Balance theory is (at its simplest) the concept that the relationship between two entities is either positive or negative and a combination of these relationships can be either balanced or unbalanced.
When three people are friends (positive) with each other, the relationship is balanced and sustainable – there should be no reason not to become friends. When three people are enemies (negative) with each other, the relationship is unbalanced and unsustainable, two people should team up and focus their hatred on the third – the enemy of my enemy is my friend.
Hamza Khan, quantitative analyst at explains the significance of the balance theory to the commodity complex, Consider those three people as the consumer, the speculator and the refiner. During the first six years of this decade, the relationship between these groups was positive and balanced, as demonstrated below.
A booming economy meant consumers’ incomes were secure and growing. As yesterday’s chart of the day in illustrated, consumers were comfortable with spending a slightly higher percentage of their income on gasoline and energy every year. Prices at the pump steadily grew above $2.00 and refiners were making 15.93% of that price, with crude oil accounting for 46.85% of the cost, a comfortable margin.
Market speculators looked at rising sales of the Hummer and assumed gasoline demand would remain strong despite higher prices. This held true for several years and the relationship was sustainable. Then the sub-prime crises began in late 2007 and credit seized up, resulting in the graph below.
This graph is unbalanced because speculators and refiners assumed consumers would continue paying high prices at the pump. Consumers were happy to believe that the speculators would lead to an economic recovery quickly, but were unwilling to pay higher prices at the pump.
This refusal created an unsustainable situation in 2008 and refiners could not pass prices on to consumers. Refiners were only earning 3.2% of the $4.062 prices at the pump while crude oil accounted for a whopping 75.80%. This situation was unsustainable and the crude oil bubble popped soon after.
In the aftermath, our triangle was in balance again – consumers had less to spend but gasoline prices were lower at the pump. Refiners still made money because wholesale crude prices were low and speculators were unwilling to let prices rise too high.
As we can see in the above picture of the last ten Januarys, crude oil’s share of the cost of retail gasoline has been steadily rising and refiner’s margins steadily falling. This last January crude oil accounted for 69.1% of the price of retail gasoline. That is massive and it is 1.2 points greater than the share back in January 2008, i.e. when Nymex WTI first traded over $100.
However, since January 2008 (the recession began a month earlier) 8.4 million Americans lost their jobs. As such, two years ago retail gasoline was over $3 (with Nymex crude oil averaging $92.93), this last January Nymex crude averaged $78.40, with retail gasoline around $2.70. Consequently, back then the EIA estimates refiners earned 7.8 cents on the dollar, today they earned only 5 cents… and that was with crude oil below $80. Thus, projects that should WTI head back to $95 and consumers fail to respond (which seems reasonable), then this summer is shaping up to be rather ugly for the downstream side of Big Oil’s ledger!
Stephen Schork is the Editor of and has more than 17 years experience in physical commodity and derivatives trading, risk systems modeling and structured commodity finance.