TEN PREDICTIONS FOR 2007 OIL MARKETS

Watch out for an especially violent upswing in West Coast gasoline prices early in 2007 that will bring back $3.00/gal and higher fuel prices to Pacific Time zones. But don’t necessarily conclude that this will be another apocalyptic year for gasoline or crude oil.

1. Gasoline prices will move considerably higher from Feb. 15, 2007 through perhaps May, but the increases will not match the surges seen in 2005 and 2006. Refining margins for gasoline will be more modest than in previous springs. You can expect to see U.S. retail average prices of $2.50-$2.80/gal on this spring surge.

2. The U.S. will see $70/bbl crude oil (near-term WTI futures price on NYMEX was $60.30/bbl when this was penned) in 2007, and we’ll see that number before we again witness $50/bbl. But there is an excellent chance that markets will see both extremes in 2007.

3. The $3.057/gal record nationwide average for retail unleaded gasoline (compiled by OPIS for AAA) won’t be topped in 2007. Neither will the 2006 high of $3.03/gal. Caveat: for the rest of this decade, U.S. markets are just one headline away from a mega-spike or a plunge.

4. Spring 2007 will bring multiple forecasts for $100/bbl crude and $4.00/gal gasoline, thanks partially to the typical springtime rally in prices, and the supply worries that accompany that move. Most of these prognostications will represent typical excess rhetoric, particularly from financial mavens with a vested interest in the outcome.

5. California, Washington, Oregon, Hawaii and some other western states will indeed see average unleaded gasoline prices rise above $3.00/gal. These states will find prices well above those found east of the Rockies.

6. Congress will hold high-profile hearings on price gouging, and spend countless dollars on this effort. The criticism of the role of multinational integrated companies and refiners may give way to an examination of the impact of hedge funds, trading exchanges and financial houses.

7. Ethanol will see its U.S. market share grow, and it will be a part of gasoline mixtures in new markets -- including Florida, Georgia and North and South Carolina. The additional displacement of 1% or more of U.S. gasoline supply will temper the spring/summer gasoline rise.

8. A modest or even mini-recession at any point in 2007 changes everything. Refining and marketing of petroleum is a macroeconomic business -- any significant slowdown in economic growth will create huge market downswings in its aftermath.

9. Diesel fuel will be the highest growth product in 2007. U.S. motorists should get used to paying 20-40cts/gal more for diesel at the pump than for gasoline. This is part of a worldwide trend.

10. Summer 2007 will be prone to hurricane rallies that could lead to “mini-spikes” of 5-20cts/gal. However, once traders perceive that the threat of Atlantic hurricanes is over, gasoline prices will give back any hurricane-inspired gains, and more.

The 2007 FORECAST…PETRONOIA RETURNS

Watch out for the Wild Wild West
Yes, we will see at least one more gasoline price spike in 2007, and yes, we will witness a heavy upward bias for global crude prices, at least in the first half of the year. But there are significant differences between the next 12 months and the 24 preceding months that fomented so-far flawed predictions of $100/bbl crude and $4.00/gal gasoline.

First, let me say, that precision in any oil forecast is a consequence of witchcraft or luck. Most analysts have a vested interest in fulfillment of their forecasts, and that goes for pundits with financial investment as well as those with emotional ties. As the Chinese proverb observes “you can’t predict what you don’t want to happen” and this axiom holds among bulls and bears in the energy space.

Certainly the market has demonstrated a tendency to gravitate toward extremes, much as the political discourse has similarly moved toward the right and left wing poles. It’s a mutated Newtonian rule of physics -- every overreaction is followed by an equal and opposite similarly powerful overreaction. We rarely see a “steady state” or relative equilibrium in prices.

Many “oil analysts” are similarly prone to hyperbole when they calculate their reasonable judgments on where prices are headed. When Katrina hit in 2005, many so-called “experts” immediately predicted $4-$5/gal gasoline, and they were quoted much more extensively than those with more measured projections. Likewise, when crude oil fell from $78.40/bbl in August 2006 to the low $60s, there was a cavalcade of predictions auguring $35/bbl crude and $1.00/gal gasoline. The extremists get noticed, and this breeds more extreme predictions in an often vicious cycle.

This forecast has no such extremism. Apocalyptic moves in oil are possible in 2007, but as in most years, the market will require similarly apocalyptic geopolitical developments, storms, or financial sector swings if extreme outcomes are to occur. It’s more likely that we’ll see a more tame 2007, but with very extreme variations between different regions of the country.

Gasoline to Surge in Late First Quarter; Western Updrafts Severe
There are some solid reasons why gasoline almost always (the emphasis is more on the always than the almost) spikes higher with spring blooms.

Remember: Gasoline is not an element -- it’s a complex hydrocarbon molecule. And quite simply, it is easier to manufacture the hydrocarbons that are suitable for use during the fall and winter than the versions that are required when temperatures rise. Cheaper components like butane can lower the cost of gasoline during cold weather months and actually enhance performance. Those same components (and other refinery “streams”) can create environmental havoc when temperatures rise and ozone is a primary concern.

2006 Retail Average by County

Enemas & Brown Bananas
The U.S. distribution industry requires nothing short of an enema when it moves from winter blends to spring blends. The old gasoline, which has limited shelf life like “brown bananas,” must be sold out of storage tanks to make room for the spring blends that are required through Sept. 15. As a health conscious male over 50, I can vouch that enemas aren’t dangerous, but they are not pleasant. In this case, the organism of the gasoline market gets stressed as this on-the-fly distribution change must be accomplished against the backdrop of relatively constant demand in the range of 9 million b/d or about 380 million gal/day or more.

It’s this enema and replenishment cycle which each year leads to spring worries about whether there will be enough gasoline to keep America running. The highly emotional and often momentum-driven trading community inevitably wonders each April or May whether “this might be the year where demand outstrips supply during the driving season.”

The reality is that these preseason problems, and the rallies that accompany the fuel switch, are problems exacerbated by the shallow U.S. petroleum storage business, and the equally shallow thinking by those that speculate or trade in gasoline futures.

We will see this enema-and-replenish cycle on display again this March and April east of the Rockies, but it occurs in February on the West Coast (California warms up first!).

Last year’s East and Gulf Coast versions of this transition were particularly challenging and accompanied by a gasoline formula change where ethanol largely replaced MTBE as the magic elixir for octane and the manufacture of reformulated gasoline. Specification changes for gasoline raise uncertainty and breed dramatic price increases ahead of the change. If I was the CEO of a refinery, I would press my lobbyists to get Congress to change specs every year to breed this uncertainty. If regulators decided this year that every gallon of gasoline had to include say, a trace of Chanel No. 5, we would see a huge rally ahead of that requirement.

The good news: This year has no significant specification changes for gasoline. There will also be much more widespread use of ethanol in markets like Florida, the Carolinas, Tennessee and Midwestern states as new plants come on line and the public embraces 90% gasoline/10% ethanol mixtures. In theory, this additional ethanol should swell the gasoline pool somewhat. We’re not talking about more than a few percentage points of contribution to supply, but markets can move 30-40% if supply/demand balances move by 2-3% or so.

So, What Should I Expect to Pay in 2007?
It will depend very much on where you live in the country. But first, let me address the wholesale markets. Despite the Oliver Stone conspiracy theorists, retail prices depend entirely on what happens in the very active, and very volatile wholesale markets -- and particularly the N.Y. based gasoline futures, where tens of millions of barrels trade each day, representing much more product than is actually consumed.

2006 Regional Retail Gasoline Averages

Wholesale gasoline prices are very tidal. There is a very predictable high tide that comes with the fuel spec change (see above) and a second less predictable rise that often accompanies those driving seasons that accompany economic growth (most years this decade). There are two very predictable low tides -- one which follows the inevitable spring overreaction and another that arrives with autumn, when specs change and foreign gasoline becomes more available.

These tides have tended to be more dramatic in the 21st century. The typical late winter/early spring tidal rise for wholesale prices averaged 55% in the last twenty years, but it surged more than 60% in the last two years.

The early ebb tidal price “loss” has been about 26% in the last 20 years, but it was a mere 13.5% last year. The typical autumn ebb tide in the last 20 years has lopped about 30% off of prices, but it arrived early in 2006 (August) and led to a dramatic price plunge of roughly 42%!

The best any analyst can do is ascertain whether the tides may be unusually high or low and make projections based on that reckoning.

In my view, the wholesale market east of the Rockies should see a lighter-than-normal tidal surge. We’ve watched in some previous years as gasoline has fetched numbers some 50-70cts/gal above the raw cost of crude, compared to more typical premiums of 10-20cts/gal in the 1990s and from 2000-2002.

The spring Petronoia rally should by mid-April add another 20-45cts/gal to wholesale prices witnessed as 2006 ended. Retail margins ended 2006 on a miserable note, so virtually all of those increases will need to be passed along (c-stores can sell only so many cups of high-margin coffee, or Slim Jims, to make up for low-margin gasoline sales). So, street prices for the eastern two thirds of the country should rise to say $2.50-$2.80/gal, depending on state and local taxes, etc.

Estimated Fuel Cost of a Trip in 2006 vs. 2002 in Various Automobiles

The wholesale rally in western states will exceed the altitudes witnessed in other regions. I wouldn’t be surprised to see western wholesale prices (exclusive of tax and mark-up) exceed the pump prices in the rest of the country. That would point to street prices for unleaded regular in states like California, Nevada, Oregon and Washington of $3.00/gal or higher before the actual driving season gets under way.

Why such high altitude out west? Well, it’s the one area of the country where supply really hasn’t increased appreciably this decade, and it is separated from global refining centers by a vast distance. And there are very few offshore refineries that can make the gasoline required in California. A single refinery accident on the West Coast can quickly create 20-25cts/gal of immediate upside movement.

Back to the tidal metaphor: The West may very well remain inundated by high tides into the summer, although pump prices may recede by 10%-20% from the high-water mark. By autumn, western states could give up most of the 2007 increases, and flirt with the $2.50-$2.75/gal price levels that were common in the last 100 days of 2006. In other words, the ebb tides should be typical out west.

The rise in other U.S. markets will be more difficult to sustain. Up until last year, spring rallies were often followed by an ebb tide that typically removed about 25% of the gains. U.S. refineries will have no hurricane hangover in the second quarter of 2007 (unlike 2006 when some 700,000 b/d of hurricane-impacted refining capacity was still down) and prices could well recede by more than the 25-40cts/gal that would be typical (20 years of history delivers a 25% giveback trend). Barring unforeseen accidents, and thanks to additional ethanol fattening the motor fuel pool, it should become apparent that refiners will be in good shape to deliver ample supply for the driving season.

The great unknown is what happens between July and September? Instinct tells me that gasoline will get shunned and oversold in June and July 2007 as the trading community concludes that summer 2007 won’t feature devastating hurricanes.

But make no mistake about it. U.S. inventories are incredibly shallow when measured against the population and it doesn’t take much of a supply interruption to provoke a short term, but very dramatic price spike. Without hurricanes or power blackouts, prices should go nowhere through the summer. However, severe storms that actually strike refineries put $3.00-$3.50/gal numbers in play throughout the country. We have done nothing as a nation to create any safety net for the Katrinas or Ritas in the rest of this decade.

Beyond the hurricane season, there should be nothing but sharp downdrafts for gasoline. Even if crude oil fetches $70/bbl in the fourth quarter of 2007, there should be enough global gasoline production to keep wholesale and retail prices in check. A flirtation with sub-$2.00/gal prices should again be the case in states like Oklahoma, Missouri, Ohio, Indiana, the Carolinas, Georgia and New Jersey.

Crude
The difference between the lowest price and the highest price for West Texas Intermediate (WTI) crude in 2006 was more than $23/bbl. Put another way, crude oil varied by more than the absolute price recorded in early 2002. The span between low and high was more than $29/bbl in 2005 and $23/bbl in 2004 so huge pricing swings hardly make news.

The extreme bookends in 2006 were a $55.08/bbl low and a $78.40/bbl high. Each extreme may be approached at some time in 2007 -- expect an assault on $70/bbl and higher in the first eight months of the year, with $55/bbl or lower threatened in the last 100 days or so.

Market dynamics at the moment point toward $70/bbl as more probable than $50/bbl in the next major market move, even if relative stability holds on the geopolitical front. The Energy Information Administration has accurately noted that OPEC doesn’t need to cut output to stabilize prices -- there is already a razor-thin margin between what is being produced and what is being used. That margin should narrow in 2007. Oil companies are spending much more money to find crude than they were in 2000-2001, but the new stuff won’t make it to market this year.

Weekly WTI Crude Average vs. OPIS National Spot Average

(National spot average = ((Gulf Coast Conventional * 4) + (NY Arbob *2) + (LA Carbob * 1))/7)

Beyond the fundamentals, however, there is a clear steroid that is driving crude oil prices ever higher. Huge sums of money are coming in to index funds like the Goldman Sachs Commodities Index or the Dow Jones AIG Index. If you have a pension, public or private, there’s a good chance that by the end of 2007, you’ll at least indirectly own 2007-2012 crude oil futures. The fear of oil prices driving inflation higher inspires investments in oil futures as a hedge against such inflation, and so on and so on in a vicious cycle. Well-heeled investors who fear the consequences of $100/bbl oil on their equities portfolios don’t mind buying oil at $60/bbl as a hedge, or an outright play.

In short, there’s every reason to believe crude oil prices will be higher in 2007 than in 2006, but whether that incremental difference is $5/bbl or $10/bbl is beyond anyone’s predictive capacity.

Footnote: Wall Street often argues about the fuel price necessary to promote true conservation and massive changes in behavior. Last year, when California prices hit $3.30/gal in mid-May, a significant amount of motorists altered their behavior and clearly used less fuel. It’s not possible to extract statewide demand from federal or industry statistics, but OPIS has many sentinels among the multi-state c-store chains, and they confirm that western fuel demand slumped during the period where street prices were between $3.00-$3.30/gal in western states.

Basis Differential between OPIS National Spot Average and WTI Crude

A Perspective on Retail Prices and their Performance this Decade

The annual gasoline price average for 2006 was a record-breaker, coming in at just over $2.55/gal. But the year did not see a record daily price — the top daily average in early August 2006 was $3.03/gal, short of the $3.057/gal on Labor Day 2005.

When all of the gallons and dollars are counted, we’ll find that American motorists spent about $998 million/day on gasoline in 2006, and demand averaged about 388 million gal/day. That would compare to a daily bill of some $872 million in 2005 on daily sales of about 384 million gal. But the average daily cost for gasoline is about double what was the norm as recently as 2002 when we used less and paid a little more than half what we paid for each gallon in 2006.

Percent of Average Family Budget Driving 12,000 miles per year in a Vehicle Averaging 16 MPG

A quick back-of-the-envelope calculation: The annual gasoline bill was about $364 billion in 2006, up from $318 billion in 2005. The same total expense was about $183 billion in 2002. Few economists would have predicted four years ago that additional costs of $181 billion in 48 months would be tolerated by the consumer segment of the American economy. That perhaps explains why cheerleaders in the equities and commodities markets now posit that the U.S. might not slip into recession even if crude oil prices hit $90/bbl and pump prices top $3.50/gal.

For the record, it took about 104 years within the history of the combustible engine to hit a $2.00/gal price in the U.S. as nationwide prices didn’t exceed that threshold until May 19, 2004. It took less than 16 months after that day to hit the $3.00/gal mark.

But for all the weeping and gnashing of teeth, here are a few other observations:

• U.S. gasoline prices have collectively been above $3.00/gal for a total of just 27 days - - eight days in the post-Katrina September of 2005 and 19 days in midsummer 2006.
• The last time we saw nationwide prices below $2.00/gal was on March 9, 2005. So, we’re on a streak of about 660 days above that mark.
• Averages can be misleading. About half of the country saw street prices descend below $2.00/gal in autumn 2005 and a similar number of states drifted below that benchmark in the most recent fall. The Continental Divide between east of the Rockies’ prices and western states has widened in the last few years.