This is an article that explains why oil is $4 a gallon. it is sane and common sense. This is the best article I have read on the relationship of crude to gasoline.

Date:   9/8/2005 9:50:26 AM ( 19 y ago)

Who's to Blame for $4-a-Gallon Gas?

By Jon D. Markman
RealMoney.com Contributor
9/8/2005 7:19 AM EDT
Click here for more stories by Jon D. Markman




Gasoline costs a lot in the U.S. today, so it just feels like a good idea to blame the big oil companies with accusations of "gouging" and "windfall profits." But like most high-octane emotional reactions, this one is wrong, as you'd need to breach every tenet of capitalism to lay all the fault at the oil giants' feet.

And even if you still think they deserve a touch of anger, as investors you're better off joining them than fighting them.

The reason that gasoline costs $1 or more per gallon today than a year ago is simple: Hurricane Katrina kicked our supply lines down a crooked staircase, and a painful kink emerged in the commodity's complex worldwide distribution system.

Although it seems unfair at times, it's a fundamental principle of our great economic system that the most efficient way to allocate a scarce resource is through price. When there isn't enough of something valuable to go around -- whether it's caviar, Manhattan property or reliable home-run hitters -- in a market society, we let the item go to the highest bidder. This is eBay 101.

In the case of gasoline, many consumers do not seem to yet grasp the difference between crude oil, the price of which is declining of late, and the stuff that they pump into their car, which is getting more expensive. One is the raw material, while the other is a finished good. It's the difference between the price of raw cotton and an Armani T-shirt. You wouldn't expect a sharp cut in prices at Bloomingdale's just because cotton futures prices fell, and neither should you expect a 1:1 change in the relationship between oil prices and gas prices.

The Shell Game
Moreover, many don't seem to grasp the difference between the large, vertically integrated companies (such as Royal Dutch Petroleum (RD:NYSE - news - research - Cramer's Take), which is the parent group of Shell) that are net buyers of oil in a hypercompetitive arena at prices that fluctuate on a world scale and the corner gasoline station that is a net seller of gasoline at prices set at whatever the market will bear on a local scale.



Gasoline costs a lot in the U.S. today, so it just feels like a good idea to blame the big oil companies with accusations of "gouging" and "windfall profits." But like most high-octane emotional reactions, this one is wrong, as you'd need to breach every tenet of capitalism to lay all the fault at the oil giants' feet.

And even if you still think they deserve a touch of anger, as investors you're better off joining them than fighting them.

The reason that gasoline costs $1 or more per gallon today than a year ago is simple: Hurricane Katrina kicked our supply lines down a crooked staircase, and a painful kink emerged in the commodity's complex worldwide distribution system.

Although it seems unfair at times, it's a fundamental principle of our great economic system that the most efficient way to allocate a scarce resource is through price. When there isn't enough of something valuable to go around -- whether it's caviar, Manhattan property or reliable home-run hitters -- in a market society, we let the item go to the highest bidder. This is eBay 101.

In the case of gasoline, many consumers do not seem to yet grasp the difference between crude oil, the price of which is declining of late, and the stuff that they pump into their car, which is getting more expensive. One is the raw material, while the other is a finished good. It's the difference between the price of raw cotton and an Armani T-shirt. You wouldn't expect a sharp cut in prices at Bloomingdale's just because cotton futures prices fell, and neither should you expect a 1:1 change in the relationship between oil prices and gas prices.

The Shell Game
Moreover, many don't seem to grasp the difference between the large, vertically integrated companies (such as Royal Dutch Petroleum (RD:NYSE - news - research - Cramer's Take), which is the parent group of Shell) that are net buyers of oil in a hypercompetitive arena at prices that fluctuate on a world scale and the corner gasoline station that is a net seller of gasoline at prices set at whatever the market will bear on a local scale.



Few U.S. states have ever wanted these noxious beasts on their coastlines, so the ones built in loosely regulated Louisiana half a century ago make something like half of all the refined crude oil products in the country. When Katrina blasted through, her high winds and storm surge knocked these plants for a loop, and the partial shutdown caused 10% of the nation's entire supply of gasoline to vanish in a weekend.

Many medium-sized refiners, such as Tesoro (TSO:NYSE - news - research - Cramer's Take), do own a lot of their own gas stations. They make much of their profit on what the industry calls the "crack spread." That's the difference in the price between what the refiner pays for crude oil and the price it receives for the products it cracks those hydrocarbon molecules into.

Because environmentalists have made it so difficult for refiners to grow, the industry consolidated mightily to gain economies of scale. In a tight supply environment, the nation's few remaining refiners naturally hoard refined product for their own stations first -- and then wholesale the rest to the highest bidder to both distributors and individual station owners.

Because there are a lot of sophisticated buyers at wholesale, prices settle at an equilibrium that reflects the cost of production plus a small premium demanded by a dislocated supply. Once the winning bidder ships the gasoline home to his station in East Crawdad, Ala., however, he may have no competitors for his product and can charge a price that reflects local demand plus a premium that reflects area residents' unwillingness to travel farther for a lower price. So even though the Alabama station might have received free signage from Shell, the oil giant has virtually no say, and gains nothing, from potentially outrageous local price hikes.

Rather than just getting mad at the local station owner, motorists can either blow his nefarious scheme by finding local gasoline in more competitive markets -- or join him, to some extent, by becoming an energy industry stakeholder.

Light, Sweet Revenge
Strangely enough, despite energy companies' explosive move in the stock market over the past two years, many of the shares are still very cheap. This has happened because unlike, say, a retailer, a commodity-based business can decide to sell some or all of its product in the futures market at a set price for a certain length of time.


A couple of years ago, many oil producers were delighted to be able to sell two full years of production at $30-$35. That looked like a good idea at the time, and it allowed them to make a lot of money if their production costs were closer to $10. But those old hedges are expiring, and companies can now turn around and sell their current and future production for $60 to $70, even though their production costs are still a fraction of that.

Analyst earnings estimates for oil and gas exploration companies have not kept pace with the rising cost of the commodity, so a lot of premium companies are selling at forward-looking price/earnings multiples of 15 or less, despite earnings-growth rates that are likely to be north of 25% a year.

A good example is Plains Exploration & Production (PXP:NYSE - news - research - Cramer's Take). Analysts figure it will earn $4.06 a share in 2006, once its two-year-old hedges roll off, which amounts to annualized growth of 125%. Yet at today's price, its P/E multiple on 2006 earnings is just 9.

David Anderson, a portfolio manager at Palo Alto Investors in California, notes that Plains has told investors that it will produce about 65,000 barrels a day in 2006, and that because of hedging it'll probably earn no less than $55 per barrel. Anderson figures that, netting out costs, Plains will actually earn $5 a share in 2006, so it is trading at a forward P/E of 7 today. If oil stays in the $65-to-$70 range, that P/E is actually more like 5. Yet even if oil falls all the way back to $40 per barrel, Anderson says, the P/E is still at 10, which is cheap.

Three other energy exploration companies with valuation and forward prospects profiles similar to Plains, according to Anderson, are ATP Oil & Gas (ATPG:Nasdaq - news - research - Cramer's Take), Toreador Resources (TRGL:Nasdaq - news - research - Cramer's Take) and Range Resources (RRC:NYSE - news - research - Cramer's Take).

All are based in Texas, but they have operations ranging from the Appalachians to France, the North Sea, Hungary and Turkey. If the next couple of years go as expected, you could get crude revenge on the suspected gougers by putting $100 into these stocks for every $10 you think you're overpaying at the pump.


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