In 2006, I wrote a series of twenty-five missives that were designed to survey the price momentum in the energy markets, particularly the price increases of crude oil. Each missive was accompanied by some relevant report or article that I had hoped would offer readers additional clarity about the activities in this sector of the economy, as well as insight on the trading markets that affected pricing. (You will not see the third-party materials attached here, but I can make them available upon request.) Today, as crude oil and other commodities demonstrate another solid uptick in pricing, I thought it might be good to revisit just a few of those missives, perhaps to establish some correlations between today’s events and those of a few years ago. –gh
POWER UP #2: 03.28.2006
I was told once that there is a crude formula for determining what unleaded gasoline retail prices will be, just by looking at oil prices: it is something like a $0.03-to-$1 rule.
Here is how it works...
For every dollar in the cost for a barrel of Light Sweet Crude, you should multiply that by roughly three cents. Hence, if we wanted to see the price at intraday trading from today, it would be $66.07 per barrel times three cents. That means the pretax price for unleaded gasoline would stand somewhere around $1.98 per gallon. Add to that the mark-up as it passes downstream, ranging from $0.30, at the low end, to about $0.55 per gallon, and you get a pretax estimate of $2.28 to $2.53 (or so) per gallon. And then, of course, you need to add the sales tax, which in Louisiana is something like $0.28 per gallon (inclusive of the Federal tax). Then presto---gas prices at the pump, somewhere between $2.56 to $2.81 per gallon of regular unleaded gasoline.
Not pretty, huh? Well, that is just the crude formula.
So what are futures, and why are these things so important to the price of anything, especially the price of a barrel of oil? "Futures" is a term that is short for futures contracts, which obligate the holder of the contract to buy or sell a set amount of a commodity like oil or natural gas on a specified day. Hence, a future valuation for the oil or whatever it is set in the present, contingent on the perception of conditions affecting that item in the present and in the time to come. And so, if you are a refiner like Valero (my favorite energy play), and if you are forecasting a price spike, you will buy futures to lock in a price for future delivery of oil. And you will hope that, when the time comes, that set price will have been less than what will be the future price of oil on the spot market.
Now think of that on a grander scale, throwing in all kinds of buyers for all kinds of reasons, all at the same time, from refiners to speculators to who knows--and then you will understand how the herd mentality governs the futures markets and, ultimately, affects our lives at the other end of the product. And as you probably realize by now, the key to success in any market is information, whether good, bad, premature, or incomplete. The guy with the most knowledge, or at least the most perceived knowledge, really sets the pace for these fellows.
This has been a very, very cursory overview, and many details about the processes and strategies for playing the market have been intentionally omitted here. (As a consultant, I charge for that level of knowledge.) However, I hope that this will suffice your understanding of the information in the accompanying AP article. If taken superficially, this article points to a continued rise in energy costs, based on the market's assumption that further geopolitical troubles will hamper supplies ahead of the summer. Hence, it might be easy to see now why our troubled President is walking a very tight rope in the Middle East, particularly with Iran. And it is easy to see why so Americans are paying more at the pump. It is not necessarily a question of supply (yet); for now, it is a question of the availability of that supply, in the face of such impressive global demand.
POWER UP #4: 04.11.2006
In the late hours of the night, while on my way home, I was blown away by something that I saw: a sign denoting premium unleaded gasoline for $2.96! Immediately, the lack of real-world familiarity with that number caused me to wonder how others were going to respond, particularly those who do not watch the markets as closely as I do. Will these new and ever-increasing numbers be enough of a psychological jolt to cause Americans en masse to pay attention now? And if they do, will they over react, and usher in a new recession, by tightening their spending to compensate for higher energy costs, higher insurance costs, higher healthcare costs, higher schooling fees, and so on? Or will they, the resilient (yet often oblivious) Americans, meet $3 gasoline with the same casual indifference as they met $1.10 or two dollars? Was three dollars going to be, as my friend Mark Herman had called it, "a new tolerance threshold"?
In a practical sense, that latter scenario might easily be more probable than all others. Though a much more painful option over the long-term, the world of finance proffers itself as a stop-gap measure for consumer spending and the sustainability of our decadent lifestyles. Americans have innately confronted these rising energy costs with their credit cards as the weapons of choice; they have either elected to finance those high gas purchases or, worse, the purchase of everything else, from food to clothing to leisure, in order to use their cash for gas purchases. Without the option to delay the impact of these costs, by simply financing them over a longer period, Americans might have found the gasoline prices of just a few weeks ago even more difficult to tolerate.
At this juncture, of course, it is important to note that for some Americans the credit option is almost not an option at all. The less affluent will continue to face even more painful choices that their stagnant incomes cannot absorb, and in real dollars, the pressure on their wallets will leave them poorer than ever.
It is often contended that our current constraints are attributable to a number of factors, from global growth to geopolitics to a lack of refining capacity for "dwindling" supplies. All of those are very valid arguments, but no one can deny the role of speculation in the markets. Traders around the world operate a system based on scarcity and limited information, and these are heady days for that lot. For two years now, they have seen weather events that have stunned the world and debilitated production capability. For three years now, these have witnessed the destabilization of the Middle East and, more recently, the rise in oilfield attacks by rebels and terror outfits from Saudi Arabia to Nigeria and over to Indonesia. They've also taken the words of guys like T. Boone Pickens as gospel, and in the face of energy constraints, they've seen governments, with the exception of Brazil, make little success of diversifying their resources. Consequently, to all of this, these traders have turned this into a time for great profits for their investors...That is the only reason why markets can move up over a dollar in one day, sending crude oil prices over $78 per barrel, without real justification or real news to substantiate this climb.
Ask any oilman, what is different today from two years ago, or even eight years ago. Many will not say very much. Production capabilities are increasingly improving with technology, and while there is some question about declining supplies, the prima facia evidence is not yet abundant in the world's oil patches. The era of Daniel Yergin's Hydrocarbon Man seems to be far from its conclusion.
To be sure, there may truly be supply constraints, particularly notable in the ability to deliver refined product to the American consumer. There is also no argument that real demand pressures are even more incipient from new Asia, as the princes of the 21st Century race to take the thrones of global dominance from perches in Beijing or in New Delhi. But adding more froth to the markets today are speculators moving with the tenacity of a herd. And with unconscious acceptance, Americans have become willing to tolerate these unrealistic prices, simply by swapping them away, adding to the largest levels of consumer debt ever seen by a nation.
From this writer's perspective, given these facts, the real problem will not be an irrational rise in market prices and, subsequently, retail prices. The capitalists will always be capitalists, of course--and we, as Americans, historically tolerate that. No, the real problem will be what comes after that. If energy prices sustain at a higher levels, what will happen if a real blow to the gut comes? Hurricane Katrina tested this question: crude prices first shot skyward in London, as the Brits watched the super storm make landfall on the Third Coast. Then New Yorkers and Chicagoans chimed in as limited information and video feeds hit the Internet and television. It was oil at $70! And at the pumps across the country, gasoline prices rose to heights that my generation cannot even remember. Hence, a supply disruption, in the face of already high prices, could easily test the resolve of our economy, as US Energy Secretary Samuel Bodman accurately cautioned an audience last week.
Barring such forces of nature, or even the lunacy of man, traders are still making off like bandits. To put this market into perspective, Light Sweet Crude closed yesterday at $68.74 per barrel, compared to $52.31 a year ago. In August, as Katrina hit, the price hit $70.85, before returning to $69.81 at the close. There is probably no doubt that we will be back there shortly, and what is compelling about that fact is that there has been no "event of merit" to take us there---just the psychology of fear, which will force us all to pay more at the gas pump or tack on ever more debt.
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