Why the Oil Boom May Miss the Pump

The energy renaissance currently under way in the United States has garnered plenty of headlines in the past year, and rightfully so. Horizontal drilling has unlocked billions of barrels of shale oil reserves that were out of reach just 10 years ago. Couple this new technology with rising CAFE (Corporate Average Fuel Economy) standards and it is difficult not to be optimistic about the country's energy future. Just don't expect our newfound domestic oil-producing muscle to trickle down to the gas pump.

The tax/subsidy threshold
Consumers may be shocked to discover that the United States offers some of the cheapest gasoline in the world. Take this graph of the four-year averages for gasoline prices from various countries:

Source: World Bank

The average worldwide breakeven price for gasoline was $0.684 per liter ($2.589 per gallon) between 2008 and 2012. Countries that lie below the threshold subsidize gasoline to keep prices artificially low, while countries above the threshold tax gasoline to generate revenue. The U.S. enjoys a lower breakeven price than most of the world due to its refining power, but you shouldn't feel too comfortable about that.

Although the gas tax generated nearly $38 billion in tax revenue for the country's highways in 2010 there is reason for concern. Should automakers reach the fuel efficiency targets established by the new CAFE standards set last year the government will see gas tax revenue fall by a factor of two. So I think it is safe to say that American gasoline – which has 49.3 cents of tax slapped on currently – is not going to get any cheaper by falling taxes or new subsidies. In fact, it seems likely that consumers will see prices increase as politicians scramble to save the Highway Trust Fund.

Surely increased domestic oil production will lower the breakeven refining price for American gasoline. Right?

The spread aids exports, not consumers
It will, but that won't necessarily lower prices for consumers, at least not in grand fashion. Refiners, like any other business, will always sell product at the highest prices possible. Since the price of oil is set globally their eyes are not always set on the American market.

The misconception that producing more oil will lead to lower fuel prices lies in the difference in oil benchmarks. A barrel of West Texas Intermediate (WTI) oil enjoys a $20 discount to a barrel of Dated Brent, its worldly counterpart, thanks to an influx of shale oil in the country's overwhelmed refinery terminals. The discrepancy will diminish as new pipelines come online, but that hasn't stopped the U.S. Energy Information Administration, or EIA, from switching its benchmark from WTI to Brent. The EIA defended the move by stating: "This change was made to better reflect the price refineries pay for imported light, sweet crude oil."

Refineries sure aren't complaining. The spread has lifted the boring, small-margin refining industry into a profit spewing monster as exports of refined petroleum products rose to a 60-year high in 2011.

Source: EIA

Here' a look at some of the nation's largest refiners positively affected by the spread:

Company

2010 EPS

2011 EPS

2012 EPS (estimate)

2-Year Growth

Marathon Petroleum (NYSE: MPC  )

$1.75

$6.67

$9.60

449%

Valero Energy (NYSE: VLO  )

$1.62

$3.68

$4.74

193%

HollyFrontier (NYSE: HFC  )

$0.97

$6.42

$8.46

772%

Phillips 66 (NYSE: PSX  )

$0.99

$6.88

$7.84

692%

Western Refining (NYSE: WNR  )

($0.19)

$1.34

$4.87

263%*

* year-over-year average

The overhaul to industry margins underscores the catalyst of the improving world economy on domestic energy supply. Refiners will look to continue to supply world markets as infrastructure improves and more pipelines reach out toward our shores. And with oil becoming more expensive to refine, who can blame them for chasing higher margin exports instead of domestic gasoline?

Dirty oil has never been so dirty
Government agencies such as the EPA and ASTM maintain a strict database on various metrics of all inputs and outputs to refineries in the country. This helps to keep track of short- and long-term trends in supply and pollution control. One closely watched metric is sulfur content, which must not exceed 0.24% for a barrel of WTI. Unfortunately for refiners – and ultimately consumers – shale (and deepwater) oil contains more sulfur than conventional oil sources. More sulfur means more refining, which means higher input costs for refiners.

According to the EIA, sulfur content of crude oil has increased by 53.8% since 1986, when more conventional oil dominated production.

Source: EIA

It gets worse when you consider that nearly all of the 2.2 million barrels per day increase in oil production from now to 2020 will come from shale oil. Here's a look at sulfur content by region of production:

Source: EIA

Crude oil extracted from shale formations has almost doubled the amount of sulfur than non-shale sources (Bakken is in dark blue, Eagle Ford is in light blue). We may have more oil, but it is getting more expensive to refine.

Foolish bottom line
There is a long laundry list of macro trends that combine to affect fuel prices. The state of California demonstrated that even isolated events can make a big difference for an entire region. Nonetheless, the rejuvenated refinery industry can be a great investment for investors who understand its driving forces. 

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