from the increasing price of precious black gold. Your gains there should more than make up for your pain at the pump.

Until next time,

—Chris