Why U.S Gas Prices Will Continue to Rise Rapidly

Consumers around the world are being indirectly taxed through record high gas prices. This, of course, hurts consumers’ pockets and can raise inflation fears. We wanted to take a look at the crack spread between WTI crude prices and US petroleum prices as measured by the Energy Information Agency. We outline the results below.

The February reading of the U.S. all grades all formulations retail gasoline prices per gallon was $3.078 verses a WTI price of $95.35/barrel for the month. Why is this important? First off, gasoline is produced by applying a refining process to crude oil, so factoring out crude previously purchased at a lower price and hedging activities, gasoline has to be more expensive than crude. For comparative reasons we broke the WTI/barrel price into a WTI/gallon price, so we could compared it to gas prices. The results were not surprising, that is, until recently.

The average spread over the last 15 years of WTI to gasoline prices per gallon has been $0.53; never going below $0.25, that is until October of 2007. As you can see from the chart below the Gas/WTI spread has remained fairly constant over the years until the recent convergence. We currently estimate the spread for March 2008 stands around -$0.15 after a reading of 0 in February.

What does this mean? Well it means eventually, and likely sooner rather than later, the US will experience a sharp rise in gasoline prices, at least without an offsetting drop in WTI prices. If you were to apply the historical spread to current WTI/gallon prices US gasoline prices would total $3.96/gallon. This number seems quite realistic to me.

This chart shows that the spread between WTI and gas prices has collapsed, meaning WTI prices will need to experience a sharp decline or gas prices need to catch up…

Source: Energy Information Agency & my calculations

Investment Relevance: Crack spreads are used as a measurement of the profit margins for oil companies, such as Exxon Mobil (XOM). In fact, we have recently seen a drop in both the spread and XOM’s share price. If this spread reverts to its historical level, then we would expect to see higher margins, which should be reflected in share prices. However, the current zero to negative spread does not bode well for the industry, but as we mentioned above we do not imagine that will last for long.

One concern however, is that there tends to be a lagging relationship between the two variables. As you can see from the chart below there does in fact appear to be a correlation between the 4 month lagged XOM price and the Gas/WTI spread. This implies that the recent drop-off in the Gas/WTI spread could place some downward pressure on XOM. However, this is a very simplistic model, and I would strongly discourage anyone from trading on it without significant refinements. There is a lot more than one variable that will affect price; this is simply meant to be a demonstration.

The 4-Month lagged XOM price vs. Gas/WTI spread in the chart below shows that XOM stock price could face some downward pressure in the coming months

Comments

[CrossProfit_:]

Nice article.

Now all you have to do to complete the analysis is breakdown XOM's revenue/profit by source. If you were talking about VLO, it would be easier.

XOM has significant upstream (production) operations that act as a counterbalance to downstream (refining) etc. Also factor in higher NG and byproducts etc. You will find that the situation is not as bleak as you might otherwise conclude from the crack spread alone.

CrossProfit

2008 Mar 25 08:46 AM

[lukezb:]

This does not take into account many small fields, re-worked wells and other sources of crude that do not cost the refining companies the WTI price. There are sources of crude locked in by a contract price for years, and crude assets that are available at a virtually fixed cost.

2008 Mar 25 10:37 AM

[CzechTex:]

I agree in your case to the point that you've presented. However, you don't mention the other restricting variable - consumer's demand/tolerance factor. How high a price will the consumer tolerate prior to reducing demand and therefore, how much net gain will the refiners actually enjoy? Where is the breaking point - $3.50? $4.00? $5.00?

2008 Mar 25 12:35 PM

[Jason Rines...:]

Well, in a recent AAA survey, 67% reported that the current gas price has altered driving patterns. While the higher gas prices don't hurt all that much, I will be driving a Prius by the end of the year and parking the big F150 for trips to the dump only. Those not born with wealth get wealthy by not wasting dollars and recapitalizing them elsewhere to make more wealth. Demand has weakened for gas and if it goes up to $4.00, I expect to see a sharp drop-off in demand this summer. On the bright side, the higher prices are creating better investment opportunity for biodeisel, solar and coal liquification meaning we'll all be better off without the arabs. They don't seem to understand the saying 'don't bite the hand that feeds you'.

2008 Mar 25 01:25 PM

[TA:]

As the above poster indicated, driving habits have been altered already to the point where recent demand was down .7% instead of up 1.5% like every other year.

Gasoline could still easily continue to rise if China has an uninterrupted move towards devolped status so it can bring up the slack.

Plug in hybrids will be commercially available in 2011 from both GM and Toyota among others. I for one will sign up - I don't drive more than 60Km a day so the option of paying for no gas is a good one even if electricity costs increase. We shall see if all the nuke projects pan out to supply what will be required.

2008 Mar 25 02:42 PM

[JeffDB:]

Your analysis is interesting and seems to mesh with the news reports of the refiners being squeezed by the higher oil prices, but soft consumer demand, but the numbers don't quite seem to add up, at least the ratios I am coming up with. Hopefully you can help me see where you are getting the numbers.

According to the Gas Buddies site, there are 42 gallons in a barrel of oil. www.stlouisgasprices.c...

But if I use that figure to try and follow your calculations I come up with these February #s:

$95.35/barrel WTI price
/ 42 barrels
= $2.27/gal
+ $.53 average crack spread
= $2.80 est. retail gas price

But you indicated that the retail price was $3.078 which amounted to a $0.00 spread.

Working backwards from your numbers it would seem that the gallons per barrel should be:

$95.35/$3.078 = ~ 31 gallons per barrel?

Are you subtracting out some of the other products (ie. asphalt) or using some other formula to come up with the gallons per barrel figure?

Thanks for any help you can provide.

2008 Mar 25 10:09 PM

[TM:]

User 168113, You are correct the ratio we used for oil barrels/gallons was 31 not 42. As you mentioned not all 42 gallons in a barrel are used to produce oil, so we calculated on average what percent of a barrel was used for fuel (this included diesel and may have been a mistake) However, if you did use 42 as the benchmark, the magnitude of the spread would be slightly less, and imply a gas price of around $3.50 vs $3.96 over the next couple of months, but since the entire barrel isn't used for gas production we did not feel this would be accurate. Important to note is that in either case there would be no change to the shape of the XOM price to GAS/WTI spread chart. Hope this helps!

2008 Mar 26 03:33 AM

[JeffDB:]

Thank you Tom. That does help.

Thanks too, for giving the Energy Information Agency as your source. They have some useful data there.

2008 Mar 26 08:24 AM

[User 28329:]

What you arent considering is that gasoline inventories are rising and that you are looking at WTI prices that many people are overpriced due to speculation. One shouldnt comparitive analysis to prices that are not at true market value. Hence look at the housing markets.

2008 Mar 26 09:37 AM

[Energy:]

I appreciate the sincereity of the author, but there are a number of issues with this article and the results are quite misleading.

Futher, the article does not address the ever important concepts as to why cracks have fallen so hard, and why they are not likely to return at a rapid pace anytime soon. First, the refining cycle has been pushed too far by artificial demand pulls by MTBE phase-out, desufurization, etc. that are no longer prevalent.

Second, aggregate distillate inventories are the highest in well over a decade with deseasonalized demand down 5% YoY, causing the wholesale rack price to push while the price of crude is in a pull. We are seeing the same thing in Singapore "dirty" cracks, kerosene cracks, and heating oil cracks.

As for the comparison between XOM and cracks, its a strange analysis since only 23% of XOM's cash flow is from downtream activities and does not make sense. The R&M index peaked over a year ago, making the arbitrary correlation btw XOM and cracks spurious at best.

2008 Mar 26 12:51 PM

[CrossProfit_:]

Energy,

Nice writing style, clear and concise.

Perhaps you would like to write an article explaining this so that the average reader understands the relationships. Also you may want to include a breakdown of revenue/profits by source for let's say XOM and VLO and show the stark contrast.

CrossProfit

2008 Mar 27 01:46 PM