October 23, 2008

The Free Market Has a Solution for Everything

IF THERE'S ONE THING we can take from our present economic crisis, it's that every cloud has a silver lining -- even when it's a funnel cloud. I fully admit this optimism may seem a bit misplaced in our current situation, when the equity markets are in free fall, real-estate values have plummeted, our credit markets are logjammed and it seems as if no one will be able to retire until they're 90. But panic does no one any good; instead, it is important to seek out opportunities for profit where they exist, and position oneself as best one can for the inevitable recovery.

Simply put, this situation is not all bad. Lost amidst the turmoil is the pleasing fact that oil prices have crashed over the past several months. As of this writing, crude oil is trading for "just" $67.75 per barrel, a stunning collapse from its July 11 peak of $147.27 per barrel. That's a drop of roughly 54 pc -- and in pure dollar terms, a drop of nearly $80 per barrel.

That's nearly $80 per barrel not going to the Governments of Iran and Venezuela and plenty of other Governments who are easy not to like, a situation that reminds one of Fred Schwed Jr's old quip about financial panics: would you really want all those people who had money to have it again? The situation is so bad that on Friday, the OPEC cartel will meet in an attempt to shore up the price of crude; an endeavor that will likely prove difficult for the cartel to pull off. After all, as much as the Iranians and Venezuelans might want to chisel the West, every producing country will want to sell as much oil as they can in an attempt to maximize their revenues -- particularly non-OPEC countries such as Equatorial Guinea. You think Equatorial Guinea cares about what the Iranians want to do?

As oil prices have fallen, of course, so have gasoline prices -- providing joy and relief to the oppressed American people. Here in New Hampshire, for instance, prices have fallen sharply. In my own city, Manchester, the average price for a gallon of regular unleaded is $2.81. That's down from $3.53 a month ago and down from $4.02 at its peak on July 15.

As of this writing, it seems further price declines -- at least in the near term -- are quite likely.

I think most people, given the severe price swings of the past couple years and consequent media attention on these matters, know their local filling stations do not profit when prices are high. Since the gasoline market is hyper-competitive, most gas stations make just a few pennies -- if that -- on each gallon of gasoline they sell. If they are lucky they can get a dime per gallon, which is still quite reasonable if you ask me.

This also prevents gas station owners from profiting greatly when prices suddenly decline. Even though there may be individual days where they're able to take advantage of an increase in the spread between their wholesale costs and their local market's prevailing retail price, the highly competitive nature of gasoline sales limits their upside: the guys down the street will lower their prices as soon as they can in an attempt to draw business their way. As such, there's an impetus for prices to keep falling. (Gas station owners like low prices, by the by, because their margins are better and their capital costs are lower. For instance, 10,000 gallons at $1.50 will cost a gas station $15,000; a nickel profit on each gallon works out to $500, or 3.33 pc; 10,000 gallons at $3.50 will cost a station $35,000, and the $500 profit earned from a nickel per gallon margin works out to just 1.4 pc. This is why gas stations these days have convenience stores).

If you want to know why gasoline prices move the way they do, you have to look two places -- first, at the refining and distribution level, and second, at the gasoline futures market. Generally speaking, there's usually a 60 to 75 cent differential between the next month's futures price and the cost at the pump. Let's look at some past prices to see how this worked out:

On July 7, for instance, the average retail gas price in America was $4.14 per gallon. On the same day, the price for the August New York Harbor Reformulated RBOB Regular Gasoline Future contract was about $3.48 -- a 66 cent price differential. Going back a bit, on Feb. 5, 2007, the average retail price for gasoline was $2.22 per gallon; the futures price was $1.56, a difference of ... 66 cents. Wow, and I just picked those dates at random, too. Crazy.

Anyway, as I write, the futures contract for gasoline is trading at $1.58 a gallon. If the past is any guide, this suggests gas prices will eventually fall to an average of $2.18 to $2.33 on a nationwide basis. (Your local price, of course, will vary due to environmental laws, state taxes, how close you are to refining operations and shipping terminals, local competition and other factors. There are places in New Hampshire, for instance, that are a good 30 cents cheaper than what I pay in Manchester).

According to AAA, gasoline is today retailing for $2.82 per gallon nationally. One may wonder why the spread is now $1.24 per gallon, but remember two things: it takes time for product to move through the system, and falling prices give everyone in the system a chance to make a bit of profit they couldn't make when prices were skyrocketing. So an increased spread is not prima facie evidence of unfair profiteering, but rather a chance for profit in a market that traditionally offers little room for it. If nothing major changes, prices should keep falling and we'll get closer to a more traditional spread -- the competitive nature of the market will force this to happen. And looking out over the next few months, RBOB futures prices are holding stable around that $1.50 and change mark.

Of course, the rub here is "if nothing major changes," and I do not have a crystal ball. But what if one could guard against higher prices at the pump? After all, large companies do this, many quite well -- Southwest Airlines is perhaps the best example. Its clever hedging strategy for jet fuel, which although recently backfired due to the sudden drop in oil prices, kept it profitable even as its competitors were having heart attacks when they examined their fuel bills.

Thanks to a clever site called Petrofix, consumers can do just that. Unlike traditional gasoline pre-buy programs, where customers buy hundreds of gallons of gasoline at a set price and then draw down those cheap gallons when prices go higher, Petrofix offers consumers a pure financial hedge against higher gas prices.

Generally speaking, Petrofix charges about 20 cents a gallon for its hedge. So let's say you use about 40 gallons of gasoline a month. Over a one-year period, that works out to 480 gallons. As such, a Midwesterner would pay $96 to hedge against higher fuel prices for a year. It's slightly more elsewhere. (Of course, one does not have to go whole hog -- you could hedge half your fuel consumption, or a quarter, or whatever you think works best, and pay less accordingly).

Now, if prices fall and stay lower for the entire year, you're obviously out of luck. You can take this one of two ways -- you can either get angry at guessing wrong (this can be cathartic) or you can rationalize the $96 spent as buying yourself some peace of mind (which can also be cathartic). But let's say prices go higher. Petrofix will pay you the difference on a monthly basis. Let's say you locked in a retail price of $2. If retail prices suddenly go to $3 the next day and stay there, you would save $384 over the year ($480 gross - $96 cost of hedge).

Think of the benefits that would offer. You would amaze your friends and confound your enemies. Not only could you live large on your savings, you could do so in a way that would make you seem really clever at cocktail parties. If you are a young man, you could use this to impress beautiful girls at get-togethers, and frustrate the ambitions of that guy with the conspicuous jewelry, fancy sport-utility vehicle and dog-eared guide to picking up women. It would be great on so many levels.

Of course, the trick is to buy when prices are low. If they are especially low, then hedge for as long as possible, in order to maximize your potential gain. This means you should put Petrofix in your favorites and not forget about it, and be ready to strike when you think fuel prices are at or near a low. Maybe you think conditions will change soon, and our present situation is just a breather -- then buy soon accordingly. If you think prices will keep falling, you would wait until you think they won't fall anymore, and then hedge about that point, or on the next significant uptick.

I must emphasize that I do not have a crystal ball and that oil prices, gasoline prices, futures prices, and the various other prices I've quoted here can and do change quickly, so I would caution readers of the need to do their own research and come to their own conclusions about what the oil markets may do. Additionally, past performance is no guarantee of future results, and so the historical examples I've noted may not hold in the future. In other words, don't blame me if things go to hell in three weeks. It's not my fault.

I would also caution that one must make sure to read Petrofix's terms and conditions and understand how things work before entering into any deal with them. But I would congratulate the company for making this offering available to everyday consumers, as I think it could offer people a nice weapon in their arsenal for the continued fight against high fuel prices.

Posted by Benjamin Kepple at October 23, 2008 08:30 AM | TrackBack
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