Another Follow-Up

Long-time readers here know that several posts on the blog have been devoted to the relative price movements between oil and gasoline. Oil has skyrocketed while gasoline hasn't moved this year. This relationship is beginning to manifest itself in lower earnings for domestic suppliers and refiners. If the cost of raw materials (crude oil) goes up and the finished product (gasoline) stays the same, margins get squeezed. Yesterday in the Wall Street Journal there was an article on whether the next move for oil is $100 or $50. While this is obviously important, it is really the price of the finished product (gasoline) that really matters.

Here's why I think oil should be capped around this level (barring some external shock). First is slower US growth. While the rest of the world seems to be doing well, the US still makes up a large percentage of the world economy. Second, with oil sustained around the $80 level, more supply will come on line. This takes time however. The longer the price stays up here, the greater the chance for increased supply. While the Saudis will want to push the price down to a level where they can keep this additional supply off the market as their cost is below $10/barrel, it won't get to that level soon. The good thing is that much of this new supply will be domestically produced. Similar to oil sands of Alberta, the Western US has huge reserves of oil, although much of it is trapped inside of shale. At $80/barrel, this can be produced profitably and without the externally generated political risks. The third point is that at these price levels, substitutes, primarily ethanol, are attractive and coming on line in an increasing rate. If the government lifted the 52 cent/gallon tariff on imported ethanol, its price would come down and use increase. The last point, plus the expansion of domestic refineries (finally), will help keep gasoline prices down.