Date: 06/13/22
Author: Kent Moors, Ph.D.
There is one facet of the rising cost of crude oil that has unexpectedly escaped attention. This one addresses the spread between the increasing cost of oil and the pain experienced at the pump.
Of course, everybody recognizes that the price of gasoline has reached historic levels in the US. National averages for regular grade have surpassed $5 a gallon for the first time ever, while premium is coming in well above $7 in many states. Gasoline, food, and housing rental costs are registering as the highest ingredients in an inflation rate that is currently worse than at any time in more than four decades.
No, it is not the price of gasoline per se that I want to address today but its curious relationship to the raw material from which it is produced.
Put simply, the unsettling question is this. Why is it that gasoline prices are spiking significantly faster than the cost of the underlying raw material? This is also not a recent matter. As I will note in a moment, it has been ongoing for months.
Later in this analysis I will identify who is responsible. But we need to cover a fair amount of ground first.
The two primary benchmarks for crude prices are WTI (West Texas Intermediate, the standard for futures contracts cut in New York) and Brent (the most often used international yardstick set daily in London). These are the prices you actually see in the corner of your TV screen while the market is trading. Those figures, in turn, provide the latest near-month costs of oil.
But both the WTI and Brent rates you see are actually providing next month’s futures contract prices for the benchmarks, not what it would cost to buy 10,000 barrels (the contract amount) of crude on the open market.
As I have noted on a number of prior occasions, WTI and Brent are “paper” barrels, that is, moves on where investors believe the price of oil will be when the contract expires. They are contrasted to “wet” barrels, referring to the consignments of oil in actual trade.
On any given trading day, there are far more paper than wet barrels exchanging hands. That’s because these are regarded as investments where the player is targeting a profit between where she sets the futures contract and what price is commanded when that contract expires (and the underlying oil becomes a physical wet consignment). The investor has no interest in owning the oil consignment(s) represented by the contracts.
These future contracts will be sold before expiration with options taken out both above and below the strike price to hedge risk. That allows for a plethora of paper barrels to exist without actually affecting the real amount of oil in circulation.
The investor just has to remember not to take a vacation of a lifetime before expiration. That would be an expensive game of musical chairs. Because if you still own the contract at expiration, you own the oil it represents. Coming back home to find thousands of oil barrels piled on your front lawn is not a preferred end to any vacation.
One other preliminary matter of importance. The price set by the paper barrel needs to meet the price commanded by the wet barrel in physical trade. That means as expiration of the futures contract approaches, there needs to be a convergence with what the underlying oil commands in the physical market. That is accomplished by arbitrage, moves on both sides to make the resulting price fit.
Any increased difficulty in reaching convergence signals problems in the oil trading market. Given that arbitrage is increasingly done with an additional level of derivatives (futures contracts, after all, are themselves derivatives on genuine oil consignments), the more a trade needs to rely on elements that are not “real” parts of the transaction, the more suspect that trade becomes.
OK, so much for oil trading 101.
As WTI and Brent provide us with readily available thumbnails, so also do we have a standard on gasoline. This is labeled RBOB (Reformated Blendstock for Oxygenate Blending) for the type of gasoline futures traded. Here we find something interesting.
While WTI has increased 58.49 percent and Brent has risen 54.49 percent Year to Date (YTD) and 13.45 and 13.11 percent, respectively, for the current rolling month daily average (adding the most recent closing value, deleting the earliest), RBOB is up a whopping 84.45 percent YTD, but slightly less (9.69 percent) for the month.
In other words, since January 3 (the first trading day of 2022) an increase in underlying oil prices is not providing most of the rise in gasoline prices.
We have already moved into the high driving season for the year (that traditionally hits on Memorial Day) by which refineries have transitioned the bulk of their production from winter-intensive heating oil to high octane gasoline. Yet that hardly explains the higher gasoline figure consistently since the beginning of the year.
There is also another matter when it comes to refineries calculating the percentage of the cut. That is, oil product producers must determine what fuels are to be emphasized from which parts in the overall process (i.e., what percentage of the raw material crude is to be committed to each draw off stage).
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As I have observed before here in Classified Intelligence Brief, there is a rising problem in the supply of so-called middle distillates, primarily diesel and its knock-on effect to propane (see, “A Diesel Shortfall Once Again Impacts Propane,” Classified Intelligence Brief, May 23, 2022). That means this year there is less leverage in where emphasis is placed at the refining level.
Well, the spread between crude price increases as signaled by WTI and Brent and gasoline levels indicated by RBOB does not seem to be coming from refineries in general. The most direct way to track prices from various refinery cuts is via the “crack spread.” This calculates the costs of crude oil against the prices of major refined products – especially gasoline and heating oil (derived from the same cut as diesel).
There has been only a narrow difference. Additionally, the overall profitability of the refining sector has been noticeably subdued. The best indicator is the VanEck Vectors Oil Refiners ETF (CRAK), an exchange traded fund that tracks refinery performance. That has risen YTD by only 23.69 percent, less than half of the rise in either WTI or Brent.
An individual examination of major independent refiners provides a mixed picture. Most are performing at or below crude. The exception is Valero (VLO) which has advanced 82.15 percent YTD, almost matching the spike in RBOB. On the other hand, Valero is the most diversified refining independent and has the most direct connection to oil product exports to higher profit margin international markets.
There is also not a shortage of supply in the American market that would account for the higher pricing of gasoline. Such a shortfall would result from the fact that the US has been getting by with reduced refinery capacity for years, emphasizing increasing efficiency of operations over expanded capacity. In addition, we will never see another major refinery built in the country, especially in view of the rising market for electric vehicles and expanded environmental regulations.
So, what is the cause of gasoline’s accelerating price and the widening spread against crude oil costs?
You guessed it. It is at the distribution and retail end of the chain. This is the single factor prompting a rise in RBOB futures disproportionate to the increase in crude pricing. In other words, gasoline is being “squeezed higher” from both ends – the futures contracts before delivery takes place and the charge to consumers at the close of the process.
First, RBOB futures contract pricing has been rising quicker than that for either WTI or Brent, despite there being little justification in any detected increase in demand for product. That means the cutters of paper barrels have been pushing the price of gasoline higher for some other reason.
This is not sustainable unless there emerges significant assistance from the other end of the oil product sequence. And here we need to revisit something I developed years ago when serving as an expert witness in a gasoline price gouging case.
I was asked to provide tangible evidence that major retail sellers of gasoline were overcharging consumers. The case involved a suit brought by independent retailers against ExxonMobil, Shell, BP, CITGO, and Marathon.
The court instructed me to come up with a methodology to demonstrate whether an overcharging was taking place and, if so, how it was accomplished.
I focused upon the refinery process controlled by the five companies (that is, their internal refineries providing product directly to their distribution networks and retail outlets), the wholesale pricing charged, and the resulting retail cost at outlets controlled by the five companies.
This is what I reported to the court:
The definitive differentials during periods of either rising or falling gasoline prices are only partly determined by the price of crude oil. It is true that crude oil pricing remains the single largest component in the ultimate price of refined retail product. However, the primary profit derives from the refinery margin (the difference between the cost of processing and the price commanded at the transfer to wholesale).
That differential turns out to be quite significant. My detailed analysis of the relationship between what I refer to as the cost adjusted refinery margin (CARM) and the actual refinery margin (ARM), the difference between these companies’ traditional operations and recent approaches introduced to maximize refinery margin from the control of retail products, results in substantial additions to profit.
The report then provided pages of details on the methodology comparing normal and heightened profits (ARM versus CARM) over an eight-year period, utilized three 100 percent owned regionally distinct and substantial refineries for each of the five companies, weighted to reflect contributions by those facilities to each company’s available oil product runs. Costs incurred were compiled from refinery intake reports and verified by sources at the processing plants, managing tanker hauling and/or pipeline volume, and compared to figures provided by the company in quarterly reports.
On the retail side, 50 company-owned service stations, representing a national and market distribution, were utilized for each company. Retail pricing was collected for each station from the Oil Price Information Service (OPIS) for each of the 418 daily “snapshot” readings utilized in the study over the eight-year period.
Further, the wholesale reference price was obtained via the same data bank, since the OPIS figures also provide the DTW (“dealer tank wagon,” wholesale gasoline on a delivered contract basis to a retail location) and rack (wholesale gasoline sold at a terminal) prices for the same locations.
The report included a 52-page summary of findings to the court and almost 120 pages of figures to support those findings. I subsequently reprinted in digest form these findings in my book The Vega Factor: Oil Volatility and the Next Global Crisis (John Wiley & Sons, 2011), pp. 125-139, 209-303.
The bottom-line finding was this: for the entire eight-year period the companies collected $82.14 billion in excess profits from the refinery margin “gouging” activities, 18.1 percent of total aggregate profits. However, over $73 billion of that was collected during two separate periods of rising prices accounting for less than 18 months total during the entire study period.
My conclusion to the court was:
The issue here is not simply ownership or branding but control over distribution. The volatility during times of increasing gasoline prices advances the profitability to those controlling the process. Volatility does not measure the direction of pricing – only its dispersion (this is because volatility is actually measuring standard deviations and in so doing all differentials are squared – no distinction between cardinal positive and negative numbers, no direction). That dispersion profits those who own the process from refining, through distribution, to retail.
Well folks, little has changed today. Dusting off the methodology and applying it to the same OPIS cross index of retail outlets, revised to reflect current control of product availability for each of the companies, has revealed the same disturbing result. Taking the period from January 3 of this year through June 10, the companies have managed to accumulate an even greater portion of overall profits (31.67 percent) from controlling the process of gasoline availability.
There is always the tendency of politicians to overstate the situation. But the figures are clearly supporting the conclusion that much of the rise in gasoline prices is not simply the result of oil costs or normal refinery operations. This is largely the result of selected companies using the opportunity to pad their internal refinery and distribution margins.
So do not blame the guy who leases or runs your neighborhood service station or even the fellow holding down the fort in the White House. Blame the big boys further up the food chain dictating the prices.
They are at it again.
Dr. Kent Moors
This is an installment of Classified Intelligence Brief, your guide to what’s really happening behind the headlines… and how to profit from it. Dr. Kent Moors served the United States for 30 years as one of the most highly decorated intelligence operatives alive today (including THREE Presidential commendations).
After moving through the inner circles of royalty, oligarchs, billionaires, and the uber-rich, he discovered some of the most important secrets regarding finance, geo-politics, and business. As a result, he built one of the most impressive rolodexes in the world. His insights and network of contacts took him from a Vietnam veteran to becoming one of the globe’s most sought after consultants, with clients including six of the largest energy companies and the United States government.
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