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May 15, 2007

Get daily research letters from Phil Flynn of Alaron Energies

Phil is one of the world's leading energy market analysts, providing individual investors, professional traders and institutions with up-to-the-minute investment and risk management insight into global petroleum, gasoline and energy markets. Phil's market commentary, fundamental and technical analysis, and long-term forecasts are sought by industry executives, investors and media worldwide. Now you can get this highly sought after analysis with your daily research newsletter from Phil Flynn. Learn more about this complimentary offer and sign-up today.

Life is full of the sweet and the sour. Times can be good and times can be bad, yet we cannot really appreciate the sweetness of life unless we taste the sour. Sometimes life gives you lemons and sometimes you can make lemonade but it seems that there is always some sweet that is mixed with the sour.

Take gasoline prices for example. It seems like rising gasoline prices are a rite of spring. Almost like celestial clockwork, gasoline prices are rising just as spring has sprung. Oh sure, we cringe at the thought of this springtime increase in gas prices but would we really forego the season of spring just to conserve on gas?

One of the biggest misconceptions about gas prices is that somehow high  prices at the pump are a bad thing and a devastating negative for the entire economy. Yet the truth is, as much as some people try to sell you on that fact that high gas prices are bad, high prices aren't so bad for the economy and I must respectfully disagree with this who believe otherwise.

In fact Americans love high gas prices! Any true American loves the sting of higher gas prices when they fill that SUV up at the pump. When we were kids we always admired the fastest car, the coolest rag-top with the mag- wheels and the toughest truck with the lifted suspension. America is a country of the roads, by the roads and for the roads with complimentary parking for all.

Oh sure, we complain about high gas prices because complaining about it is really a national past time. You know it’s kind of like complaining about the weather. We love to complain about it even though we can't do anything about it. And recently as gas prices have been rising our demand for gas is running near record highs. The truth is we love high gas prices because - gosh darn it! - we continue to drive and drive in ever increasing record numbers.

This spring is no different. Just yesterday the Department of Energy reported that gas prices hit a record high of $3.10 a gallon just as the trees and flowers are blooming. Sound familiar? But as familiar as the run-up in gasoline prices appears to be, this run-up is unlike others we have seen in the past mainly because of what hasn’t rallied with it. And what hasn’t rallied with it is the benchmark Nymex WTI - West Texas Intermediate - sweet crude.

In what could be described as a shocking development by some, this year as gas prices have soared to unprecedented heights, crude oil has been lost in all the action. In fact as gasoline prices have soared, the price of crude has floundered.

What is even more unusual about this situation is it’s normal for the Nymex sweet crude to rally during times of high gas prices because the quality of the NYMEX sweet crude. The sweet grade is more pure than other grades and yields the most gasoline. And with gasoline prices soaring and gasoline crack (which is the amount of profit a refiner receives for turning crude into gasoline) at record highs, you would think the refiners would pay a hefty price to get their hands on that light sweet stuff. We would expect to see crude oil trading in the $70.00 range yet here we are languishing in the $60.00 range.

Why is this happening? Well one of the reasons is the same reason gasoline prices are so high in the first place and that is that refiners, as far as refining goes, have had a run of real bad luck.

This has been the year of the refinery outage. And some of the refineries that have been down have depressed the price of the light sweet crude. Even as lesser sour grades have rallied, the sweet crude has been held back. And the reason it has been held back is due in part to where the sweet crude oil is delivered.

The light sweet cruse oil is delivered in the land of the refineries in Cushing, Oklahoma. The problem is that Cushing is landlocked and when some major refineries that buy their oil from Cushing went down, the crude oil started to back up. The situation became worse due to the contango in the futures market. With prices higher out in the later future contract months, it paid for many speculators to buy oil and deliver it in later months which in turn tied up storage space at Cushing. And with the refineries not buying as much oil more and more oil started to back up at Cushing depressing the price. Because Cushing is landlocked there is no easy way to get the crude out of Cushing sending it to thirty refineries that would covet that oil. Sweet crude that normally commands a premium of $2.00 or more over the sour, is now trading about a $3.50 discount. The spread between the light sweet crude is at a historic low against the heavier sour Brent.

So because of some refining outages and Cushing being landlocked there are so many historical relationships that are out of whack. In fact they are so out of whack with the norm that some democratic politicians now want to define gouging as the difference between the prices of crude versus gasoline and that could make it illegal to sell gasoline right now because if you did, you'd be accused of gouging.

All of this talk of sweet crude might leave a sour taste in your mouth but really it should not. Because even though the sour crude is out of reach the sweet crude depression in price could provide opportunity. As time goes on the backlog in Cushing should start to work itself out. If you have a choice where to send your crude you can bet you will send it anywhere but Cushing. With gasoline demand hanging tough with prices already near all time highs, the demand for the sweet crude should reappear. With sweet crude as benchmark crude that normally would be shipped to the US, we might now see it be sent to other places where the prices are higher. And even if you have higher quality crude, you would want your selling price to be tagged to Brent crude that usually trades at a discount to sweet but right now is trading at a premium to sweet.

Yet except for Cushing, Oklahoma, the supplies of the sweet crude world wide is tight. Another major supplier of sweet crude is the country of Nigeria and they are having problems. On going violence by militants has led to periodic shutting off of Nigerian sweet crude supply.

The problems are so worrisome that Secretary of Energy Samuel Bodman is warning that OPEC will need to increase supply before they meet in September.

OPEC, on the other hand, is looking at the price of crude based on the Cushing situation that is obviously flush with plenty of oil. Their thinking is the world has plenty of oil and an increase in supply would further sink the price of sweet crude. They blame the US refining sector and fear that if they increase production it will sink the price of crude world wide. They worry they would create a glut of heavier sour crude destroying their profits. It doesn’t help that OPEC is paid on dollars for their crude supply and the dollar has been less than strong.

The bottom line is sweet for investors especially those who missed the run-up on gas. As the refiners start to come on line, the truth will become known that the sweet crude is undervalued. Now that’s assuming of course that demand stays strong and we don't lose anymore refineries.

Despite being above average US crude supplies are still below year ago levels. And as logistical issues work there way out in Cushing the demand will drive oil. In other words, based on the NYMEX, crude oil is probably undervalued.

As I said before sweet crude is trading at a discount to the sour Brent of over 3 dollars. Normally this relationship trades at a 2 dollar premium. As refineries come back online the sweet crude should rise dramatically as the sweet is most desired by refineries. If things were back to normal now, the front month sweet crude would be trading perhaps in the near $68.00 to $70.00 a barrel area. An area that I think will be reached at some point this summer. As the logistical issues work out the demand for sweet crude will be incredible. In fact due to worldwide demand I think the sweet crude is the most undervalued commodity on the board. At some point this should lead to a huge price spike because somehow the market will get their hands on that oil. If I am right there may be some sweet returns on options. Small investors with limited capital to risk might do well to but bullish option strategies or even gamble on out of the money calls. The time to make big moves in the market is when the market imbalances start to unravel.

Get daily research letters from Phil Flynn of Alaron Energies

Phil is one of the world's leading energy market analysts, providing individual investors, professional traders and institutions with up-to-the-minute investment and risk management insight into global petroleum, gasoline and energy markets. Phil's market commentary, fundamental and technical analysis, and long-term forecasts are sought by industry executives, investors and media worldwide. Now you can get this highly sought after analysis with your daily research newsletter from Phil Flynn. Learn more about this complimentary offer and sign-up today.