Why Our Oil Boom Hasn’t Lowered Gas Prices

Americans are paying an average of $3.45 for a gallon of gas right now, yet the Midwest has experienced an oil boom for more than a year, and the International Energy Agency expects the U.S. to become the world's largest oil producer by 2020. More oil coming up from American soil means lower gas prices in the U.S., right? It's a simple calculation, but it's not even close to being true.

Where'd all this oil come from, anyway?
A few years ago, politicians debated about the price of oil, how to lower it, and whether America's dependence on foreign oil imperiled our future. But, last week, the International Energy Agency said the U.S. will be the largest oil producer within the next eight years, and will be practically energy self-sufficient by 2035.

If you're scratching your head, wondering how the U.S. could find itself in such a different position, you're not the only one. Phil Flynn, an analyst at Price Future Group, recently told the L.A. Times: "They said we couldn't drill our way out of this mess, but we are drilling our way out of this mess."

High oil prices sparked innovations for not only finding oil, but also extracting it. Three-dimensional seismic technology has become more advanced, and new drilling techniques have opened up areas that were once deemed too difficult to produce oil. Schlumberger's (NYSE: SLB  ) Q-Technology seismic systems now provide detailed reservoir imaging and data information, which basically lets us see straight through the ground to find oil pockets. Directional drilling technologies, like SperryDrill motors and the line of Pilot rotary steerable drilling solutions from Halliburton  (NYSE: HAL  ) , make drilling more cost-effective and efficient. As a result of these technologies, the Eagle Ford Shale formation in Texas and the Bakken formation in the Dakotas, Montana, and Saskatchewan are seeing oil booms.

Don't expect $2-a-gallon gas
According to Businessweek, the U.S. is on track this year to produce the most oil since 1991. But that same year, we were paying just over $1.50 for a gallon of gas – adjusted for inflation, that's almost $2 a gallon cheaper than right now.

Increased U.S. oil production doesn't guarantee us $2-a-gallon prices at the pump. There are several reasons for this, but one of the most influential is that oil prices are determined globally, not domestically. Because refined products are easy to ship overseas, the price of refined products is set in the international market.

Let's explore this for a moment. Yes, we have plenty of black gold spewing from our beloved ground, but other people around the world want the refined products from that oil, too. Drivers in the U.S. are competing for cheap American gas with the rest of the world, and seventh-grade economics taught us what happens when there's high demand for the same product: prices rise. Refiners operating near the Gulf of Mexico, like Valero (NYSE: VLO  )  and BP (NYSE: BP  ) , have increased their exports to the rest of the world, because they can earn more money by exporting it than selling it here. But why?

The two leading oil benchmarks, Brent and West Texas Intermediate (WTI), help determine the price of oil, and eventually gasoline. Brent is considered the global benchmark, while WTI is the U.S. benchmark, and right now the spread between the two is at an almost all-time high of $25 a barrel. For most of the past 20 years, these two benchmarks have been within $1 of each other. This means customers around the world can now buy refined oil products like gasoline based on the much cheaper WTI prices, instead on Brent prices. Simply put, refined products from the U.S. are much cheaper to purchase right now than from other countries.

The WTI prices are low because all the oil in the Midwest has been bottlenecked there. To get the oil out of that region and into the Gulf, new pipelines need to be built, and existing ones have even been reversed. For 17 years, the Seaway Pipeline, a 50/50 joint venture between Enterprise Product Partners (NYSE: EPD  ) and Enbridge (NYSE: ENB  ) , used to send oil from the Gulf of Mexico to Oklahoma; now it flows in the opposite direction. When the pipeline was reversed back in May, it had a maximum capacity of 150,000 barrels per day. That number should jump to about 400,000 barrels per day in early 2013.

No one knows how long the price of WTI will remain significantly lower than Brent, but some expect the price gap to narrow to $14 in March 2013.

Someone is benefiting from this
Even if America pumps out millions of additional barrels of oil a day, the price of gas isn't likely to drop, because of high demand from China, India, and other developing countries. The International Energy Agency says that in the next five years, almost half of all global oil demand will come from China, and that transportation needs both in that country and India will strongly increase oil demand.

One of the world's leading energy economists, James Hamilton, said in an interview with Oilprice.com: "Demand for oil, particularly from the emerging economies, has grown significantly, and we have had a hard time increasing global production. The single most likely outcome is that both conditions will continue to be with us."

Although U.S. drivers aren't benefiting from higher oil production, that doesn't mean no one is. A handful of oil companies are seeing huge profits, and they're making some investors very happy. In the next article in this series, we'll talk about a few companies that are benefiting, and how you can make the most from their gains.

Without giving it all away, I will mention one major player in the Midwestern oil boom – Kodiak Oil & Gas. The company has a dynamic growth story, but with great opportunities come great risks. Before you hitch your horse to this carriage let us help you with your due diligence. To see if Kodiak is currently a buy or sell, check out our new premium report, which comes with a year of timely updates and analysis.


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