The selling level of crude oil is traditionally the benchmark that determines the prices of gasoline and distillates when they reach the open market. This year, in a reversal of roles, gasoline futures on the New York Mercantile Exchange appear to be dictating the terms for the price of crude. As a result, this new relationship may be setting the price for crude oil and gasoline at artificially high levels. Traders with exposure to crude and gasoline futures may be subjecting themselves to unnecessary volatility and price risk, whereas refiners like Frontier ( FTO), Tesoro ( TSO) and Valero ( VLO - Get Report) are well positioned to profit from the high energy prices. Reformulated gasoline recently closed at $1.96 a gallon, up more than 27% from its 2007 low of $1.54 on Jan. 18. Crude oil has recently been trading near the $57-a-barrel range, up nearly 14% since the first of the year. A confluence of issues is making this year different for energy traders. First, gasoline demand was high during the first 10 weeks of the year, which generally isn't a period for Americans to hit the open road. U.S. drivers used 9.1 million gallons of gasoline a day from Jan. 1 through March 9, a 2.8% increase over the same period in 2006 and 12.8% higher than the same time five years ago, according to figures from the Energy Information Administration.
Second, inventories of motor gasoline are relatively low for this time of year. U.S. refineries usually ramp up their production of gasoline during March and April ahead of the summer driving season. However, gasoline inventories are 4.4% lower than they were the same time last year. One reason inventories are so low is that weekly draws have been larger than expected this spring. During the first three weeks of March, analysts were expecting 6.4 million barrels' worth of draws. Instead there was a 10.1-million-barrel drawdown -- 58% more than expected. The higher demand for gasoline and larger-than-expected inventory draws are all arriving in a year when North America's refinery system is being plagued by shut-ins and geopolitical turmoil. A major fire in February at Valero's refinery in Sunray, Texas, closed the 170,000-barrel-a-day plant through at least April 1. A fire at Imperial Oil's ( IMO - Get Report) Nanticoke refinery in Ontario seized up a portion of that 118,000-barrel-a-day refinery. Also last month, a leak shut down a 240,000-barrel-a-day Teppco ( TPP) pipeline running from Indiana to Ohio for a few days. Meanwhile, hostage-taking by rebel groups in Nigeria's vast oil fields is reducing that country's exports to the U.S. The EIA reported last week that U.S. refineries are operating at just over 85% utilization, abnormally low for a period when refineries are supposed to be building their gasoline stores. Although most refineries go through maintenance during the early spring, utilization is usually around 90% for this time in March.
Third, crude oil and gasoline futures markets are feeling the aftershocks of a government-mandated change in the chemical makeup of gasoline that occurred in 2004 and 2006. During the changeover, a long-used additive of gasoline called MTBE (methyl tert-butyl ether) was switched out for the cleaner-burning additive ethanol. The change has been both expensive and complicated for refineries. When refineries used MTBE, they mixed it with gasoline at the plant before sending the finished product to the transport terminals that distribute fuel to retail stations. They can't do that with ethanol because ethanol attracts water, which degrades the quality of gasoline. Thus, refiners have had to undertake the expense of retrofitting their terminals so they can add ethanol to basic reformulated gasoline just before it's sold at retail. The ethanol production and distribution infrastructure in the U.S. isn't yet at adequate capacity, according to Max Pyziur, an energy analyst at CPM Group in New York. When MTBE was banned, refineries foresaw delays in the ethanol-mixing process that could have caused gasoline shortages. They reacted by building their stores of gasoline in case something went wrong. This drove up the price of gasoline beyond its historical levels during spring months when refiners normally increase inventories in preparation for the demands of summer travelers. As a result, margins between gasoline and crude oil, sometimes referred to as crack spreads, climbed as high as 60 cents in the spring of 2006, even while refinery utilitization was normal. To calculate the spread, the price of oil is divided by 42 gallons per barrel and then subtracted from the price of gasoline.
"It is still unclear whether the high margins last year were justified by the fundamental data or whether it was un unfounded fear that refiners would not be able to make the conversion in time for the summer driving season," Jim Williams, energy analyst at WTRG Economics in London, Ark., wrote in a report. Traders appear to be relying on historical data from 2004 and 2006 to forecast the price direction for gasoline, according to Williams. These traders aren't accounting for the fact that all U.S. refineries are now retrofitted to use ethanol instead of MTBE. Thus, refiners don't need to keep abnormally large inventories of gasoline on hand, and traders don't need to bid up the price of gasoline as much. Regardless, gasoline crack spreads, which normally rest around 25 cents a gallon, are now approaching 40 cents or higher. (Underscoring the volatility of recent months, spreads plummeted to around 10 cents in less than a week in September.) Analysts at Merrill Lynch confirmed the upward trend in a report released March 19, saying that they were revising their "gasoline crack spread forecast to $20.20 a barrel (48 cents a gallon) from $15.80 a barrel (37 cents a gallon) on the back of stronger-than-expected global light product demand in the transportation and petrochemical sectors and low gasoline inventories in Europe" for the second quarter in 2007.
Independent refineries are now in excellent position to profit from these advantageous crack spreads by buying crude oil cheap and selling gasoline at higher rates. On March 20, Merrill Lynch raised its earnings estimates for Frontier, Tesoro, Valero, Holly ( HOC) and Sunoco ( SUN - Get Report). Frontier, Tesoro and Valero all have buy ratings, whereas Holly and Sunoco have hold ratings. With gasoline crack spreads being this high this early in the gasoline refining season, it won't be surprising if they reach the same levels that they made last spring. Investors should also be prepared for crude and gasoline futures prices to plummet when the summer driving season ends in September. Using 2006 as a guide, gasoline futures reached a summertime high of $2.43 a gallon on Aug. 2, while crude oil topped out at $77.05 a barrel on Aug. 7. On the back end, gasoline fell to $1.44 a gallon on Sept. 20, and crude oil bottomed out at $57.56 on Oct. 11. That's a trading pattern any investor can follow.