Playing the One-Armed Bandit at the Gas Pump

By Brad Zigler

Heading into driving season, motorists are wondering where pump prices are likely to peak. That knowledge, if nothing else, will help homeowners decide whether a drawdown on their equity lines of credit will be necessary to fuel the family chariot for their summertime frolics.

Mortgaging one's future for fuel seemed a much grimmer reality at this time last year. The average gallon of petrol cost $4.09 in the first week of June 2008. Now, that same fuel can be had for $2.67.

Still, gasoline costs have been rising at a fast clip since their yuletide nadir. Gasoline cost only $1.71 a gallon at the pump last Christmas. In the last 30 days alone, wholesale fuel costs have jumped better than 15%.

The biggest influence on gasoline pump prices, as you might well imagine, is the cost of raw ingredient crude oil. Over the past decade, crude oil input costs have accounted for 51% of the pump price of gasoline in the United States. That's the average contribution, mind you. There have been times, most notably the summer of 2008, when crude oil costs figured even more prominently in the price equation.

At the peak of the driving season last year, when crude oil was trading at $145 a barrel, the black stuff's contribution to pump prices jumped to 76%. At the other end of the cycle, crude's price influence wanes. Amid the dripping liquidity of early 2001, for example, oil's weight was felt lightly at the pump, accounting for just a third of gasoline's retail price.

With that kind of a history, it's not hard to understand how crude oil's settlement above the $70-a-barrel level has got gasoline customers more than a bit, um, unsettled. Oil's now kicking in 63.5% to the pump price of petrol. People are wondering if it's going to get better or worse now that the $70 plateau has been attained.

If the government's to be believed, it'll get worse before it gets better. Not much worse, though. Tuesday, the U.S. Energy Department revised its 2009 energy price forecasts upward after being caught rather flatfooted by the market's recent velocity. Spot West Texas Intermediate (WTI) crude is now expected to average $67 per barrel for the second half of 2009. Previously, the agency had forecast a $55 average price for crude. To date, crude's average cost this year's been about $49 a barrel.

Nationwide regular-grade gasoline prices, say the Feds, should peak in July near $2.70 a gallon, only 8 cents above current levels.

Given the government's track record of underestimating fuel costs, consumers and investors alike are skeptical of such prognostications. Everybody's wondering about the odds of gasoline prices again outdoing Energy Department guesses.

Seasonality

It'll come as no shock to anyone that we're now in gasoline's high season. Looking back at 10- and 20-year patterns, gasoline futures typically peak in late May or early June and spend most of June rangebound until a final price spike in early July sets up a decline into the July contract's expiration. In gasoline's longer history, prices slid deeply in July, but that's not been the case so much in recent years.

Last year was atypical in the extreme. Prices didn't develop the usual June trading range top in 2008. Gasoline, driven by skyrocketing crude oil, stalled only after the Independence Day holiday. And what followed was a precipitous drop, not a trading range.

In 2007, gasoline's double top was marked between May 21 and July 10. Similarly, the 2006 market peaked between May 11 and July 14.

If 2009 is going to be more "typical," then we ought to be seeing a trading range by now. Looking at gasoline's price chart, that hardly seems to be the case.

NYMEX RBOB Gasoline (Jul. '09)

Technically, gasoline's uptrend remains strong. Though there are indications that the market's reached overbought levels, that's little assurance that prices will soon backslide. In fact, the most recent Energy Department inventory report, showing a surprising 1.6-million-barrel drawdown in gasoline stocks, has encouraged buying. Supplies of gasoline are now below seasonal norms and the energy agency noted a 0.4% uptick in fuel demand from year-ago levels.

Refinery Output

Oil refiners aren't altruists. They're going to try to maximize their refining yields by adjusting the mix of distillate outputs to capture the best profit margin obtainable. It makes sense, then, for refiners to meet the seasonal demand for motor fuel, without flooding the market and causing pump prices to sag. That's especially true when input costs - read: crude oil - are rising.

That brings us to the crack spread - the profit obtained by refining ("cracking") crude into distillate fuels such as gasoline and diesel. Because of crude oil's volatility, refining margins have been put under extreme pressure in recent months. Surging oil prices squeeze refiner profits and act as a brake on product supplies. (You can learn more about refining margins in the HAI article, "Time For Crack Spreads?").

Over the past four years, the futures-implied crack spread's averaged about $12.50 a barrel. That's an 18.3% gross profit margin. This year, though, margins are a lot tighter. At last look, the NYMEX crack spread was $10.74 a barrel, for a margin of 15%.

Yields on gasoline typically peak in May, corresponding with the topping in fuel prices. This year isn't shaping up as typical, though.

NYMEX Distillate Fuel Cracks (RBOB = Unleaded Gasoline)

Yields on gasoline are still comparatively low, a disincentive for building stockpiles.

The sweet spot enjoyed by refiners in the recent past was about $10 a barrel, or 24 cents a gallon, higher than current levels. If prices could be ratcheted up to historic margins, pump prices would likely rise another half-buck or so. But that's not likely. The current political and economic environment would make such a move-how shall I say it?-risky at best.

The Odds

Despite the reticence of refiners to goose up fuel stocks and the market's persistent bullishness, the odds are still long for much more upside in seasonal gasoline prices.

July unleaded gasoline futures go off the board on June 30. Given the contract's volatility and current price (around $2 a gallon), we can lay these odds for a finish on last trading day:

Per Gallon Price Increase	Probability
≥ 10¢	33.3%
≥ 20¢	19.9%
≥ 30¢	10.8%
≥ 40¢	5.3%

You can translate these prices to a national average pump price by applying a 90-95% markup.

Armed now with this information, you may need to consider a call to your broker after making that reservation for your summer cabin.

Happy driving!

Comments

[Drago D:]

It appears to me that this market has been reinfultrated with speculators assuming that $70 to $75 / barrel oil is the appropriate target due to statements from the Middle East. Is it possible that people aren't stockpiling gas at this level because there is an expectation in the market that both prices and demand will fall after July 4th and thus leave them upside down on their stock piles?

Jun 12 09:39 AM

[Drago D:]

It appears to me that this market has been reinfultrated with speculators assuming that $70 to $75 / barrel oil is the appropriate target due to statements from the Middle East. Is it possible that people aren't stockpiling gas at this level because there is an expectation in the market that both prices and demand will fall after July 4th and thus leave them upside down on their stock piles?

Jun 12 09:39 AM

[Drago D:]

It appears to me that this market has been reinfiltrated with speculators assuming that $70 to $75 / barrel oil is the appropriate target due to statements from the Middle East. Is it possible that people aren't stockpiling gas at this level because there is an expectation in the market that both prices and demand will fall after July 4th and thus leave them upside down on their stock piles?

Jun 12 09:39 AM

[User 357705:]

Neglecting to factor in the continued and accelerating USD decline skews this data and article.

Jun 12 09:40 AM

[sticktoitiv...:]

"that knowledge, if nothing else, will help homeowners decide whether a drawdown on their equity lines of credit will be necessary to fuel the family chariot for their summertime frolics"

What economy do you live in? You do know it's 2009 not 2006, Riiight?

Jun 12 12:12 PM

[Just Say Whoa!:]

>Playing the One-Armed Bandit at the Gas Pump

But unlike Vegas, the Gas Pump "pays off" every single time with....

...gasoline.

I wish the whiners who complain about the "high gas prices" in the US (yes, I know they are manipulated--because it's a monopoly), but you guys should really get out of town more often and check out the gas prices all around the world:
en.wikipedia.org/wiki/...

Gas is still cheap here.

Jun 12 02:46 PM

[sanvick:]

The object of my trade is to make money.

So go with the flow, crude that is.

Some make it seem like a crime to bet on crude, why?

Stop whining and start buying

Jun 13 12:04 AM

[User 357705:]

Because it was this sort of activity that hastened the economic collapse with oil as high as 147 without any fundamental reason.

Look at it as foregoing immediate economic gain for the good of your country. If your flag waving is only for show perhaps your family's future is more important.


On Jun 13 12:04 AM sanvick wrote:

>
>
> Some make it seem like a crime to bet on crude, why?
>
> Stop whining and start buying

Jun 13 12:43 AM

[icandoitdon:]

crude oil no longer trades on fundamentals of supply and demand. like gold, it is a currency trade and a bet on inflation. in my view, oil is a scarce resource that should not be subject to the whims of armchair speculators. futures trading in oil should be banned for all but those producers or commercial users who are authorized to hedge related commercial activities. oil markets will do fine without speculators, as they did for years prior to the advent of futures trading.

if you want to speculate that's fine....trade orange juice or pork belly futures. if you want to speculate in oil that's ok too....as long as you can take delivery of what you buy and deliver what you sell. if you can't, you don't belong in the game.

On Jun 13 12:04 AM sanvick wrote:

> The object of my trade is to make money.
>
> So go with the flow, crude that is.
>
> Some make it seem like a crime to bet on crude, why?
>
> Stop whining and start buying

Jun 13 01:02 AM

[Brad Zigler:]

Actually, the price of crude in the crack spread computation includes the dollar risk.

We're talking about a time horizon here (through last trading day of the nearby July contract) of only two weeks.

This past week, the dollar gained 1.6% against gold. The previous week, the greenback gave up 1.8%. Pretty much a wash.


On Jun 12 09:40 AM User 357705 wrote:

> Neglecting to factor in the continued and accelerating USD decline
> skews this data and article.

Jun 13 10:41 AM