Financial Watch

Politicians are once again ratcheting up the pressure on oil company executives in the hope of alleviating some of the pain occurring at the pump. In the past the mere mention of Congressional hearings was enough to push speculators out of the oil markets and drive prices lower. This time is much different. The run up in gas prices we’ve seen past times since 2003 have been driven by rumors and wild predictions of supply problems. Financial Watch is going to take a look at the reasons behind the most recent run up in gas prices and put forth a few unexpected, but possible events that could take prices well above where they are now.

What is causing Gas Prices to Soar Toward $4

Gas supplies going into the summer driving season are at their lowest point since Hurricane Katrina in 2005. Some of us will remember having to drive all around town trying to find an open gas station in the days following the storm. Although shortages last time were caused by temporary problems in the pipes that transfer refined gasoline from the New Orleans region, this time we are currently seeing supplies run dangerously close to minimum levels necessary to keep the system running.

Politicians are trying to point the blame at the refiners for failing to build a new refinery in the past thirty years or at oil executives for not aggressively investing in new oil fields. Washington should take a look at themselves to find where the problems lie. Regulations currently in place have made it unprofitable and/or extremely unpopular to allow new refiners to be built. The refining company’s only option has been to expand existing facilities to meet growing demand. Not to mention politicians moved up day light savings to promote energy efficiency. Should not be surprising to find it had the opposite impact of driving up demand for gasoline beyond anyone’s expectation. Further keeping the blame on politicians, mandates requiring the use of ethanol in gasoline have proven to be both unproductive and expensive. Consumers are fortunate that corn prices (key component of ethanol) have more off of records set earlier this year.

Politicians in Washington do not deserve all of the blame for pain at the pump. Our international economy is growing at its strongest rate in recent memory. The middle class in China and India are expanding at explosive rates. For the first time in history developing economy consumers hold enough wealth to purchase vehicles and are doing so at a rapid clip. At the present time the U.S. with 4% of the world’s population uses 25% of the world’s oil. This rate is simply unsustainable. We will only see long-term gas prices level off once U.S. consumption of gasoline falls back in line with the nation’s relative level of wealth.

Financial Watch’s last argument for the problems we are now seeing boils down to simple economic theory. In the 1990’s the United States was the sole new source of oil demand. Compound that with a strong dollar and oil prices dropped to levels that made it uneconomic to build new capacity. Only now with prices at $3 is it worthwhile for existing firms to expand upon their capacity. It would take prices rising to $5 to attract new competition into the market. On the encouraging side, liquid futures markets actually makes it easier to attract new competitors if prices substantially rises further. Canada holds vast amounts of untapped oil supplies. At a cost of $40/barrel Canadian oil supplies are 4 times more expensive to reach than light sweet crude in the Middle East that we’ve typically relied upon to satisfy demand.

Scenarios for Gas Prices to Soar Further

Before becoming too alarmed about predictions for $10 gallon/ gasoline remember that this argument lies out a couple scenarios that for the first time since the 1970s it is plausible that there will be a gas shortage in the near term. It would still take extraordinary circumstances still to bring about gas prices at these levels. Financial Watch expects gas prices to modestly trend upward this summer and top out near $4 for regular. However with the demand/supply balance tighter than we’ve seen it for several decades outrageous scenarios are no longer so impossible.

We are currently in an active period for tropical activity. After a record breaking 2005 season, last year’s hurricane season proved to be much calmer. Forecasters this year are calling for a return to above normal activity. Refiners running at peak output delayed major maintenance until this year. With demand up, and supplies down a major hurricane in the Gulf of Mexico could be enough to create prolonged gas shortages. Hurricane Katrina briefly demonstrated how delicate oil infrastructure is within the United States. Faced with a major storm, futures traders would inevitably drive up prices until there was demand destruction. Gas prices moving to $2, $3, and now $4 have shown to be largely inelastic. We are only speculating that $10 would finally encourage sufficient conservation to restore supply/demand balance.

Earlier we mentioned that corn prices fell substantially off record highs set earlier this year. Back a couple of months ago the government came out with results from a farmers survey showing that corn production should come in well ahead of expectations this summer. A drought in the Midwest would be enough to encourage traders to move back into corn positions. Although corn prices are a relatively modest component of gas prices and by itself could not cause prices to soar further.

A strong hurricane bearing down on oil refining infrastructure in the Gulf remains the biggest threat to nation’s gasoline supply this coming summer. Supplies are running abnormally low going into the summer driving season and prices will run higher in the near-term. In the long-term do not expect gasoline prices to retreat much. High prices are beginning to encourage exploration in places the oil companies would not previously go. Increased demand from developing nations will strain the system for many years to come.