Still buying premium? The end of high octane gasoline

In most parts of the world, when you pull up to the gasoline pump there are two and sometimes three octane choices: regular (lower octane), midgrade, and premium (higher octane).

The price difference between regular and premium is roughly 35 cents per gallon in the US at the moment. The current price of regular in the US is $3.35 per gallon and premium is around $3.70 per gallon on average across the country.

The number of vehicles requiring premium has fallen from 21 percent to 17 percent over the past 10 years, according to Edmunds.com. But the number recommending premium, has risen from 2.5 percent to 12 percent over the same period.

So in summary, in the most recent 2014 model year, manufacturers require or recommend premium gasoline for 29 percent of US vehicles. Most consumers ignore this and buy regular gasoline. The data proves it - only 12 percent of gasoline sold in the US is premium or midgrade (see chart below).

Why is this happening? Manufacturers and vehicle purchasers are using a 'recommendation' of premium gasoline to play the MPG ratings vs horsepower game.

It goes something like this: a vehicle manufacturer wants to list the highest possible miles per gallon (MPG) rating as it is a big sticker on the window of a vehicle at a dealership. They get the high MPGs in part by putting smaller lighter engines in vehicles. However, customers also want performance. So manufacturers attach turbochargers and other premium gasoline demanding technologies to these small engines in order to keep horsepower levels up.

After the horsepower availability ego trip at the car dealer at the time of purchase, most vehicle purchasers go home, choose to go without the power, go with the cost savings, and buy regular.

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What is Driving US Oil Demand?

A few years ago it became popular to say that US oil demand had peaked and would never recover. However, the US DOT just released traffic statistics for July 2014. It shows miles driven on all US roads increased by 1.5% in July 2014 as compared with July 2013 (see chart below). If this trend holds, we will see new highs for US miles driven within a couple of years.

Although miles driven has begun to increase, this does not directly translate into an increase in US oil demand. Since the rally in oil prices in 2005, the increase in miles driven as a potential source of additional oil demand has been offset by efficiency gains occurring in the US vehicle fleet (see charts below).

Vehicle efficiency has been led by the deployment of ten technologies (listed in order in which they have become widespread): fuel injection, transmission lockup/torque converters, multi-valve engines (cylinders with more than 2 valves), variable valve timing, hybrids/regenerative braking, continuously variable transmissions, gasoline direct injection, turbocharging of small bore engines, variable displacement/deactivating cylinders, and start-stop systems.

The most recent wave of efficiency mechanisms are now, in late 2014, beginning to be overwhelmed by the increase in miles driven such that US oil demand is beginning to increase year on year. Within a few years US oil demand should make new record highs (the highest historical annual US oil consumption year was 2005).

Lower oil prices no longer help the US economy

The US currently consumes around 19 million barrels of oil per day (5% of the world's population consuming 21% of global oil supply. Global supply is roughly 91.5 million barrels per day).

A drop in prices of $1 per barrel equates to a $7 billion boost in non-oil US consumer spending when annualized. This is money which US consumers do not have to spend on oil and instead can spend on new mobile phones and other goods.

However, the US is also increasingly a larger oil producer. Since 2009 there has been an upward trend in US oil supply which had until then been declining steadily since 1973. This has been due to new high cost US tight oil (fracking) supply. With this increase in US oil production there has been a reduction in US oil imports which is expected to continue until around 2020 (see chart below). Whether this US trend can continue beyond 2020 is subject to a high degree of uncertainty at this time.

Netting the spending boost from US consumers against the revenue reduction to US oil producers, each $1 drop in oil prices currently provides only a net $2 billion annual boost to the US economy.

This is a small number given the overall scale of the US economy. For example, Apple Inc's revenue is running at $175 billion per year. So while lower oil prices in the 1990s and 2000s were almost always beneficial to the US economy, today they are neutral.

There are three caveats:

*1. Neutral until below $75: The recent increase in US oil supply is due to high prices. Marginal production from high cost tight oil (fracking) requires $75 per barrel (basis WTI crude). As a corollary to this, if prices were to decline below $75 per barrel, production from high cost tight oil (fracking) could decline and prices lower than $75 may, over the short term (1-3 years), hurt the US economy. In summary, lower oil prices are neutral to the US, so long as prices stay above $75 per barrel. Prices below $75 may be negative to the US economy.

*2. The big sign effect - consumer price psychology: A further caveat is the sentiment effect. Almost everyone in the US is aware of the price of oil due to large government mandated signs at refueling stations. If oil prices move below $3 per gallon at the pump (see chart below) then there may be an boost in consumer spending on non-oil goods due to pricing psychology which overwhelms the decline in revenue for oil companies.

*3. Shocks are unpredictable - speed of the price move: Consumers react to the speed of price movements in addition to the magnitude of the move. Oil prices halving or doubling in 6 months generates a much different and more unpredictable reaction than oil prices gradually doubling or halving over 5 or 10 years.

[Summary: Lower oil prices in the 1990s and 2000s were almost always beneficial to the US economy, today they are neutral. Oil prices below $75 may be negative to the US economy.]

[For the sake of brevity and simplicity I am not including economic multiplier effects in the above.]

Where is the floor for the price of oil?

Oil prices (WTI crude as a proxy) are close to $90 per barrel this morning, down from almost $110 earlier in 2014. $90 is also major trend line support (see chart below).

This is despite global unrest in Russia, Ukraine, Syria, Iraq and elsewhere. As I have mentioned before (see charts below or click link), wars over the past 30 years have generally been negative for oil prices, even when, and sometimes precisely because, oil producing and exporting nations are involved.

Over the short term (next 3-6 months) it looks like oil will continue to head even lower due to weakness in Chinese and EU oil demand and there are three levels which have to come into play to define the downside:

*1. Marginal Producers: At what price do the global marginal high cost oil suppliers, currently US tight oil (fracking) producers, begin to shut in supply and stall exploration activity? The general assumption is that this begins in the mid to low $70s per barrel (basis WTI crude).

*2. Consumers: At what price do oil consumers increase their consumption? Consumer behavior changes slowly over time with respect to oil - this is why oil demand is called inelastic. Oil prices have to go to extreme levels to change consumption behaviour - hence the rally to $150 in 2008 required to stall demand in the face of insufficient supply growth. So although lower oil prices will likely increase demand above historic patterns, this is likely to occur only over the longer term (3-5 years). So count this factor out for a hard floor level in the short term.

*3. OPEC: At what level will OPEC (which just means the Saudis these days) act? The Saudis already say they are cutting supply. However, they are still only matching reductions in demand growth and have yet to get ahead of the curve. The Saudi budget break-even is currently in the high $70s per barrel. This is the level below which the government there has to start borrowing money to pay for schools, roads, defense and so on.

So the mid to high $70s may be the first floor to be tested. That is the level at which US tight oil producers and OPEC (Saudis) have to begin reacting by cutting supply to match the lack of robust oil demand growth.

US Energy Stocks Turn Red on Russian Sanctions

There were a slew of new sanctions against the Russian oil industry announced this morning by the US and EU. So why isn't oil rallying? And why are US energy stocks being hit?

Why isn't oil rallying on sanctions that could cut oil supply? Because the International Energy Agency (IEA) on Thursday reduced its forecast for the rise in oil demand this year for the third month in a row. European and Asian demand weakness are the main causes. The IEA expects global oil demand to grow by only 0.9 million barrels a day in 2014, down 65,000 barrels a day compared with last month's forecast and lower by 300,000 barrels a day since July.

Furthermore, according to the IEA the Saudis (the only OPEC country willing to cut production) reduced oil production by 330,000 barrels a day in August and are now producing at their lowest level since 2011. However, they are merely matching falling demand and so this cut in supply is not bullish for oil prices.

The Russian story is still very bullish over the longer term and if you look at longer dated oil contracts (December 2018, for example) the oil market is up almost $2 per barrel this week.

So the short term bearish outlook for oil continues, but longer term (2+ years) these Russian sanctions are fairly bullish for oil prices.

Why are US energy stocks down today? Because oil is a global industry with many US oil companies investing in Russian oil production. Russian oil companies also use US oil services companies for exploration and production. Sanctions cut both of these revenue sources.

[ Market Cap Changes today of Energy Sector of US S&P 500 ]

Oil market calling end to US tight oil (shale fracking)

There was an interesting article today on an oil trader betting that the US tight oil (shale fracking) boom will end soon.

The oil market appears to supports this thesis.

The front of the oil curve continues to sell off, while the back end (January 2015 onwards) is rallying.

Short term weakness in oil futures is likely to continue for balance of this year due to the bump up in US oil supply. However, despite this short term price weakness, longer term the market is saying that this new supply will be insufficient.

Production of $15 oil began to decline back in 2005. Oil producers since 2005 have shifted up the supply cost curve in order to produce more oil.  Fracking, Canadian oil sands and ultra deep offshore are all $50+ per barrel sources that had to be tapped to make up for the decline of $15 oil.  These three sources are very difficult to scale quickly due to cost and complexity and the market is telling us that they may not add enough supply to offset the decline in global $15 oil production.