Fast and Furious

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Fast and Furious

Retailers who expect to see gasoline prices continue their recent fall are kidding themselves and should rethink their business models because $4-per-gallon gasoline is just one negative headline away, and the day of $100/barrel crude isn't too far off. Any escalation in news about the nuclear threat from Iran and North Korea, war in the Mid-East, terrorism, hurricanes or other supply disruptions could send retail prices accelerating upwards again in the next year.

Then again, maybe not.

Many industry players believe retailers need to face the new fuel reality: An environment where the August news of BP plc's Prudhoe Bay pipeline spill sent the cost of U.S. crude oil surging 3 percent to $77 a barrel and gasoline prices jumped six cents a gallon in some markets on the mere threat of a tropical storm. Yet others believe the likelihood of gasoline falling back to $2 a gallon is as strong as the chance it will hit $4 in the next year. As of press time, the average price for a gallon of gasoline nationally was $2.50, a decline from the summer high of just over $3.00 per gallon.

"We are probably a couple years away from $100 per barrel oil if the economy stays strong," said Phil Flynn, lead energy analyst for New York-based Alaron Trading Corp., who said oil prices have been increasing approximately $10 a year. "The thing that would drive it to $100 fastest is a supply disruption from Iran, but the odds of that seem to have gone down a little bit.

"You'll see gas prices edge up as long as demand holds up. It seems like supply is fairly adequate, but we won't see a big washout on gas prices, because demand growth will keep refiners on the edge for at least the next year."

Others see it a bit differently. "Gasoline prices could go up, or prices could go down, but I think there is more chance they will go down," said Joe Petrowski, CEO, Gulf Oil LP, based in Chelsea, Mass., which distributes motor fuels through a network of 1,800 Gulf-branded sites.

"Looking at standard operating models, I'd say there is 17-percent chance oil will hit $100 in the next year. But there is also a 17-percent chance it will drop to $46. There is a very good shot we will have $50-per-barrel crude in the next year."

Though the oil market was short 2 million or 3 million barrels a day in early September and crude is priced on the margin — "Whoever needs that last barrel sets the price for the rest," Petrowski noted — that shortage is a byproduct of explosive energy needs in China and India and a production lull caused by the oil industry's infrastructure that is geared to $12 per barrel oil, the price just five years ago.

"Back then, we thought that price ($12 a barrel) was the new paradigm," Petrowski said. "Now everyone says $70 is the floor? How ridiculous is that?"

As early as next spring, he forecast, the world will have a surplus of 3 million or 4 million barrels a day, as global production increases, driving down crude prices. "At $73 a barrel, some marginal-producing areas are now economical to develop," he noted.

Michael C. Lynch, president of Strategic Energy & Research in Amherst, Mass., predicted even sharper declines in gas prices, according to an article in the October 2 issue of Forbes. Lynch predicts that oil will fall to $45 per barrel by mid-2007, and could dip below $30 per barrel in 2008.

Still, as industry observers do their best to forecast the price of crude and motor fuels, convenience store and gas station operators need to plan for an uncertain future. Here's what the experts have to say about forces influencing the retails posted on the corner and operators' margins:

U.S. and Global Demand

Big Oil companies and others point to continued demand for petroleum products, especially in China, as a key factor in spiraling gasoline prices. Environmentalists and some legislators are touting conservation to reduce demand and lower gas prices. Still, Americans' ability and desire to reduce demand — and whether or not a concerted effort would reduce the price of gasoline — is debatable.

In May, U.S. motorists cut back on fuel use (measured as gasoline deliveries out of primary distribution system refineries, bulk terminals and pipelines) by 3.3 percent from year-ago levels, according to the American Petroleum Institute. For the full second quarter of 2006, the country's demand for gasoline fell by 0.4 percent, compared to a 0.5-percent increase in the first quarter of the year.

"Our figures show that consumers, facing higher gasoline prices, apparently found ways to drive less and to use fuel more efficiently," said Ronald J. Planting, API's manager, statistical information and analysis.

If U.S. demand continues to fall, prices might fall, even with the world's geopolitical unrest, said Dan Gilligan, president of PMAA, based in Arlington. "If gasoline went to $4 a gallon, I do believe demand would drop significantly and prices would not stay at $4 very long — but who really knows."

Many Americans are conserving in small ways, such as combining errands, keeping their cars under 60 miles per hour, avoiding jack-rabbit starts and slamming on their brakes, said Karen Matusic, a spokesperson for API. "But because of the American lifestyle, there is a limit to what they can do without investing in a new car or moving closer to their jobs."

Indeed, "the story of demand continues to be swept under the rug," said Phil Flynn, lead energy analyst for Alaron Trading Corp., based in Chicago. "The incredible demand has kept prices high. U.S. consumers are not changing their habits."

In late June, U.S. demand for gasoline posted its fifth-highest weekly rate ever, noted John Zehler Jr., owner president of gasoline distributor Virginia Fuels Inc., Mechanicsville, Va. "When we hit $3 a gallon, we saw a tremendous amount of demand destruction. But when gasoline went back to $2.50, we saw demand go right back to normal. As we inch back to $3, demand hasn't been disturbed. Maybe at $3.50 it would be."

Gulf Oil's Petrowski puts that figure at $5 a gallon, but adds: "Americans need to get past the thought of reducing demand for gasoline as a way to calibrate the world's energy needs. Politicians who [contend we can] are either totally ignorant or disingenuous."

Total BTU consumption has only fallen once in the last 200 years — in 1929. "We can get energy consumption down if we want to have 25-percent unemployment or a worldwide depression," Petrowski said. "Energy use is going to grow — and grow fast in China and India. It's not going to go down."

In the long run, Americans will go to more economical cars and give up on frivolous uses of gasoline, he said. "But we consume about 550 gallons of gasoline per person per year. If the price went up $1 a gallon, given people's preference to be mobile and what the car means to Americans' belief system, I don't see that $500 a year affecting demand.

"I know environmentalists don't want to hear this, but in the end, we will have to produce our way out of these high prices. You're not going to ration demand to [a significant degree] through high prices, until you are willing to take the price to $10 or $12 a gallon."

Supply Levels

World supply levels are on an upswing and U.S. refining capacity is growing.

"We have repaired a lot of the infrastructure hit by Katrina," Petrowski said. "We've added worldwide refining capacity significantly this year. We've gone all out, squeezing additional barrels out of existing infrastructure so that the market is now comfortably supplied."

As of the end of July, U.S. gasoline inventory was at 211 million barrels, higher than the three-year average of 206 million barrels, Zehler noted. "But supply and demand is balanced on the end of a pin. Anything one way or the other will tip this."

At press time, U.S. refiners had publicly reported planning or "strongly considering" actions to raise refining capacity by nearly 10 percent per month to 19 million barrels by 2011.

"That would be an all-time high for this country, even though no new refineries are being built," said API's Matusic. "But I'd tell retailers until there is more spare crude oil capacity online, we are in for a very volatile ride and there will always be a threat to supply."

A few of those threats on the front burner: Iran's threat to cut off oil supply, strain to Nigeria's oil industry, keeping Iraqi supply flowing, and hampered production in Venezuela.

Still, Petrowski is not concerned about geopolitical issues as they relate to the price of oil. "Terrorism sometimes has a bearish, not just a bullish, effect on crude prices," he said. "The incident with the planes in London proved that. On Sept. 10 2001, the wholesale price of gasoline was 87 cents a gallon. After the 11th, it went to 50 cents."

The U.S. Economy

The demand for petroleum products will depend a great deal on the economies of the United States and China, Flynn noted. "As explosive as China has been, their growth depends on the stability of the U.S. economy, because that is where they export most of their goods. If the Chinese economy bubble bursts, you could see a drop off in price, but until that happens, you have to bet that gas prices will continue to go up."

Still, current gasoline prices are not good for the economy, said Gulf Oil's Petrowski, and $73-per-barrel oil is too high. "We don't want energy prices to stall the economy," he said. "The extra money people are paying for gasoline is coming from someplace – travel or eating out or other spending."

Still, the biggest fear for retailers in this whole marketing environment is probably a softening in the economy, Flynn said. "With the Fed done raising interest rates, at least in the near term, and the jobs market looking pretty good, we will be solid going into the end of the retail year and should hold on to gains."

Refiner Margins

"Refiner margins that normally average $7 a barrel, have gone as high as $22 a barrel and are averaging $17 per barrel," Zehler said. "At the end of July, crude, gasoline and distillate inventory were higher than the three-year averages. So [you can see] why gas prices are so high."

Added Alaron's Flynn: "Retailers should build refineries in their backyards. That is where the money is."

Since 1999, refiners' average margin has jumped by 85 percent, according to an analysis by the Associated Press published in mid-August. The margin increased 20 percent for the seven years before that.

Big Oil, though, is quick to characterize current prices as payback for the lean times. "They will also argue it is incumbent on them to expand capacity and to meet stricter environmental regulations and what could turn out to be pressure from government to build more refineries," Flynn said. "They are saying this profit has been a long time coming and they need it to invest. I don't think they have a choice."

Still, retailers can't win in this type of market, he said. "But that is the way the retail business is these days."

Retail Margins

In fact, retail gasoline margins have all but disappeared. "Retailers continue to live in an Oz-like environment wishing for or anticipating lower prices coming tomorrow," Zehler said. "They are hoping to maintain volume by keeping the average rack-to-retail [margin] at a whopping 3 cents per gallon."

Retailers must take margin increases, he said. "I know they have competitive situations, but [if they don't], they are gone. Don't keep sitting there thinking you're going to get a 20-cent pot next week because prices will fall. We've been in an erratic up, down, up, down margin for last few years and now we are in a static or uptrend."

Petrowski, however, predicts healthier margins on the horizon. "The real question is: Where is the equilibrium price? Don't get too complacent when margins are 25 cents, and don't get too despondent when they are 5 or 6 cents."

To strengthen their profit margins, retailers should change street prices daily, he said. "Like it or not, the retailer has to look at the price of replacing what he has sold, versus the cost of what he has in the ground."

Retailers "all want to be the lowest person on the street," he continued. "I argue they are their own worst enemy."

If the average consumer fills up with 12 gallons of gasoline, he noted, a 5-cent hike in retails would be just 60 cents a visit, he said. "If you don't have an inside-the-box strategy that is worth a 60-cent premium, either because of the right location, friendly sales staff or right presentation inside the store, you will not survive."

Retailers who insist they are low-cost operators and can afford to offer the lowest price in the market, are not being realistic, he said. "If you have an integrated major anywhere within striking distance, you have just gone to the poker table against someone with billions of dollars. I don't care if you have Superman's x-ray vision and can see their cards, you are not going to win a price war with a major. Your total offer has to carry the day."

C-store operators must lower net operating costs from 8 or 9 cents a gallon sold to 4 cents. "You don't get there by paying people less," Petrowski said. "You get that by having an inside offer that lets you sell $35,000 a week instead of $30,000 and having 40-percent margins, not 30 percent."

Alternative Energy Sources

"I think they will catch on," said Flynn. "You'll see alternatives come into play as high prices are sustained. Things we thought not feasible when crude was $30 a barrel look attractive at $70 a barrel."

High crude prices will encourage more use of natural gas in industrial and home heating and the building of some nuclear plants, Petrowski predicted. More coal will be used in electric plants, too. "All of these energy sources are interrelated," he said, "but I fully expect world oil production to be over 100 million barrels in the next decade and go even higher — we aren't running out of oil."

Even so, retailers should be exploring the sale of E85, he said. If ethanol production approaches 10 billion gallons — it is expected to reach 5 billion gallons this year — and there aren't more mandates for ethanol usage, ethanol could trade below gasoline in 2007, the oil executive said. "Retailers need to be prepared for E85 appearing in markets where it is not mandated. You wouldn't want to have a corner without an E85 pump when the guy across the street with one has a 25-cent retail advantage."

The "Fear Premium" — Some industry watchers believe anxious traders are fueling price jumps. "Maybe there was a bit of overreaction [to the war between Israel and Hezbollah], because there is no oil exported from Israel or Lebanon or Syria," Matusic said. "But because the market is so tightly balanced between supply and demand and spare capacity is smaller than we've seen in many years, even when there is a remote possibility of a threat to production in the Middle East, West Africa or even our Gulf, there will be trigger knee-jerk reactions on the futures market and price spikes."

Still, Matusic doesn't blame the markets. "They are reacting to possibilities, because they are making a bet of where prices will go in the future."

Still, much of the talk about a fear premium has been overplayed, Flynn said. "The risks of trading oil have been higher than it has been in decades," he agreed, "so much can go wrong — war in Iraq, threat of terror that all goes into the bottom line. But none of that would matter much if we didn't have exploding demand."

Perhaps distributor Zehler put it best: "Where are we going with price and what can we expect? Who knows! No one knows the ceiling. Nobody."