Friday, May 9, 2008

High Risk Of The Price Of Gasoline Rising Rapidly

Just when news couldn’t get any worst for driver, it just did. MarketWatch reported May 7that the U.S. refiners are now shifting production to make more diesel fuel for export to Europe. What that means is higher prices for the U.S. consumers for gasoline.

The reason for higher gasoline prices is simple. Less gasoline will be produced from a barrel of oil. Therefore, even if the refiners are working overtime, the amount of gasoline being produced will be lower. Just as the demand for gasoline rises over the summer, the refiners are making less of it. The result is a one-two combination that will push the price of gasoline up, perhaps over $4.50 per gallon by mid-summer.

As I had noted in What Should Be The Right Price For A Gallon Of Gasoline, a barrel of oil produces 19.6 gallons of gasoline. However, with the refiners making more diesel, the output ratio will change. Here is a comparison of the refiners’ output in the U.S. and in Europe / Asia (source: ExxonMobil)
Assuming the U.S. refiners also change their refining mix to the European / Asian model, then the potential output of gasoline per barrel of oil will reduce by 50%. With 50% less gasoline coming into the market and demand seasonally rising by about 5% over the summer, the price of gasoline will spike.

Again, using a quick back of the envelope calculation:

1. Refineries typically operate at 95% capacity
2. Refineries reduce the output of gasoline by 50%
3. Elasticity of Price to supply is 0.5
4. Elasticity of Demand to price increase, in the short run is 0
5. Demand increase by 5% over the summer

Then the calculation is: 95% x 50% x (0.5 x 1.05) = 24.9% potential increase in the price of gasoline over the short run, excluding speculation.

Using current price of gasoline of $3.61 per gallon, there is the potential that gasoline price may reach $4.51 per gallon ($3.61 x 24.9% increase) by the summer driving season.

Ed Kim
Practical Risk Manager

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