Do you remember the Monty Python satire of the Inquisition? The would-be convert is harangued by the inquisitors until they resort to extreme measures. They say, "So you think you are strong ... We shall see ... Put her in the comfy chair."
Many Americans believe that the comfy chair will be the total sacrifice needed to reduce gas prices. Politicians feed this belief through promising the comfy chair of ethanol. Looking at the data, however, I see only one road to lower prices at the pump: Conservation.
What is driving prices?
Gasoline prices are set by supply and demand. The majority of the price depends on crude markets. Beyond crude, the crack spread (the price difference between refined product and crude oil) is determined by the balance of refining capacity and refined product demand. State and federal taxes comprise the final addition to the price.
Looking at crude oil, I wondered what happened to the oil boom back in January, when crude prices fell to $50 a barrel. At that time, I painted a picture of tight supply and demand, with all of global spare capacity being held by Saudi Arabia. The picture for crude oil remains essentially the same. The persistent high price of crude has driven big gains for oil service companies like Transocean (NYSE: RIG ) -- my personal fat pitch.
The main difference is refined product supply. Refinery shutdowns and reduced product imports have driven gasoline stocks far below their historical averages. This graph from the EIA (Energy Information Association) basically tells the story. Refining companies like Tesoro (NYSE: TSO ) and Valero (NYSE: VLO ) are enjoying record crack spreads. These high crack spreads will not persist, however, because the factors that have created this spike are temporary.
No new refineries
This recent price spike is just another example of how thinly stretched our energy infrastructure has become. With no excess capacity in either the crude or refined product supply, even small events have an impact on price. A combination of events, such as the current situation with multiple refinery outages, causes a major price increase.
I have said there would be no new refineries several times. Arizona Clean Fuels Yuma is trying to build the first new refinery in the U.S. in more than 30 years. It hopes to start construction in 2008, and if -- a very big if -- it encounters no additional delays, the refinery would be operational by 2011. The cost is estimated at $3.7 billion for 150,000 barrels per day (bpd) of crude capacity, plus a pipeline and crude terminal. This works out to nearly $25,000 per bpd of refining capacity.
It is cheaper and faster for oil companies to expand existing locations. Through expansions, domestic refinery capacity increased by 1.1 million bpd between 1999 and 2006, and will expand substantially in the next few years. In one example, Marathon Oil (NYSE: MRO ) is spending $3.2 billion to expand the Garyville, La. refinery by 180,000 bpd. At $18,000 per bpd of capacity and scheduled completion in December 2009, the Garyville expansion is about 30% less expensive and should be completed well before the Arizona project is operational.
In addition to crude imports, the U.S. also imports 3.6 million bpd of refined products. Therefore, we are only starting to play catch-up on the supply side, and prices certainly will not fall in the face of rising demand. Gasoline demand is up 1% over 2006. Taking a slightly longer view, even though gasoline prices nearly tripled from 1999 through 2005, U.S. gasoline demand grew at 1.4% annually --essentially the same as during the previous 10 years. Furthermore, new vehicle sales figures suggest that demand growth will continue.
Back to the future
The road to lower prices might be visible if we look at the last peak in oil prices from 1980, when OPEC was withholding production. In the face of high prices, U.S. gasoline demand fell by 12%, and the U.S. economy was in recession. Efficiency standards were implemented for cars, speed limits were reduced, and power production shifted from fuel oil to natural gas. Meanwhile, new oil fields in Alaska, the North Sea, and the Soviet Union increased supply from non-OPEC regions.
Conservation combined with new production loosened OPEC's grip on world markets. In 1986, Saudi Arabia flooded world markets with cheap oil to drive higher-cost producers out of business. Prices plummeted to less than $10 a barrel. The oil boom was over.
One way out
Today, demand is the only side of the equation we control. Americans consume 20.8 million bpd of crude, compared to domestic production of 5.2 million bpd. U.S. production has been declining for 37 years. Even if every inch of the Rockies, the Pacific Coast, and Alaska were open to drilling, we could not produce our way to lower prices. Globally, increasing production in new regions barely compensates for falling production in Mexico, the North Sea, and several OPEC countries. Geopolitical problems further complicate the situation.
Conservation stands as the lone card in our hand. The EIA basically said the same thing in last week's report: "If prices are high due to supply and demand factors, and consumers cannot directly increase supply, reducing demand is left as the main option for consumers."
Few people can reduce demand in the short term. Public transportation, telecommuting, and carpooling are possible for a minority of the workforce -- and the lucky few are probably already taking advantage of these options. The people who could reduce demand, new car buyers, have not demonstrated a significant shift away from trucks and SUVs. Perhaps $3.20 a gallon is still affordable after all.
Before change occurs, Americans will likely need to suffer some pain. The comfy chair of ethanol will not reduce prices; volumes are too small. So, we are faced with a choice: change now, or wait for the thumbscrews of $4.00 a gallon or possibly endure the rack of a global recession. Sadly, I think we are in for the thumbscrews.
As an investor, all of this points toward continuation of the oil boom. Companies like Motley Fool Hidden Gems selections Dawson Geophysical (Nasdaq: DWSN ) and OYO Geospace (Nasdaq: OYOG ) will deliver increasing profits as long as oil remains above $40 a barrel. Both companies have posted big gains in recent months, but they are also quite volatile, providing opportunities to pick up shares during the occasional swoon. For the more conservative investor, large integrated oil companies like ConocoPhillips (NYSE: COP ) continue to trade at reasonable valuations. Finally, if you are in the market for a new car, you might want to run the numbers using $4.00 gasoline to make sure you don't break your budget.