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Here is an interesting article about the where's and why's of oil and ultimately petrol prices.
Here is an interesting article about the where's and why's of oil and ultimately petrol prices.
No help for gas buyers -- or oil investors
Rising oil prices and increased refinery costs mean gas prices will keep going up. Yet record profits mean little to investors, since companies don't have a good place to reinvest the cash.
By Jim Jubak
Gasoline prices are likely to continue rising, and it's not just because crude oil prices have risen above $75 a barrel.
Oil refineries, which usually buy their oil at a price below that headline price, have seen their discounts virtually disappear. So the price they pay for oil is up twice -- once because the headline price of oil is higher and a second time because their discounts have just about vanished. You can bet that those two price increases will be passed along to anyone filling up at the gas pump.
Very little oil actually trades at the number that shows up in the headlines. That number represents the price of the futures contract, an option to buy oil in the future, on a specific grade of light sweet crude oil. So, for example, on July 16, when the headline number read $74.15 in the futures market, in the cash market the prices for two widely used benchmarks, West Texas Intermediate and Brent crude from the North Sea, traded at $74.16 and $79.73, respectively.
Oil prices vary widely from there. On the same day, two other U.S. grades of crude, Louisiana Sweet and West Texas Sour, traded at $80.26 and $70.06 a barrel, respectively.
That's a big swing from $80.26 to $70.06. About 15%.
Europe has its own grades with varying prices ranging from Forties at $80.53 to Urals-Mediterranean at $77.68.
And so does the Middle East. Crude from Saudi Arabia sells as Extra Light, which sold as of July 16, and Arab Light, Arab Medium and Arab Heavy, trading at discounts to the Brent benchmark of $3.20, $4.90 and $6.60, respectively, a barrel.
All together there are about 160 traded grades of crude oil, each with its own price.
Why all the different prices? Three reasons, really. First, the closer the crude is to the refinery, the lower the transportation cost and the more valuable the oil. So Louisiana Sweet sells at a premium because it is produced near the big cluster of refineries in Louisiana and Texas.
Second, some crude oils are more difficult to refine, and not all refineries can handle these grades. The more sulfur in an oil and the more viscous (thicker) it is, the harder it is to refine. Crude oils such as West Texas Intermediate and Nigerian Bonny Light, which are low in sulfur and viscosity, are easier to refine and sell at a premium. Turning the heavier parts of the heavy grades of crude into marketable products often requires very high temperatures and the addition of catalysts. The lighter hydrocarbons that will become propane, butane and gasoline when refined boil at lower temperatures and require less energy in processing.
Third, and most importantly, when refined some crude oils yield more of the most valuable lighter products such as gasoline and less of less valuable products such as heating oil. Crude oil is actually made up of a variety of different hydrocarbons that are separated during the refining process. Typically, about 70% of the volume of light sweet grades of crude oil can be turned into gasoline and diesel fuels. That yield of valuable light products drops to about 50% for heavy sour crude oil grades from the Persian Gulf.
So you can see why light sweet oil should sell at a premium. And why refiners look for a discount when they buy heavy sour oils.
Normally.
Why it's different now
But these aren't normal times. The nasty civil war in Nigeria's major oil-producing region, the Niger River delta, has cut 700,000 barrels a day from that country's production. Not just any 700,000 barrels a day either, but 700,000 barrels a day of premium light sweet crude.
The result -- added to the decline in the mature fields of the North Sea and the United States that also produced lighter grades of crude -- has been a supply crunch so severe that it has erased much of the normal discount on heavy sour grades of crude. Arab Extra Light now sells at a premium to the OPEC benchmark price of all Middle Eastern oil. In the first week of July, the discount for Arab Light, which makes up the biggest part of Saudi production, shrank to $4.90 a barrel and then continued to fall to $3.20 a barrel the following week. That's the lowest discount since late 2004. On average the discount was $6 a barrel in 2006.
Heavier grades, such as Arab Heavy, have seen discounts shrink, too.
This creates a nightmare scenario for anyone who buys gasoline. Shrinking discounts give oil refiners a legitimate reason to pass on rising costs in the form of higher prices. But because the cost structure behind the final retail price of gasoline is completely opaque, consumers have no way of knowing if the higher price at the pump is justified by an increase in crude prices and a drop in heavy crude discounts or simply oil-company gouging.
Certainly with demand for gasoline continuing to grow even as prices at the pump soar, refineries have no reason to cut prices. Refinery profit margins are running about three times above their average for the last three years and profit margins continue to climb. Margins at the beginning of June were about double margins in the first quarter. Refinery profits hit a record in 2006 and look headed to beat that record in 2007.
No new U.S. refineries
Don't look for any relief at the gas pump from U.S. refiners putting some of those profits to work by building new refineries. U.S. refiners are expanding capacity by upgrading existing refineries, a capacity creep that has added an average of about 1% to industry capacity for the last few years, according to Oppenheimer & Co. (OPY, news, msgs). But no new refinery has been built in the United States since 1976.
There is new refining capacity being built elsewhere in the world -- in Saudi Arabia, China, Egypt and Qatar, for example. That will eventually add enough capacity to the global gasoline market to at least slow the rise in prices at the pump. But painfully enough for U.S. consumers, that construction of new refineries elsewhere pretty much guarantees that very few refineries will be built in the United States. If refiners haven't broken ground already, they're not likely to do it now -- just in time to get whipsawed by new capacity in the Middle East already under construction that will get into production first.
New capacity elsewhere should give U.S. drivers some relief in about five years -- if the cost of importing more gasoline from overseas doesn't more than negate lower prices from rising supply. Gasoline imports to the United States have climbed by 60% over the last 10 years. That trend isn't about to reverse.
I'm certainly not a big fan of this scenario when I fill up at the gas station. But all these profits don't fill me with joy as an investor, either.
I don't want to pay a high price for current profits if the company I'm buying a piece of doesn't have a profitable place to reinvest today's money. Without that reinvestment, I'm buying an annuity at growth-stock prices.
Oil is one of the few industries still built on a 19th-century model, where one company handled everything from drilling to refining to gas-station sales. That’s why consumers are so quick to blame Big Oil for high prices, argues MSN Money’s Jim Jubak.
The oil industry is stuck in exactly this tight spot. Oil companies are generating record profits -- but they don't have a good place to put those profits back to work. A big share of today's oil exploration and development capital expenditures are unlikely to earn back a reasonable return on the money invested. The prices paid for today's assets are too high, the costs of development are rising too fast and the risk that politics will prevent full production in the future is too great. That's why you see companies across the industry buying back shares or increasing dividends and waiting – hoping, really -- that the price of investing in future production growth will fall.
The more profitable an oil company is, the bigger the problem. If an oil company earning an 8% return on its capital can find a project that will pay back 10%, that's a win. But if the oil company is earning 24% on its capital, as ExxonMobil (XOM, news, msgs) is right now, a project with a 10% return is a complete nonstarter.
Look for reinvestment opportunity
The challenge for today's investor in oil stocks -- besides looking past the anger we feel at these companies personally -- is finding companies that have big opportunities for reinvesting today's cash. Devon Energy (DVN, news, msgs), with big new fields to drill and develop, and Apache (APA, news, msgs), with a steady supply of declining fields to reinvigorate, both fit that description -- and that's why they're in Jubak's Picks.
Rising oil prices and increased refinery costs mean gas prices will keep going up. Yet record profits mean little to investors, since companies don't have a good place to reinvest the cash.
By Jim Jubak
Gasoline prices are likely to continue rising, and it's not just because crude oil prices have risen above $75 a barrel.
Oil refineries, which usually buy their oil at a price below that headline price, have seen their discounts virtually disappear. So the price they pay for oil is up twice -- once because the headline price of oil is higher and a second time because their discounts have just about vanished. You can bet that those two price increases will be passed along to anyone filling up at the gas pump.
Very little oil actually trades at the number that shows up in the headlines. That number represents the price of the futures contract, an option to buy oil in the future, on a specific grade of light sweet crude oil. So, for example, on July 16, when the headline number read $74.15 in the futures market, in the cash market the prices for two widely used benchmarks, West Texas Intermediate and Brent crude from the North Sea, traded at $74.16 and $79.73, respectively.
Oil prices vary widely from there. On the same day, two other U.S. grades of crude, Louisiana Sweet and West Texas Sour, traded at $80.26 and $70.06 a barrel, respectively.
That's a big swing from $80.26 to $70.06. About 15%.
Europe has its own grades with varying prices ranging from Forties at $80.53 to Urals-Mediterranean at $77.68.
And so does the Middle East. Crude from Saudi Arabia sells as Extra Light, which sold as of July 16, and Arab Light, Arab Medium and Arab Heavy, trading at discounts to the Brent benchmark of $3.20, $4.90 and $6.60, respectively, a barrel.
All together there are about 160 traded grades of crude oil, each with its own price.
Why all the different prices? Three reasons, really. First, the closer the crude is to the refinery, the lower the transportation cost and the more valuable the oil. So Louisiana Sweet sells at a premium because it is produced near the big cluster of refineries in Louisiana and Texas.
Second, some crude oils are more difficult to refine, and not all refineries can handle these grades. The more sulfur in an oil and the more viscous (thicker) it is, the harder it is to refine. Crude oils such as West Texas Intermediate and Nigerian Bonny Light, which are low in sulfur and viscosity, are easier to refine and sell at a premium. Turning the heavier parts of the heavy grades of crude into marketable products often requires very high temperatures and the addition of catalysts. The lighter hydrocarbons that will become propane, butane and gasoline when refined boil at lower temperatures and require less energy in processing.
Third, and most importantly, when refined some crude oils yield more of the most valuable lighter products such as gasoline and less of less valuable products such as heating oil. Crude oil is actually made up of a variety of different hydrocarbons that are separated during the refining process. Typically, about 70% of the volume of light sweet grades of crude oil can be turned into gasoline and diesel fuels. That yield of valuable light products drops to about 50% for heavy sour crude oil grades from the Persian Gulf.
So you can see why light sweet oil should sell at a premium. And why refiners look for a discount when they buy heavy sour oils.
Normally.
Why it's different now
But these aren't normal times. The nasty civil war in Nigeria's major oil-producing region, the Niger River delta, has cut 700,000 barrels a day from that country's production. Not just any 700,000 barrels a day either, but 700,000 barrels a day of premium light sweet crude.
The result -- added to the decline in the mature fields of the North Sea and the United States that also produced lighter grades of crude -- has been a supply crunch so severe that it has erased much of the normal discount on heavy sour grades of crude. Arab Extra Light now sells at a premium to the OPEC benchmark price of all Middle Eastern oil. In the first week of July, the discount for Arab Light, which makes up the biggest part of Saudi production, shrank to $4.90 a barrel and then continued to fall to $3.20 a barrel the following week. That's the lowest discount since late 2004. On average the discount was $6 a barrel in 2006.
Heavier grades, such as Arab Heavy, have seen discounts shrink, too.
This creates a nightmare scenario for anyone who buys gasoline. Shrinking discounts give oil refiners a legitimate reason to pass on rising costs in the form of higher prices. But because the cost structure behind the final retail price of gasoline is completely opaque, consumers have no way of knowing if the higher price at the pump is justified by an increase in crude prices and a drop in heavy crude discounts or simply oil-company gouging.
Certainly with demand for gasoline continuing to grow even as prices at the pump soar, refineries have no reason to cut prices. Refinery profit margins are running about three times above their average for the last three years and profit margins continue to climb. Margins at the beginning of June were about double margins in the first quarter. Refinery profits hit a record in 2006 and look headed to beat that record in 2007.
No new U.S. refineries
Don't look for any relief at the gas pump from U.S. refiners putting some of those profits to work by building new refineries. U.S. refiners are expanding capacity by upgrading existing refineries, a capacity creep that has added an average of about 1% to industry capacity for the last few years, according to Oppenheimer & Co. (OPY, news, msgs). But no new refinery has been built in the United States since 1976.
There is new refining capacity being built elsewhere in the world -- in Saudi Arabia, China, Egypt and Qatar, for example. That will eventually add enough capacity to the global gasoline market to at least slow the rise in prices at the pump. But painfully enough for U.S. consumers, that construction of new refineries elsewhere pretty much guarantees that very few refineries will be built in the United States. If refiners haven't broken ground already, they're not likely to do it now -- just in time to get whipsawed by new capacity in the Middle East already under construction that will get into production first.
New capacity elsewhere should give U.S. drivers some relief in about five years -- if the cost of importing more gasoline from overseas doesn't more than negate lower prices from rising supply. Gasoline imports to the United States have climbed by 60% over the last 10 years. That trend isn't about to reverse.
I'm certainly not a big fan of this scenario when I fill up at the gas station. But all these profits don't fill me with joy as an investor, either.
I don't want to pay a high price for current profits if the company I'm buying a piece of doesn't have a profitable place to reinvest today's money. Without that reinvestment, I'm buying an annuity at growth-stock prices.
Oil is one of the few industries still built on a 19th-century model, where one company handled everything from drilling to refining to gas-station sales. That’s why consumers are so quick to blame Big Oil for high prices, argues MSN Money’s Jim Jubak.
The oil industry is stuck in exactly this tight spot. Oil companies are generating record profits -- but they don't have a good place to put those profits back to work. A big share of today's oil exploration and development capital expenditures are unlikely to earn back a reasonable return on the money invested. The prices paid for today's assets are too high, the costs of development are rising too fast and the risk that politics will prevent full production in the future is too great. That's why you see companies across the industry buying back shares or increasing dividends and waiting – hoping, really -- that the price of investing in future production growth will fall.
The more profitable an oil company is, the bigger the problem. If an oil company earning an 8% return on its capital can find a project that will pay back 10%, that's a win. But if the oil company is earning 24% on its capital, as ExxonMobil (XOM, news, msgs) is right now, a project with a 10% return is a complete nonstarter.
Look for reinvestment opportunity
The challenge for today's investor in oil stocks -- besides looking past the anger we feel at these companies personally -- is finding companies that have big opportunities for reinvesting today's cash. Devon Energy (DVN, news, msgs), with big new fields to drill and develop, and Apache (APA, news, msgs), with a steady supply of declining fields to reinvigorate, both fit that description -- and that's why they're in Jubak's Picks.
