March 10, 2004

Do the financial markets reflect economic conditions, or do they cause them?  That question again is being raised as oil prices and inventories both rise sharply as the heating season is in its final weeks. 

Last year, when oil prices exceeded $55 per barrel, open energy contracts on the major commodity exchanges also spiked to more than 85,000.  That both collapsed soon after suggests that more speculation than reality was contained in that price spike. 

As oil prices again climbed past the $50 barrier last week, open contracts took a one week jump of 22,548 to reach 54,176.  Certainly, the contract purchases, mainly from hedge funds, did not restrain the oil price rise, but were they the primary reason why prices rose?

Every Wednesday, the energy department releases a publication on oil markets showing price patterns and inventories in the U.S. The recent and continuing cold weather not surprisingly is drawing down heat fuel stocks.  They are below last yearís levels and fell 1.8 million barrels last week. 

Moreover, Europe is suffering a very significant cold spell.  This means that their refining capacity is fully employed to provide heating fuel for their citizens.  Normally, Europe has excess refining capacity in the winter that can be used to meet heating shortfalls in the U.S.  Not this year. 

Historically, another month of heating fuel inventory reductions occur before the driving season causes gasoline to become a greater concern for refiners.  There is no question that stocks of heating fuel are low around the world.  In the U.S., they barely are in their ten year range of holdings for this time of year. 

Nevertheless, natural gas supplies remain ample.  At nearly 300 million barrels, U.S. petroleum inventories are near the high end of their ten year range, and they grew last week. 

While refineries were pushing for heating oil, they had to also produce gasoline.  (The product mix can be altered by refiners, after some significant adjustments, but more gasoline than heat fuel is produced even when the mix is for maximum heating fuel.)  As a result, gasoline stockpiles are 22 million barrels above last year and well above stocks held at this time of year in normal times.  Indeed, gasoline inventories are near a record about two months before the driving season begins. 

Yet, buying pressure on gasoline contracts have been driving up oil prices.  The latest worry is not the heating season (although this winter is hanging around longer than we would like).  Nor is it the continuing decline in fuel economy as SUVs supplant passenger cars on our highways.  No one seriously believes that Russia can produce a million barrels per day of oil more than a year ago, as they claim.  But the million barrel expansion in capacity by OPEC probably will happen. 

Chinaís demand continues to surge, but needs should be for an additional half million barrels per day, not the million daily increase of a year ago.  Europe already is showing slower growth and the world economy probably will grow nearly a percentage point slower with less energy needs per percentage point of growth than a year ago. 

And, if everything breaks right, we might even have more energy production supplied by the U.S. and Iraq. 

So, why are oil prices rising, except for the speculation?

The speculatorís answer is refining capacity.  Refineries are not clean industries.  No new refinery complex has been built in the U.S. in the past 25 years.  When refineries shut down for maintenance prior to making the adjustments from heating maximization to massive gasoline production, problems sometimes develop.  An Indiana refinery caught fire last week, and more of these kinds of stories will surface in the next month.  A refinery in Houston currently is completely shut down (that Indiana refinery was operational even before the fire hoses were repacked).

Now, you do not need to build a new complex to get more production out of refineries.  In the past three quarters, production in the U.S. petroleum and coal sector expanded 4 percent.  While capacity utilization rose to 91.9 percent, well above historical norms, capacity did expand near the 1.2 percent average of all capacity growth for all industry. 

Nevertheless, the growth of utilization indicates that little margin exists to absorb operational shutdowns, fires or even shutdowns to change mix to comply with environmental protection agency clean air requirements by locality.

Just as speculators last year bet that the absence of crude oil production capacity would lead to some price increasing conditions, they are betting today that high refinery utilization in old facilities will lead to price surging disruptions.

They were wrong last year in the crude bets.  And I think they will be wrong again this year.  But I understand why they are making their market moving bets.   

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