Gasoline, Diesel, and Oil
Adam Hamilton, May 9th, 2008
Adam Hamilton: Gasoline, Diesel, and Oil
Gasoline, Diesel, and Oil
by Adam Hamilton
Gasoline, usually taken for granted, is weighing heavily on consumer sentiment today. In the States, the AAA just reported that retail gas soared to an average of $3.65 per gallon nationwide! This all-time record high is motivating Americans to drive less, drive slower, and migrate to more efficient cars to save fuel.
As a student of the markets, I find gasoline fascinating. The impact of its pricing creates far-reaching ripples throughout the entire economy. And since transportation is such a basic necessity of life, everyone monitors gas prices on a regular basis. It is fun to watch and analyze such a widely-followed market.
Like every other American, I've marveled at prices at the pumps in recent weeks. It is hard to believe that retail gas briefly edged under $1.00 a gallon in late 1998! That idyllic world, driven by $11 oil, is never going to return. Quite the contrary, odds are gasoline prices are heading considerably higher soon.
Refined from crude oil, gasoline prices have been lagging their progenitor for the better part of a year now. This is just killing oil refiners, who can't even hope to earn profits in such a hostile environment. Many of their stocks are trading near 52-week lows, they've just been slaughtered. The carnage in this sector is amazing. This is rather ironic since retarded politicians are blaming oil companies for high gas prices.
In the free markets, if something can't be produced for a reasonable profit then soon it will no longer be produced. This truism of capitalism even applies to such a capital-intensive industry as oil refining. Refiners will cut back on zero-margin gasoline production, which will reduce gasoline supplies, which will then drive gasoline prices higher to catch up with crude oil. Gas prices have only begun their march higher!
As a consumer, I'm sure this really irritates you. I don't like it either. But as investors and speculators we must strive for total neutrality on all prices. We shouldn't care one bit if a price is likely to rise or fall. Instead of wasting effort fretting, all our energy should go into figuring out how to game the trend for profits. The low-gasoline-relative-to-oil anomaly we see today will likely prove to be a great trading opportunity.
Understanding the historical relationship between oil and gasoline prices is the key. As I studied this, I decided to throw in diesel too. Boiled out of raw crude oil lower and hotter in the fractionating column than gasoline, the broad economic impact of rising diesel prices may ultimately rival that of gas prices. In both cases, the new $100+ oil world will radically change longstanding notions of "normal" fuel prices.
This first chart compares wholesale gas and diesel with oil over the past decade to establish a baseline. Today's low-gas-price anomaly is difficult to perceive until you understand how gas and oil have interacted in the past. The ratios between oil and gas, and oil and diesel, are also rendered in the background.
Gas and diesel are so highly correlated with crude oil that the latter's black line is nearly covered in this chart. Over this decade-long span encompassing the entire secular oil bull, the correlation r-squares are stupendously high. Gasoline's r-square with oil ran 95.7% on a daily basis while diesel's was even better at 98.6%. This means that 95.7% of daily gas-price action and 98.6% of diesel's was directly attributable to oil price action.
This is crucial to understand, that motor fuels always eventually follow oil. There can be short-term supply-demand differentials that drive temporary decouplings, but in the end oil is king. So if oil doesn't correct sharply soon, then gasoline will inevitably climb until it adequately reflects the expenses of producing and delivering it in a $100+ crude world. There is simply no other economic option.
The best example of a temporary decoupling was the legendary Katrina spike in gasoline in late August 2005. As that wicked storm ripped through the heart of oil refining in the US, refineries responsible for 10% of national gasoline consumption went offline. It was an unprecedented gasoline supply disruption.
In the 5 trading days ending September 1st, 2005, wholesale gas soared 65.7%! But in the 5 days after, it plunged 34.6%. The net 10-day gain surrounding Katrina was just 8.4% to $2.05 wholesale. Since oil prices didn't rise anywhere near sharply enough to support such a gas parabola, this gas spike quickly collapsed.
But today, despite what American consumers and our brain-dead politicians want to believe, the opposite has happened. Oil has been over $100 continuously since late February, 49 trading days! With such a long duration, this is far more than a speculative spike. Real global fundamentals are driving the lion's share of it. World oil demand is growing faster than global supplies, and oil is being bid up as a result.
So far gasoline prices haven't fully reflected this oil surge, but they will. The tight Oil/Gas Ratio rendered in these charts makes this crystal clear. Regardless of where oil went between $11 and $124, the OGR didn't break. And it is not going to break today either. You just can't have finished goods priced lower than their feedstock input costs. Other than the goofy airlines, industries will not operate at losses forever.
This chart zooms in on the Oil/Gas Ratio, with the Oil/Diesel Ratio added in the background for good measure. Over one of the most volatile oil and gasoline decades ever witnessed, the OGR remained solidly locked within a tight range. It averaged 35.7, which means a barrel of crude oil cost 35.7x as much as a gallon of wholesale gasoline since 1998 on average. Diesel's average ODR came in very close at 35.5.
The horizontal trend channel of the OGR ran from 27 on the low side to 42 on the high side, with few extra-trend anomalies. I find this 42 resistance number very intriguing. A barrel of crude oil contains 42 gallons. Is there some chemical or economic logic explaining why the top of the OGR range should also be 42? Or is this pure coincidence? Gasoline certainly isn't the only distillate cracked out of a 42-gallon barrel of crude. My woefully rudimentary refining knowledge offers no insights here.
At the top of this OGR trend channel near 42, profits for refining oil are nonexistent. When this happens, refiners will cut back on producing gasoline. They can't do this quickly as refining is very complex, but they can gradually idle parts of their operations for maintenance or switch their focus to other distillates like heating oil or kerosene (jet fuel). This helps to work the temporary gasoline oversupply out of the system until gas prices rise again.
