Why Is Gasoline So Pricey

High priced gasoline

Why Is Gasoline So Pricey

Gasoline prices have been off the charts volatile for the past several weeks. Excess volatility will be an unpleasant feature for western markets for just 20 more years.


Have You Noticed The Price of Gas Lately?

Gosh, but gasoline prices are elevated. Like record-setting elevated. I recently drove from my home on the BC coast through the Rocky Mountains to Calgary and back. We filled up the tank at our neighborhood Chevron station for C$2.40/liter, only to find the price tumbled to $2.10 once we arrived on the mainland (after the short ferry ride across Howe Sound). In the Rockies, prices were around $1.95 and were $1.80 in Calgary.

Normally the spread from coast to the interior is tighter, and the prices generally lower. Like 50% lower.

We could have flown to Calgary for about $1800 return. However, it still made sense to drive, because there were three of us, we had time, and we’d need to rent a vehicle to get around once we landed in Calgary (have you seen the prices of rental cars lately?). Our 55 liter tank supplied us for about 500km before we needed to refill, so a return trip was 4 tanks, or about $500, $400 for two hotel rooms in Salmon Arm, and $100 for meals (or $1000).

A lot of drivers make this kind of calculation to decide between plane, train, or automobile. Unless the distances are long and the travel time meaningful, cars usually win. Few of us are anal enough to do a fuel cost calculation when we need to get groceries. For suburb-dwellers, there’s typically no alternative to personal transportation, so why bother.

Car owners grumble about the high cost of fuel, yet people are furiously driving around, rental cars are scarce, new car lots are sparse, and used cars are in short supply. I have yet to even meet anyone in my circle who has put their F150 up for sale.

And so, I see three questions worth pondering:

  1. Why did prices rise so quickly?
  2. When will prices come down?
  3. Is price volatility the new normal?

Why is Gasoline Suddenly So Pricey?

The price of gasoline is determined by supply and demand forces. That’s a glib statement, but it’s accurate. Economists like to study the oil and gas industry because supply and demand duke it out throughout the crude oil conversion supply chain. Various bottlenecks in the supply chain appear and disappear over time as oil companies react to pricing discontinuities. An oversupply of oil in a location with a transportation constraint means the price of the oil at that location is discounted to allow for a higher transportation charge to get the crude to an alternative market, or a storage charge to await better trading conditions. Mid streamers are then incentivized to build a new pipeline, or introduce rail transportation.

Similarly, when demand for gasoline in a market races ahead of supply, traders try first to source available gasoline and figure out how to get it to the market (by paying extra for shipping) before embarking on a refinery expansion.

Refiners add capacity to their refineries if they detect a market opportunity to capture the spread between the local market price of gasoline less the cost alternatives to supply that gasoline, when measured over years. For example, the demand for gasoline on a small island economy is too small to justify a refinery so the right answer is to secure gasoline on the open market, and ship it to the island. Investing in a pier and tank farm is economic.

And usually it is a local market that drives the decision. Refineries primarily produce transportation fuels (LPG, gasoline, diesel, jet fuel, fuel oil, and kerosene), along with a wide range of other products (dozens) in relatively small quantities. Storage costs money, and shipping refined product is expensive and risky. Calgary is a big city (over 1m people) but has no refinery. It’s more economic to refine in Edmonton and ship fuels by rail and pipeline.

Most refineries are quite small (less than 50k barrels per day), but refining is now a scale game, shipping is a scale play, and regulations are tight. These days, only very large refineries get built, in Asia and the Middle East, and the smaller refineries are an endangered species.

In January of 2020, there were 647 refineries operating globally. During the pandemic, several marginal refineries shut down permanently, triggered by the shortfall in market demand for refined products, which was in turn caused by the rapid collapse of economies. At least one refinery suffered a very damaging fire, and the owners decided to shutter the facility. The US is now structurally short 5% of daily demand.

Refiners don’t shut down without a fight, even in a pandemic. Oil refinery sites are huge environmental liabilities because the ground under and surrounding refineries is contaminated with hydrocarbons, and carries a big remediation cost. Refiners will do everything in their power to keep going to avoid triggering that liability. The usual play is to convert the refinery site to a storage facility or a bio fuel plant, which kicks the environmental jerry can down the road.

The dramatic and rapid ramp up of economic activity, coupled with the short fall in refining capacity, acerbated by the sanctions imposed on Russian refined product due to the war, has caused prices to rise dramatically.

When Will Prices Come Down

I’ve learned never to predict oil markets. I’m usually wrong. But John Maynard Keynes tells us that in a purely market-driven economy, prices fall when new supply enters the market and competes away the excess price, or demand tumbles to match the available supply, or governments get involved.

Adding Supply

Adding new refinery supply is hard to do. There needs to be a market to consume the refined products at scale. It takes years to design and build a refinery. Raising money is tough.

Demand growth for refined products in North America and Europe has been flat for over a decade as these economies shifted to be more service oriented than manufacturing, engines have gotten more efficient, and (lately) workers have been able to work from home. Witness how North America has not added a major new refinery in 30 years.

Refineries feature another quirk. Capacity is added or removed in lumps, and the lumps themselves are very large (measured usually in thousands of barrels a day). If demand looks to be flat or declining, then adding supply is risky.

Financiers will step up with capital to build new plant when they think they can make a return, but they’re on the sidelines, and have been for three decades. Their models argue that demand for petroleum products is unlikely to ever return in sufficient volume and price to guarantee a return for an asset that must run for decades (and will take years to bring to market).

Energy security can create an off ramp from this scenario as governments step in to own some of the means of production (as they already do in many oil industry settings. Canada’s federal government owns a new pipeline intended to ship crude oil from Alberta to the BC coastline for transportation to Asia). Russia’s invasion of Ukraine has revealed just how dependent the European economy is on Russian energy, including refined gasoline. You can imagine the conversations underway in the EU about securing alternative fuel supplies by September when Europe tries to cut off fuel purchases from Russia.

Reducing Demand

Tempering demand is the fastest response in this scenario, but that entails fiscal pain (aka recession) for households and economies that are just recovering from the pandemic. Households figure out how to drive less, consolidating shopping needs to create fewer trips and cutting back on long driving holidays. Little Johnny is in two sports this year, not three. The week-end getaway to the cottage doesn’t happen. Workers petition their employers to allow work from home or boost wages to allow for travel.Those who have the option go back to public transit. Worker shortages trigger some job leavers to seek more local employment.

Selling the costly gas guzzler is a problem because there aren’t any fuel efficient cars to purchase (thanks pandemic). Battery electric cars are suddenly very compelling (but charge spots are a constraint, both in the family garage and in public), but sadly expensive and in short supply.

Fiddling with Price

Don’t be surprised to see governments getting involved. Many will try to reduce petrol prices by temporarily relieving taxes on the refined products (which will reduce the social pain but ironically delay the lifestyle reckoning). Some will create pricing subsidies to support gasoline prices at a market acceptable level.

Some may even consider buying a refinery and becoming a swing producer, to boost supply when it’s needed and to take the hit when demand volumes fall structurally.

Is Price Volatility The New Normal?

The problem I foresee is the mismatch between refinery configuration and structural transportation demand erosion.

Refineries can’t just cut back on gasoline while keeping jet fuel and diesel fuel supply strong. Overall refinery capacity is added and taken away in big lumps, and valuable products like gasoline cannot be easily manufactured by manipulating available molecules. Put another way, over time demand is on a smooth downward glide path but supply is a step function, and the steps will get bigger as the small refineries shut down and only big refineries are left. Between the steps prices will be volatile.

As gasoline demand structurally recedes, excess gasoline production will be dumped on the market, causing gas prices to fall, until some refinery decides to throw in the towel and shutter. Volumes will then peel back, causing prices to rise. Smoothing this out is nigh impossible everywhere, all the time, in all markets, for all products.

How Do You Win?

Most of us will just try to ride it out under the assumption that prices will naturally go down as adjustments to high prices take hold. But if you are more activist:

  • Temper your personal exposure to fluctuating prices. For most of us, this means embracing battery electric vehicles as quickly as possible. Drive less. Move closer to work. Take transit. Fly minimally. Make live style changes for you and your kids.
  • Push your prices up (or negotiate a pay raise). If you can, raise your prices ahead of your actual fuel cost increases.
  • Elect interventionist and populist governments who can be swayed to own refineries and manage market prices through subsidies and taxation.

Conclusions

Personally I can’t wait to get my hands on a battery electric car. I just need to find a way to pay the electrician to install the charger, and for some reason, his prices are up 20% this year.


Check out my latest book, ‘Carbon, Capital, and the Cloud: A Playbook for Digital Oil and Gas’, available on Amazon and other on-line bookshops.

You might also like my first book, Bits, Bytes, and Barrels: The Digital Transformation of Oil and Gas’, also available on Amazon.

Take Digital Oil and Gas, the one-day on-line digital oil and gas awareness course on Udemy.

Mobile: ☎️ +1(587)830-6900
email: 📧 geoff@geoffreycann.com
website: 🖥 geoffreycann.com
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