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Thomas Cefalu:
Energy: Why we’re all on crack


Energy prices are moving upwards again. As with many other stories, it is improbable that the MSM will report on this in any satisfactory way. Their energy reporting is largely confined to sound bites: oil company profits, people complaining about how expensive it is to fill up their SUV, dire scaremongering that we are running out of fossil fuels and, lately, global warming proselytizing. And don’t forget to catch Al Gore at the Oscars!

So it’s time for some Citizen Journalism. First things first, let’s observe historical trends in energy. Energy prices are set by MARKETS, which are composed of fallible, impressionable and emotional human beings. So in the short term, markets can be distorted by human traits such as the proverbial greed and fear factors. But humans are also intelligent and analytic. Over the longer term, this will push the markets back to rationality and a more accurate reflection of the balance between supply and demand.

The MSM does not care about supply and demand, preferring conspiracy theories and portrayals of dark forces (preferably Republican) victimizing the average citizen. Fortunately, it only concentrates on a few industries. If it covered more territory, we would have a hard time tracking all the nefarious plots. There would be the Christmas Card Conspiracy, whereby boxes of cards selling for $10 on Dec 1 are dumped on the market at $2 by Jan 1. There would be the Corn Conspiracy, where price gouging forces the price from 8 ears for $1.50 in July to one ear for $2 in February. My favorite would be the SuperBowl Coke Conspiracy, where those large thirstbuster bottles get marked up 30% in the days leading up to the great weekend.

Now most people would view such conspiracies as ridiculous. Common sense tells us that prices respond to demand, and demand is both cyclical and seasonal. During upticks in cyclical demand, prices rise. During downticks, they fall. Seasonal factors affect prices in any cycle.

Crude oil is like any other commodity. Wall Streeters make fortunes in constructing black boxes to analyze its price movements. Occasionally they even make money for their clients! But we don’t need those boxes to understand the basics. Simple charts will do. Chart 1 shows crude prices for the 2000-2006 period. The price is rising during the waning months of the 1990’s boom, then drops sharply during the post dot-com bust and recession. Prices rise again as recovery commences, further strengthened by the speculative runup to the Iraq war. After a brief post-war decline, a sustained price increase occurs during the strong economic recovery of 2004-2006. But this should not be a surprise. America’s consumers were using more energy than ever for their increasingly large cars, homes and the PC-Entertainment Complex: that new array of computers, big screen TV’s, DVD players and other gadgets that have become so prominent a feature in daily life. Industrial demand by America and the rest of the West rose as well.. The booming economies of Asia, especially India and China, were entering a period of unprecedented growth in both their industrial and consumer sectors. You would think that the MSM might connect the dots linking the outsourcing phenomenon, the Asian surge and oil prices, but you would be disappointed. It is apparently a mystery to them, but there is no mystery.

The same applies to the even more dramatic price increases of gasoline and heating oil. The markets have established structures to price those products in response to supply and demand. The key statistic here is the crack spread: the price difference between these products and the crude oil from which they are refined. This spread reflects the extra cost of refining, the overhead of storage and distribution, general demand and the supply of the refinery capacity available to produce the product. The crack spread sits on top of the crude price. When you add the two together, one gets close to actual consumer prices.

There is a great deal of seasonality in demand for refined products. As illustrated in Chart 2, gasoline tends to spike in advance of the peak summer driving season. Heating oil tends to peak in anticipation of the winter weather cycle. Jet fuel follows the fortunes of the airline industry, which was depressed during the first three years covered by the chart and recovering during the last three. Speculative activity can intensify the effect of these objective demand patterns. Just ask any futures trader who has to worry about how weather projections affect his heating oil position.

The last three years of the chart are characterized by increasing volatility with crack prices trending upward. This simply reflects the demand and supply patterns in the market. Just as demand for crude has pushed price levels of the base commodity upwards, demand for the refined products has a similar effect on their prices. Oil producers (think OPEC) and the integrated oil companies benefit from the first; integrated oil companies and other refiners benefit from the second.

Supply factors are especially important for crack spreads, because refinery capacity is basically a constant. If demand for oil rises, producers have the option of producing more crude. But if demand for refined products rises, there is no virtually no option to build more refineries: environmentalists and neighborhood opposition make the permit process very difficult. Prices move upward rapidly at the slightest suggestion of shortages.

Weather events provide the final piece to the puzzle. Refinery capacity is concentrated in coastal areas of the US, most of which are vulnerable to hurricanes. The Florida hurricane epidemic in 2004 was the precursor to the “perfect storms” of 2005, when Hurricanes Katrina and Rita knocked out refineries and related infrastructure, including port facilities. Increasing demand and falling supply produced record prices for the refined products. The sudden and dramatic impact on jet fuel prices was the last straw that pushed a number of major airlines into bankruptcy.

The rise in energy prices is very explainable - increased worldwide demand for crude, rising demand for refined products and limited capacity to make those refined products. Speculative activity can enhance the price pressures, but supply and demand is the driving force. The price tag for energy is painful, but that’s what happens when we live on crack.

 

Thomas Cefalu is a staff writer of The HinzSight Report. Petroleumworld does not necessarily share these views.

Editor's note: This commentary was originally published by The HinzSight Report, on March 11, 2007. Petroleumworld reprint this article in the interest of our readers.

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Petroleumworld News 03/21/07

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