$5 Gas By Labor Day

March 12, 2008 by Douglas A. McIntyre

If gasoline prices move from their current average price of $3.20 to $5, the cost of fuel for a family that spends $50 a week for gas would move up over $1,000 a year. That would wipe out any tax rebate payments from the Federal government and drive the economy deeper into its currently slowdown. It would also further fracture already delicate P&Ls and balance sheet at large auto makers and airlines. Retailers would get less traffic. Very few industries would be spared some effect.

Rising oil prices cannot be fixed by the Fed, That means that the most crushing blow to the economy, higher fuel prices, is largely beyond the control of the government. Rising crude is driven by futures speculation, the falling dollar, and an imbalance of supply and demand.

The supply issue is the most permanent and the most vexing. Tremendous consumption of oil and diesel in China is underwritten by the government which buys high-priced oil and then refines it and markets it at below market prices. China does this so high fuel prices will not dampen GDP growth which is running at 10% a year. China is also building a 100 million barrel strategic reserve to cover the country for 30 days in the event of a major interruption in supply.

Further straining supply, oil producing countries are keeping more crude in their home markets to handle building out infrastructure and provide gas for a growing number of cars.

OPEC has rejected US pleas for raising production and the president of the cartel says he expects oil to stay at current price levels through the end of this year. That stands against a market where oil demand has gone up 1.5 million barrels a day for the last ten years.

Analysts at Goldman Sachs recently wrote that with rising demand several events could cause oil to spike to as high as $150 to $200. "As the lack of supply growth and price-insulated non-OECD demand suggest a future rebound in U.S. gross domestic product growth or a major oil supply disruption could lead to $150-$200 a barrel oil prices," Goldman said according to MarketWatch. That would move the cost of a barrel of crude up as much as 55% from current levels.

Because of the dynamics of refining and government gas taxes. oil does not have to get to $150 for gas to move to $5. In some parts of the US gas prices are well above $3.50 due to transportation costs and local fuel tax rates.

There are elements aside from crude which could push gas much higher over the next six months. Demand for gas in the US usually rises as Memorial Day approaches and stays high through the end of the summer.

Worse than seasonal demand, a number of states are considering raising their taxes on gas. They may need to do this to offset the falling income and property taxes which are being hurt by the faltering economy, Maryland has considered raising the tax-per-gallon by $.12. The state is looking for $400 million a year to keep up with infrastructure building and maintenance. A number of states are debating higher gas taxes to offset falling income and cover capital expenditure needs. Some drivers could see an increase of $.20 in their cost per gallon of gas simply because their states can’t do without the income.

The single largest factor in the increasing price of gas is the need for refineries to improve their margins. Valero (NYSE: VLO), the largest refiner in the US, is taking some of its capacity off-line because the company makes so little in the process. As capacity falls, other refiners will be able to move their refining charges up. In the United States, refining margins were down at the end of December about a third from their peak in 2007, according to a report from Bloomberg News.

As the CEO of Valero made clear when he announced the company’s reduction in refining capacity "I don’t feel the obligation that we have to run at a loss and our shareholders would not expect us to run at a loss."

For big refiners like Valero and Exxon Mobil (NYSE: XOM) to get back much of the profit they are losing it would not be unusual for them to add $.20 to $.30 to each gallon of gasoline that they refine.

Taxes and refinery charges could take gas from $3.50, its price in several states to $4 or slightly more. In that case, crude would only have to be at about $1.35 for gas to be at $5. That means crude would have to move up 22%. It jumped from $85 to $110 in the blink of an eye, a 30% bump, over the last few months.

All it takes is some more heavy buying from China, a coup in Nigeria, or word that OPEC will cut production at its summer meeting.

Gas at $5 is a strain the current economy can’t withstand, but betting against it would be a bad idea.

Douglas A. McIntyre