From the September 2006 issue of Wealth Manager Web • Subscribe!

September 1, 2006

Fill'er Up

The price of gas may be the best-known number in the U.S. economy, but it's also one of the most mysterious. Just who or what is it that controls its ups and downs--and lately, mostly ups?

The short answer is: gas station owners. David Hackett, a gasoline analyst at Stillwater Associates in Irvine, Calif., says these owners look "at what everybody else around them is charging, and they also know what their supplier is charging them for their wholesale supply." Whether it's a mom-and-pop independent station or part of a regional chain, the owner looks at the prices up and down the street and changes the signboards accordingly.

And the wholesale price? According to Hackett, that is set in a similar fashion, only wholesalers look not just at their competitors, but at the spot price as well. "The spot price is basically set by raw supply and demand," he explains. "A refinery blows up, supply gets constrained, and the price goes up."

Tim Evans, an energy analyst for Citigroup Futures Research in New York, says the price of gas is set by accident. "It's the sort of thing where no one party is really responsible," he adds, "but everyone contributes. Consumers, for example, can look in the mirror, because their demand for gasoline is part of what determines the price. If they didn't consume so darn much of the stuff, then it wouldn't be so expensive."

But demand is only part of the equation. One hypothesis making the rounds is that oil prices are going up now because we're running out of oil. Evans is skeptical, however. He notes that in BP's latest annual energy review, known global oil reserves actually went up last year, not down--despite all the oil produced and used last year.

If you look back to 1980, Evans says, proven reserves at that time amounted to 29.6 years of consumption at 1980 rates. In 2005, the world had 40.6 years' worth of consumption at 2005 rates. "So we have a larger cushion of reserves at the end of 2005 than we did in 1980," he says.

Proven reserves now stand at 1,194.1 billion barrels, according to the June edition of the BP Statistical Review of World Energy. In 1985, proven reserves stood at 1,027 billion barrels.

"How is this possible?" Evans asks. His answer: "We explore for more oil, and our technology is continually improving."

There has been demand growth in some economies such as China, but Evans is not sure how much impact that additional demand has had on U.S. oil prices. He notes that commercial crude oil inventories in the U.S. are actually higher than they were in May 1998--back when oil was $12 a barrel--not exactly a sign of constrained supplies.

"What we're doing here is we're building a larger and larger risk premium," Evans says. "Prices are up here primarily because we're afraid and because we're afraid, there's also speculation that we're vulnerable...What happens if there's a revolution in Venezuela? What happens if there's civil unrest in Nigeria? What happens if China eats our lunch?"

Here, however, Evans believes investors discount history. "Is the world more dangerous than it was in 1979 during the Iranian revolution? Is oil production at greater risk than it was during the 1988-89 Iran-Iraq war? Was Nigeria ever a peaceful place? Not in my lifetime," he says.

Even Iraq, which might be said to be the current leader in global fear production, is producing 2.5 million barrels of oil a day--its highest levels since June 2003, Evans notes.

While OPEC (the Organization of Petroleum Exporting Countries) constrains supply to some extent, Evans says OPEC tends to be careful not to "push the global economy over the cliff, because that's not in their long-term best interest." Nor do they really want to raise their prices to the point where non-OPEC countries decide to expand their production dramatically.

So is there a Hummer in your future? Maybe. Since 2003, the physical market has grown by 8 percent, Evans says. At the same time, open interest on the commodities exchange has grown by 110 percent--in part, he says, because hedge funds are getting more interested in the market. "To some extent, they are simply chasing a trend. They're buying it because it's going up, and it's going up because they are buying it. They are still working that loop," he says.

Evans estimates that the fear premium has added at least $30 to the price of oil--a number he does not believe is sustainable. "If it were a cartoon, Bugs Bunny has already sent Yosemite Sam way over the edge of the cliff, and he hasn't looked down yet to notice that his feet aren't yet on the ground," he says.

Bennett Voyles is a New York-based freelancer who wrote about the real estate bubble in the June issue of Wealth Manager.

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