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Gasoline Not Driving Oil Price: Goldman Sachs

Izabella Kaminska |special to CNBC.com
Tuesday, 6 May 2008 | 1:54 PM ET

U.S. gasoline is no longer the leading fundamental driving oil markets, according to a report penned by Arjun Murti of Goldman Sachs Tuesday. Murti who famously predicted the dawn of the “super spike” back in March 2005, says this dramatic shift could have meaningful implications for the energy markets.

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As the world’s thirstiest oil market, the health of the U.S. gasoline consumer has traditionally always led oil markets up or down. But Murti’s team, which Tuesday raised oil price targets to between $150-$200 from a $120 for the next 6-24 months, now believes the relationship could be becoming unstuck.

“Gasoline, at least in the short-run, has traded more like an annoying by-product of crude than as its core fundamental driver,” Goldman’s report said. “Weakness in U.S. gasoline margins is not the surprise… the surprise is that the weakness not only has not mattered to crude oil markets, but if anything, is helping to keep oil supply/demand in balance.”

Meanwhile Murti says demand for middle distillates, like diesel, gasoil, heating oil and jet fuel and kerosene is racing up. The difference in prices between gasoline and middle distillates, known as a crack spread, has been exceptionally strong signaling tightness in global refining capacity.

Just a year ago US RBOB spot gasoline prices were worth some $92.60 per barrel while NWE jet was priced in at some $83.3, a discount of over $9 per barrel. Today that same jet fuel is nearly $30 more expensive than RBOB, and has led to U.S. refinery Valero switching production by up to 7 percent from gasoline to gasoil.

Murti attributes that strength to resilient non-OECD demand growth as well as numerous global power problems, all of which have led to increased usage of diesel and gasoil-fired generators.

Underpinning that pressure is a lack of adequate supply growth resulting in needed demand rationing in OECD areas and in particular the United States.

OPEC: No Supply Issue

But Despite fresh record highs in the Nymex WTI futures contract of more than $122, OPEC continues to insist there is no supply issue. They blame the record prices on the role of speculators and a weak dollar. At the same time, weekly U.S. gasoline inventories have been building more than expected nearly week by week, and the dollar strengthened.

But other oil traders agree with Murti’s analysis. It’s tightness in the so-called middle part of the barrel that is sending oil prices higher. U.S. gasoline consumption patterns are no longer relevant.

“High crude oil prices despite weak U.S. gasoline cracks is sending the signal that global oil markets do not need or perhaps want the U.S. gasoline consumer to recover,” Goldman’s report writes.

Adding bearish momentum to the price of gasoline in the medium-term is also the increased production of ethanol. Up to 7 percent of a barrel of gasoline has to be made of ethanol in the United States, further pushing gasoline production into the “by-product” category.

The soaring price of middle distillates meanwhile picture paints a bleak outlook for the airline industry. The industry is already split into two halves by those operators who hedge like Lufthansa and those that don’t like Easyjet, RyanAir and British Airways.

Chris Avery, aviation analyst at JP Morgan, told CNBC those that have decided they can’t bear to hedge at current price levels, perhaps because they feel the price is not reflective of a longer term picture, will be hit hardest by ongoing rises in crude prices. For the time being he says the strength in crack spreads is irrelevant, it’s the underlying price of oil that is causing the biggest pain.

But overall trend is undeniable according to products traders. They say demand for jet fuel can only continue to rise as Europe races to compete with soaring demand from the Middle East & Asia. This they say means strength in middle distillates is likely to remain a long-term rather than short-term trend.

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