Retail Gasoline Is Too High Against Crude, Despite Secular Changes In Market Dynamics

Changes in Secular gasoline and crude still has room for price corrections

Last article “Gasoline Price To Stay Firm Against Crude, Based On Foundational Gasoline Market Dynamic” discussed what appears to be a secular change in petroleum markets. Changes support gasoline pricing, particularly where U.S. became a net exporter of refined products in 2011, first time since 1949. However petroleum remains procyclical in correlating with economic conditions, now global conditions in particular.

U.S. presents an interesting situation in that gasoline futures on NYMEX are showing very high demand, resulting in backwardation. Confusingly, existing backwardation in gasoline is confounded by Energy Information Administration (EIA) data. EIA information reveals a counter to backwardation of low demand for gasoline products supplied by refineries, down -6.1% Y/Y on April 6, 2012 and -5.1% as of latest June 15 data. Coincidentally, April happened to see a peak in gasoline pricing of $3.94.

Gasoline and Brent have been in backwardation, but are convincingly looking to flip into contango. Gasoline found backwardation in May and Brent crude since February.

Gasoline and Brent have been in Backwardation, but are tipping into Contango

Backwardation is a commodity market condition opposite of contango. With backwardation, the futures curve goes from high prices today into lower pricing tomorrow. Revealing a market situation where participants are willing to pay more today than wait for a cheaper price later. Shortages and increasing demand are associated with backwardation.

U.S. economic slowing combines with global slowing to ask why gasoline and Brent have been in backwardation for a few months. Backwardation suggests conditions of high demand and low supplies in the two commodities. Data, however, reveals low demand in the world’s largest gasoline consumer, the U.S.  Likewise, world demand for Brent also is in decline told especially in Asian markets with Singapore naphtha pricing at 21 month lows against rising crude stocks according to a June 21 Reuters report entitled “Asia Naphtha/Gasoline –Naphtha price near 21 month low.”

Where gasoline and Brent are in false backwardation amid slowing global demand, a tipping point reaches into contango, and price reversals. Contango is a condition where the futures curve goes from lower prices today into higher price tomorrow. Market suppliers are less willing to accept today’s price and will hold onto their product for higher prices later.

Backwardation is a seller’s market where sellers get more today than expected tomorrow. Contango is a buyer’s market where buyers pay cheap today versus tomorrow.

Central bank influence on refineries and supporting gasoline

Economies of countries drive petroleum prices, and where Q4, 2011 saw gains in U.S. GDP, refineries experienced declines in sales and income. Accounting for divergence appears to be a freezing of bank liquidity and consequent insecurity in European Union countries in Q4. In fact, through Q4 WTI based crack spreads went from a high of $35/bbl in October down to $12.99 in December.

European Central Bank (ECB) responded with a second form of quantitative easing, termed Long Term Refinancing Operations (LTRO). Such ECB second round of cash infusion brought total amounts to nearly 1T euro.

Specifically in Q4, U.S. refineries like Marathon Petroleum Corp. saw sales decline by -6.10%, where net income was a loss of -$80M. Likewise, Western Refining Inc. saw Q4 sales down -5.06% and net income down by some -$62M. Overall, similar circumstances were common among refineries in Q4. But after ECB’s Q1 infusion of cash, refinery results improved.

Q1, 2012 refinery results correspond closely with ECB’s LTRO and witnessed Marathon finding Q1 sales increasing by 4.3% and net income to a positive gain of $595M. Western Refining, as with others, enjoyed similar advances.

Trouble with today, no central bank is committing itself to major cash infusions. Now it looks like central bank ammunition is being saved for hard case scenarios of European banking. So, refineries do what they must to protect themselves.

U.S. inventory declines, increasing refinery production and declining emerging market demand can tip gasoline into heavy Contango

Where gasoline demand declined between 5 to 6% year over year, supplies of gasoline are also in major decline. Crude however has been increasing in surplus inventories.

Starting in March, even prior to retail gasoline’s price spike, gas went into inventory decline. Surprising was gasoline inventory declines with coincident completion of ECB’s LTRO. EIA data tells gasoline inventories went into decline for 15 weeks ending May 31. Retail gasoline prices held substantially firm.

Crude prices meanwhile fell, down some 20% over the period. Refinery capacity utilization ranged in mid to upper 80% while gasoline stocks declined. Gasoline's 15 week inventory decline showed inventories up on June 1 by 3.3M barrels but only at 203M. June 1 results contrast with same period of 2011 which had stocks at 215M barrels. With reduced demand gas retail prices declined but not by much, perhaps recieving support from tight supplies. According to EIA data, gas stood at $3.61 on June 4 and declined to $3.57 by June 11.

Most recent data from EIA as of June 15 tells of gas inventories approaching historically low levels while crude (WTI) goes above 5 year average surplus. Gasoline stands at 202M barrels versus 2011 at 214M. Crude supplies are at 387M barrels versus 2011 at 363M. To burn off some crude and meet peak driving season demand, refineries are currently running above 90% utilization, even though gasoline production is in deep year over year decline.

U.S. gasoline production is down significantly year over year at a time when inventories are short, prices firm and refinery utilization is increasing. EIA data says gasoline production is down -626M barrels against same period 2011. Total refinery production is down -3.3% overall, or- 438M barrels. Retail gas pricing remains resilient at $3.53 versus 2011 at $3.65. At refinery utilization running above 90%, supply can over shoot demand considerably producing significant price declines.

Appears that where crude’s balloon deflated fast, U.S. gasoline pricing remains inflated in comparative terms. Most telling of coming contango are Singapore refinery production, pricing and inventory. It shows surplus in both gasoline and crude, with declining prices at 21 month lows.

Backwardation in U.S. markets, under these circumstances, appears unsustainable and should revert into contango. Risk of markets not going into contango comes from maintaining depressed gasoline supplies against demand.