Apr 24, 2007

Why oil chiefs are feelin' groovy
By Julian Delasantellis

In 1980, Paul Simon sang of a "One Trick Pony", an animal that "does one trick only - it's the principal source of his revenue". These days, the world's major oil companies are a lot like this animal. They do one thing - engineering price rises by restricting gasoline supply through manipulation of oil-refinery output - really, really well and, much like the pony, they make lots and lots of revenue from this activity.

In my April 4 article in Asia Times Online, Crude: Barrels of fun to crack you up, I explained how the rise in prices of world oil products going on at that time was not, as the popular media were then proclaiming, the result of tensions over the 15 British sailors then being held by Iran; it was more the result of the lack of any spare capacity worldwide to refine oil, a condition that, at the very least, the oil companies found serendipitous. Now that the sailors are home, safe and sound in the warm, loving bosoms of their literary agents, you might have expected oil and gasoline prices, if only just for show, to give back some of their March gains.

Not on your life, as all US drivers know. Like vampires, they now fear each new rising of the sun, for it is then they will learn just how much retail gasoline prices have risen overnight. According to the US Department of Energy's Energy Information Administration (EIA), average US retail gasoline prices have risen every week since early February. The national retail average of US$2.876 for a gallon of regular gasoline (75.98 cents per liter), as of the April 16 report, is the highest price since the historical twin peaks of just under $3.10 early last summer and just after Hurricanes Katrina and Rita in the early autumn 2005. The national average masks wide regional disparities; lower in the Midwest, but on the west coast, the average is already at $3.195 (84.4 cents a liter).

But like those of a bad magician at a child's birthday party, the oil companies' tricks are showing. Government-released oil-industry data, along with the oil futures markets, are showing the world just exactly how this trick works - lucky for them the world, as usual, is looking elsewhere.

When the US media report on what's happening in the oil markets, what they are really reporting on is a commodity called West Texas Intermediate. WTI is what is called a commodity benchmark - it's the basis for the crude-oil futures contracts traded at the New York Mercantile Exchange (NYMEX).

When a trader commits to buy, say, 10,000 oil futures contracts, and does not then sell or roll over the contracts prior to one of their monthly expirations, the trader has no intention of having 420,000 gallon pitchers filled with oil delivered to the trading floor in Lower Manhattan. Instead, written into the specifications of the futures contract is a proviso that the seller of the oil must deliver the commodity to the nexus of oil-pipeline connections at Cushing, Oklahoma - from there, the owner of the crude oil can make arrangements for the product to be delivered to and refined at one of the many nearby Gulf of Mexico Coast and Midwest refineries. Europe has its own oil benchmark, Brent Crude, originating out of the oil-drilling platforms in the North Sea, and traded at London's International Petroleum Exchange.

WTI can be refined into a less polluting, "cleaner" fuel than Brent, so it normally trades at a premium of about $1 above what Brent is trading at. However, this year, the reverse is happening, and is happening rather dramatically. On April 10, the premium for Brent over WTI widened to a historical high of more than $6 a barrel.

What's happening here, in the fall-off in demand for WTI and the accompanying surge in Brent, is that the oil companies are becoming so brazen in their attempts to manipulate the markets for petroleum products that it's becoming very, very obvious.

As I noted in my April 4 article, crude oil, by itself, has very little utility. It must be processed, refined, into its usable component products of gasoline, diesel fuel, home heating oil, and jet fuel. The reason WTI is losing relative value to Brent is that it's becoming harder and harder to do that at the traditional networks of refiners that service Cushing. The oil companies have recently shut down so much US refining capacity that there is no place for the crude oil at Cushing to go, no refinery with spare capacity to process it. The massive network of underground oil-storage tanks at Cushing is full, and oil being stored in tanks makes money for no one except the owner of the storage facilities. If you can't refine WTI, there's no reason to buy WTI.

In my April 4 article I demonstrated how oil companies were not building the new refining capacity necessary to meet surging world oil demand; figures from the EIA indicate that they're not even adequately using the US refinery production capability that they already have.

US oil refineries operated at less than 87% of capacity for the first three months of 2007. With the exception of 2006, when production was inhibited by the continuing effects of Hurricanes Katrina and Rita, and the recession year of 2002, that's the lowest average capacity-utilization rate for the first three months of the year since 1992. (Oil companies defend their low early-in-the-year refinery-utilization rates by claiming that they use these months for repairs, for maintenance, and to shift their production mix from winter home-heating-oil blend to summer gasoline blend; be that as it may, it did not prevent US refineries from operating at more than 93% capacity during the first three months of 1998, 92% in 1999, and 91% in 2005.) The refinery capacity-utilization rate reported on February 16 of this year, 85.2%, was one of the lowest weekly rates not affected by Katrina and Rita since the early 1990s.

You could see the workings of the oil companies' trick as it developed. In early January, refinery capacity utilization stood at a healthy 91.5%, and the gasoline crack spread, the crude-oil-to-gasoline price ratio (the crack spread is explored in depth in my April 4 article) that defines the profit to be made from refining crude oil into gasoline, stood at a fairly low $7.154. NYMEX gasoline futures were then trading for less than $1.45 a gallon, the lowest prices for more than a year. It was then, with US gasoline demand still very strong, that the reduction in refinery capacity utilization began; all of a sudden the financial press was full of stories related to various and sundry "accidents" and "repairs" that were causing US refineries to shut down and/or limit production.

By late March, as the Iran/UK crisis began, and as crude-oil supplies at Cushing began to build, NYMEX gasoline futures had risen to $1.95, and the crack spread was near $19, meaning that oil companies were making just under two and two-thirds times the profit on every gallon of gasoline sold that they had in early January. On April 13, gasoline futures topped out at more than $2.20, up more than 75 cents since January. On that day, the crack spread stood at just under $28, meaning that the business of refining oil into gasoline was now four times as profitable as it was just three months previously.

Therefore, is it any surprise that the oil companies have now decided that all those needed "repairs" and "maintenance" can be put off for a while? The most recent report released by the EIA shows that oil refinery capacity utilization now stands at 90.4%, up 5 percentage points from two months previously.

Now that it's so much more profitable to sell the stuff, they might as well make some of the stuff.

With refineries producing this now much more valuable commodity flat-out, it's possible that the worst of the motorists' short-term pain has already been afflicted, but in the longer term, there is no cause for sanguinity. The first of the three big US summer driving holidays, Memorial Day, Independence Day and Labor Day, is still weeks away (May 28); many analysts see a real possibility of mid-to-late-summer US gasoline prices averaging in the mid-$3 range nationally, and closer to $4 a gallon ($1.05 a liter) on the west coast. Until the root cause of these price spikes, the oligarchic nature of the oil distribution and refinery system allowing oil companies to engineer and sustain supply restrictions virtually at will, is addressed, you'll always be reading about something, somewhere, be it Iran, Nigeria, Canada, or Cushing, Oklahoma, that is causing gasoline prices to skyrocket.

Imagine what it must be like to be some young eager-beaver oil-refinery manager seeking to rush his facility back into service before corporate headquarters thinks the time is right. This is the response he might get from the head office, sung to the tune of Paul Simon's and Art Garfunkel's 1966 hit "The 59th Street Bridge Song" (more commonly known as "Feelin' Groovy":

Slow down, you move too fast
You've got to make this shortage last
Hear the consumers' whines and moans
The oil business - it's just so groovy!

Julian Delasantellis is a management consultant, private investor and educator in international business in the US state of Washington. He can be reached at juliandelasantellis@yahoo.com.

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