Analysts (most notably, CNBC analysts) are beginning to call for $5 gasoline to hit pumps by this summer. I don’t know if they will – but it’s certainly within the realm of possibility.
And though we’re still patting ourselves on the back here in the United States for increasing oil domestic oil output, the problem has little to do with oil supply, and everything to do with refinery capacity.
For significant periods of time, refineries have swung in between profitability and non-profitability. Though the politicians at the helm mean to “punish” oil companies with higher taxes, these taxes frequently hit the bottom line of refiners harder than anyone.
Refining is a costly business – not just because it’s heavily taxed at about 10% before a single barrel of gasoline is even sold, but because of the massive shipping, storage and actual product and refinery costs.
And though refining can experience periods when it has higher profit margins, on the average, it’s pretty low on the totem pole when it comes to profit margins. The average for the industry is somewhere between 3-5% - which is dwarfed by railroads (12% profit margin), cigarettes (17%), and even generic drugs (6.6%).
Today, refineries in Europe and the United States are closing. Why? Well, it’s not for lack of refinery demand. It’s because margins are so slim, that there’s no guarantee of profits in the sector anymore.
So refining capacity is beginning to be strained in the West – which is bad news for gasoline prices even if the United States is producing more oil.
Refining capacity in India and China is taking off though. So while we’re beginning to export more oil to the East, our own gasoline is getting more expensive (thanks in part to taxes), while Asia’s gasoline is getting cheaper.
So what can you do?
While it’s tempting to look into the refinery space, I think a better way to play the trend (before $5 gasoline comes) is to buy a world-leading oil company – not a pure refiner.
Right now, I think Chevron Corporation (NYSE:CVX) seems to have the best upside. The stock still trades at a very cheap 8 times trailing earnings. It pays a 3% dividend and it has no debt whatsoever.
Chevron does refine oil too – and since it's among the biggest oil companies in the world, and somewhat vertically integrated, it's in a unique position to weather slim margins on domestic refining capacity.
The thing is, if you wait for $5 gasoline (which I think we’ll see sooner or later, if not this summer), then it will be too late. High priced oil tends to flood headlines and market sentiment for a short period of time before prices crash lower – as we saw in 2008.
Buying oil companies at the height of the summer driving season in 2008 would have guaranteed that you lost money over the following years.
Invest now, or soon in companies like Chevron, and you’ll be ready for the next potential run-up.