Kloza: The Lowdown On Energy Pricing

This post is from guest blogger Tom Kloza. Tom is Chief Oil Analyst at OPIS (Oil Price Information Service) and has his own blog. He has been writing about downstream oil markets since 1975 and was among the founders of OPIS over 25 years ago.

Not many answers are being clearly provided in the financial markets these days, but let me again take a shot at answering some questions related to energy pricing. Some are quite easy. Here goes:

Q. How low can crude oil prices go?

A. When markets have this much momentum, they generate their own atmosphere (much like Orson Welles did) and that is what is happening with crude. I’ve heard some oil production CEO’s, research mavens, and analysts say that $60 bbl is the floor. That may be the case but markets always overreact, and in the electronic age, they do not wait. Right now, prices are anticipating the worst possible scenario and that brings all sorts of heretofore unreasonable numbers into play. But my instincts say that somewhere between today’s $75 bbl price and $50 bbl represents the basement.

Q. Where is Boone Pickens and how is he doing?

A. I haven’t heard much from Boone since he prophesied that oil prices wouldn’t go “much below” $100 bbl. That was about $26 bbl ago, so he probably is contorting his face much like Dallas Cowboys’ owner Jerry Jones did last Sunday.

Q. Where will retail gasoline prices go?

A. It’s a lay-up to suggest that nationwide retail prices will be below $3.00 gal by Halloween. My sense is that Halloween weekend 2008 will see year-versus-year comparisons that show most Americans paying less for gasoline than they did in 2007. That puts us on course for something less than $2.90 gal by Devils’ Night, always a big holiday in Detroit.

Q. Isn’t that good for the economy?

A. It would be good if we achieved this via a strong energy policy, conservation, or some sort of dynamic technological break-through. But we’re achieving this 2008 weight-loss via illness. The economy is quite sick and that’s why demand is down by nearly 10% from the same days in 2007, and that is the major, if not singular, cause of the cheap gasoline effect.

Q. The last time crude was around $75 bbl, the nationwide gasoline price was much lower. Why the difference this time around?

A. Be patient. Crude oil closed at $75.08 bbl on September 4, 2007 or very close to today’s settlement price of $74.54 bbl for WTI (West Texas Intermediate or light sweet crude oil). On that day in 2007, the average retail price was $2.78 gal.

Remember that we’ve endured several Gulf Coast hurricanes that significantly cut gasoline supplies to a huge swath of the country. And also recollect that like politics, all gasoline prices are local. Wholesale supply has been relatively tight in the southeast, in the Chicago area, and on the West Coast but a 10% demand cut will lead to more comfort for end-users, and pain for refiners.

There have been many occasions of disconnect. We saw retail gasoline prices of $3.12 gal (on average) in June 2007 when crude oil was worth less than $65 bbl. In that case, demand for crude was modest because of refinery woes, but gasoline demand was strong and worries about finished products’ supply were paramount.

Think about it this way. Steel prices have dropped appreciably in the last 100 days, but you don’t see the price of cars going down. The dynamic that shapes the raw materials’ cost is different from the dynamic that shapes finished products. Stop the whining about gouging or collusion - - it’s not happening. Work on fixing the problem related to energy supply and consumption - - stop worrying about fixing the blame.

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Q. Okay, so if crude goes to $70 bbl, or $65 bbl, etc, what would you expect at the pump?

A. You can count on gasoline fetching a very small premium to crude oil in the next 90 days or more. That means that a crude oil price level of $70 bbl probably translates to retail gasoline prices of $2.75 gal or less; a crude price of $65 bbl extrapolates to perhaps $2.50-$2.75 gal; and a crude price of $60 bbl equates to something under $2.50 gal.

If these prices seem like a distant memory, check the historical record. The last time we saw a crude oil close of below $50 bbl wasn’t that long ago - - it happened on May 24, 2005 - - -and retail prices were at $2.12 gal then.

Q. What sort of mathematical models have you used to come up with such precise figures?

A. I have pulled these numbers out of my .. .er, my astute knowledge of market psychology, and the fundamentals of petroleum refining, distribution, and downstream tax charges and typical profits.

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  • Q. What about heating oil? Would this be a good time to lock in my heating season needs?

    A. It’s probably not a bad time. Four months ago, it looked like retail heating oil prices would average close to $5.00 gal this Winter. Now, customers can find companies that will lock them in at a price closer to $3.00 gal. The recession will mean that low inventories of this product will be the norm, rather than the exception, so spikes could occur with little notice.

    Q. How does this swoon measure up in historical terms?

    A. As I write this, I see November WTI crude trading for as little as $73.55 bbl in after hours’ trading. Remember that it traded for over $147 bbl in the second week of July. In other words, it descended today to a level less than half the peak price witnessed less than 100 days ago. Commodities’ trading is for people who like Baccharat, and not for the nickel slots players.

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