Valero Energy: The Price of Oil

Jun. 5.08 | About: Valero Energy (VLO)

Oil peaked at $135 and has since retracted to $122. Many speculators want to know just how low oil can go before resuming its upward trend. Gary Gordon has depicted the oil boom as a hoax; "Now the only thing to keep egging the oil boom on in the near-term is the desire of speculators to make money on the long side." 

Aside from refiners, such as Valero Energy Corp. (NYSE:VLO), who desperately need the price of crude to fall in order to improve margins, the price of oil affects everyone both in the commercial and private realm. 

There are three components priced into a barrel of oil;

  1. Fundamental supply/demand 
  2. Currency devaluation
  3. Speculation 

Using $30 as an arbitrary starting point (based on when the three factors synchronized their upward influence), the total escalation amounted to $105. It is readily easy to calculate the currency devaluation contribution by comparing the price of oil in other currencies. For arguments sake, we will peg this at a third (33%). A more difficult task is calculating the remaining two thirds relevant to fundamentals and speculation. By no means should the following be construed as a scientific analysis, but for the sake of simplicity we will allocate a third to each. 

Fundamental Supply and Demand 

Until we have a viable substitution for oil that addresses our transportation needs, it is fairly safe to assume that consumption will increase over the long term. Short term, conservation and other various efforts can slow things down a bit, resulting in pockets of reduced demand. Sticker shock at the pump has resulted in both Europeans and Americans changing their consumption habits. This tends to have a short term effect as any reduction in consumption is gradually replaced with new consumption originating from global growth, combined with the natural waning of the initial shock. The price of crude oil eventually continues its upward climb, based on fundamentals. 

Currently, we are experiencing a pocket of resistance, contributing to the reduction in consumption. This in turn has resulted in the price at the pump being deflated by at least 8%. Needless to say, the refiners are the ones that are absorbing the difference. From a crude oil standpoint, slightly lower consumption has no effect on the major oil exporting countries as they will gladly lower the flow by 3 to 5% and wait for demand to return. 

Conclusion: fundamentals are not currently contributing to lower crude oil prices. This also explains the "Fuel Check" conundrum. 

Currency Devaluation 

Unless the macro economic picture for the U.S. improves by leaps and bounds, it is highly unlikely that the dollar will appreciate substantially vis-à-vis other G7 currencies. A three percent fluctuation has little effect on crude prices other than to cause the price of crude to fluctuate in tandem. 

Conclusion: the dollar may no longer contribute to the upward spiral of crude and is likely to have a stabilizing effect to the tune of three percent. This is approximately $4; resulting in 135 - 4 = 131. 

Speculation 

Assuming that speculation has contributed a third to the current increase in the price of crude, this being a very big assumption, should this factor be totally removed we would have lower crude prices by about $34. Taking into account the dollar and speculation, the best case scenario for lower oil prices would come in at about 135 less 4 less 34 = 97. 

In reality, what we are seeing today is crude in the 122 range as traders are waiting to see what Congress will or will not do. The chances that Congress will remove all speculative contributions in one fell swoop are practically nil. 

Wrapping Up 

From Valero's (VLO) and other refiners' perspective, this temporary pullback in crude prices is a well timed reprieve. VLO needs crude to stay below 120 for several months in order for it (and others) to raise prices at the pump by 8% by yearend. We could see crude pullback to the $105 level, but that's about as low as it will go for now. The fundamentals and the dollar have not come into play in a meaningful way. 

How low it will go now depends on Congress egging* speculators. 

Disclosure: No positions.

*I haven't heard the term 'egging' used in decades. Upon reading Gordon's article, I was inspired to write this confutation. Thank you Mr. Gordon.