Why US Gasoline Prices Remain Elevated

For consumers, the most visible part of the energy industry is the weekly shift in retail gasoline prices at their local gas station. When oil prices spiked earlier this spring, local news broadcasts around the country featured stories about rising gasoline prices, their effect on consumers’ spending habits and the link between oil and gasoline prices.

But oil prices have declined since spring. With the US economy mired in a soft patch, West Texas Intermediate (WTI) crude oil tumbled into the low $80s per barrel at one point in August.

Readers often ask why retail gasoline prices continue to hover around $3.60 to $4.00 per gallon when the price of crude oil remains well off its high. The apparent disconnect between WTI prices and the cost of filling up at your local gas station perplexes many Americans.

At the end of August, the price of WTI was up 18 percent from year-ago levels; retail gasoline prices, on the other hand, have skyrocketed by 36 percent (almost 95 cents per gallon) over the same period. In other words, gasoline prices have risen at about twice the pace of WTI over the past year.

Source: Energy Information Administration

This pie graph breaks down the retail cost of a gallon of gasoline in the first half of 2011. Although these numbers change from month to month and over time, this data offers a reasonable approximation of gasoline costs for the nation as a whole.

Why has the price of gasoline continued to increase despite the decline in the price of WTI crude oil? Pundits have come up with dozens of conspiracy theories to explain this anomaly, including price gauging by local retailers, Wall Street speculators and environmental opposition to new pipelines.  

Many of these theories have no basis in reality.

For example, your local gas station probably makes less than 5 cents for each gallon of gasoline its sells. Moreover, gas stations’ margins tend to decline when gasoline prices rise; most retailers try to keep their prices low to attract customers. If you want to know how your local petrol stations make money, look inside the convenience stores attached to these station; their profit margins come from selling you overpriced coffee, mini-donuts and hot dogs–not from gasoline. Many stations also make money by repairing automobiles and offering oil changes.

If environmentalists successfully blocked the construction of new pipelines to transport oil and refined products, the resulting bottlenecks could produce regional fuel shortages. Likewise, if a particular country or region is short of refining capacity, this will also tend to push up retail gasoline prices.

Although I’m no fan of environmental groups that peddle offer hollow rhetoric instead of practical solutions, environmentalists aren’t to blame for the disconnection between retail gasoline prices and crude oil. US refiners operated at a 90 percent utilization rate in June 2011; only 10 percent of the nation’s capacity was idle that month. From 1993 to 2006, US refinery utilization ranged from 93.1 to 99.1 percent in June. In other words, refinery capacity was less of an issue this summer than in previous years.

In reality, higher oil prices have driven up retail gasoline prices, Many commentators continue to focus on a compromised benchmark for crude oil rather than a varietal that reflects global supply and demand conditions. Let’s compare futures contracts for a gallon of gasoline to the price of WTI and Brent crude oil. (For more on the price spread between, WTI and Brent crude oil and its implications, check out this recent issue of Personal Finance Weekly.)

Source: Bloomberg

Although US gasoline prices have decoupled from the price of WTI crude oil, retail gas prices remain closely correlated to the price of Brent crude oil. When you look at year-over-year price changes, US consumers are actually getting a bit of a break at the pump. Through the end of August, the price of Brent crude oil has jumped by more than 50 percent. Meanwhile, the price that households pay at the pump has increased by roughly 36 percent over the same period. In other words, US gasoline prices have ratcheted up at a slower pace than oil prices.

Why has WTI temporarily lost its relevance as a benchmark of global supply and demand? Historically, when Brent crude oil–which is of slightly inferior quality to WTI–commands a premium to its North American counterpart, shifts in local supply and demand conditions are the culprit.

For example, in 2005 WTI traded at a larger-than-average premium to Brent because of hurricane-related supply disruptions on the Gulf Coast. In early 2009, this price relationship was once again inverted, as oil consumption surged in emerging markets and the US remained in the throes of a crippling recession.

In recent trading sessions, a barrel of Brent crude oil has gone for as much as $30 per barrel more than a barrel of WTI.

This unusual price spread stems from two factors. Local supply conditions at the physical delivery point in Cushing, Okla., have depressed WTI prices: Rising US imports of Canadian oil, higher domestic output from North Dakota’s Bakken Shale and an uptick in ethanol production have prompted pipeline operators to add new lines or reverse the flow of existing lines to carry crude south to Cushing and other refinery centers.

This shift has not only glutted storage facilities at Cushing, but reversed pipelines have also limited flows out of the hub. When an influx of crude oil overwhelms refining capacity, stockpiles build, and the price of WTI declines. This logistical logjam can only be resolved by the construction of new pipelines to move crude oil from Cushing to the Gulf Coast.

Light, sweet crude oils trade at Brent-like prices on the Texas Gulf Coast, but there isn’t enough pipeline capacity to bring oil from Cushing down to the coast to arbitrage away the difference. 

A few companies have proposed projects to develop oil pipelines to connect Cushing to the Gulf Coast, including Enterprise Products Partners LP (NYSE: EPD). The master limited partnership (MLP) recently announced the termination of a joint venture with Energy Transfer Partners LP (NYSE: ETP) to develop such a project. But management also indicated that it remains committed to the project and will continue to solicit commitments from shippers.

Even if one of these proposed pipelines gets the go-ahead and comes onstream, there won’t be enough new capacity to alleviate the glut at Cushing.

Demand conditions haven’t helped matters. As WTI prices tend to reflect the US supply-demand balance, traders have demonstrated their concerns about the domestic economy and the possibility of a second recession by selling oil futures linked to WTI.

Meanwhile, Brent crude oil’s strength reflects a much tighter supply and demand balance for crude oil outside the US. Although much of the scuttlebutt over the past couple of months has focused on the lackluster outlook for the US and developed European economies, the emerging markets continue to drive demand for crude oil, natural gas and coal.

Also note that WTI–not Brent–is out of whack relative to historic norms. Brent crude oil isn’t the only varietal that trades at an unusually high spread to WTI. For example, a barrel of Louisiana Light Sweet (LLS) crude oil commands a roughly $27 premium to WTI. A year ago, LLS traded at a $5 premium.

Meanwhile, Maya crude oil–a heavy, sour oil produced in Mexico–traditionally trades at a $5 to $10 discount to WTI because its high sulfur content makes it more expensive to refine. Today, Maya crude oil goes for about $99 per barrel–a more than $10 premium to WTI.

WTI remains a valid benchmark for refiners who sources oil from Midcontinent producers. (See Bull Market for Refining Stocks.) However, East Coast and West Coast refiners must pay Brent-like prices for crude oil.

That being said, the US has benefited from rising oil output from Canada’s oil sands and the Bakken Shale and Eagle Ford Shale; an uptick in production from these unconventional plays in part explains why gasoline prices have lagged the increase in the price of Brent crude oil. Nevertheless, gasoline prices will continue to track movements in Brent crude oil prices–a better gauge of global supply and demand conditions–more closely than WTI prices.

As I explained in the most recent issue of The Energy Strategist, the price spread between Brent and WTI suggests that investors should focus on names that stand to benefit from this temporary price glitch. For details on how to profit from this trend, sign up for a free trial of The Energy Strategist. If you begin your free trial today, you’ll be able to participate in my next live chat with subscribers. During these popular online discussions, subscribers can ask me questions about specific Portfolio holdings or broader trends.

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