For most of this week, oil markets have suffered from what I’ll call the “hedgy energy wedgie.”

But the wedgie could get a major adjustment this morning, thanks to Mother Nature and the Federal Reserve.

   Oil futures sold sharply lower for much of the week, not because of fundamentals or typical energy headlines, but thanks to the “hedgies”. Countless global hedge fund managers had to liquidate commodities’ positions in order to meet margin calls in equities, bonds, etc. The press called it a “liquidity” crisis. I remember having similar “liquidity issues” in my youth, but back then we referred to the malady as “the dry heaves”. Remarkably, the energy wedgie created by the hedgies, and my 1970’s dry heaves, were both spawned by excess.

   In a moment, I’ll press on with some additional observations. But first, let’s take a look at the August 17, 2007 numbers. They may be dramatically different a week from now.

    Retail gasoline eased ever so slightly to $2.759 gal nationally, down about 47cts gal from Memorial Day, and about 22cts gal below August 17, 2006. There are many many suburban and rural markets scattered across the country where one can find motor fuel for about $2.50 gal or less, however.   Retail prices for diesel are at $2.925 gal, down 20cts gal from last year. I’ll come back to the issue of diesel prices in a moment.

   Now back, to the hedgies and the energy wedgie. .

   Oil markets are quite accustomed to 10 percent or greater “corrections” but they are unaccustomed to such downdrafts getting spawned by action in stock, bonds, and currency markets. In any case, the need for liquidity to pay the piper in one highly leveraged instrument (stocks or bonds) led to selling on the New York Mercantile Exchange and InterContinentalExchange (the two major venues for energy futures) earlier this week.

   This is one of the consequences of the emergence this decade of oil futures as an asset class for investors as well as speculators. If one comes into the home or office and hears of a triple digit point drop in the Dow, one can anticipate a tremendous headwind for oil futures prices.  And for the most part, that headwind extends to the bulk spot markets, and likewise to wholesale rack prices, and so forth. But this rule doesn’t necessarily apply to the inverse: stock market rallies may fail to provoke across the board increases in oil as Summer draws to a close.

   Initially, crude oil, gasoline, and distillate all dropped even as three separate tropical systems were on global weather maps. If the calendar read July, and equities were stable, the mere emergence of Hurricane Dean probably would have pushed gasoline prices up by 25-50cts gal. For a look at how refiners prepare for hurricanes, visit a special OPIS website at http://www.opisnet.com/supply/storms.html

   There is still much to worry about on the supply side, with stocks hardly at comfortable levels given the population growth since Katrina. Some of the probability cones for Dean (see previous post) now have the storm turning toward Louisiana and Texas next week. That would not be a good thing, as it would result in precautionary shutdowns at the minimum.

   Meanwhile, a spectacular fire knocked out Chevron’s Pascagoula, Mississippi refinery yesterday. Initial reports say that the nearly 400,000 bbl/day complex is completely out of operation, at least until investigators can make a damage assessment. Not counting this recent loss, U.S. refineries are processing about 600,000 b/d less crude than they were just before Hurricane Katrina struck in late August 2006, so this puts much more stress on the supply system.

   But, a larger point I’d like to make is that any recovery in gasoline prices, or even a spike, depends not so much on demand but almost entirely on supply.

   When the market was in full paranoid bloom this spring, pundits prone to hyperbole predicted that wholesale gasoline might top $3.00 gal or that $4-$5 gal retail prices were in the cards. They based those predictions in part on ignorance (or vested interests) but also tied the forecasts to demand numbers that ran nearly three percent above last year. People were driving more, even as prices were surging, the hype suggested.

   But demand this Summer has clearly been front-end-loaded. Anecdotal evidence as well as statistics now suggest that consumers aren’t using nearly as much gasoline in August than in July.  One would not think that that trend will be interrupted, given the fact that the perceived wealth of families has dropped on two scores: home prices and stock fund savings.

    But here’s something that merits more than just a footnote entry.

      Diesel, and not gasoline, is the product that could get the greatest “lift” from any refinery difficulties in the next 60 days.  Demand growth since Katrina has been spectacular, and the industry is further strained by the splits into three grades of distillate - - a high sulfur product for home heating oil or non-road use; a legacy low sulfur product that has 500 ppm sulfur, and the ultra-low-sulfur diesel that made its debut a year ago.

   The industry had a “Get Out of Jail Free” card in 2006. The EPA could simply exercise discretion and waive tougher sulfur rules, and allow, say heating oil, to be used for on-road purposes. That does not appear to be an option this year, given that 2007 truck engines can go into their own version of the dry heaves if they use anything but the lowest sulfur product.

  And if all that isn’t enough to raise concern about the potential for a diesel price spike, consider that many traders estimate that U.S. refiners export more than we import of this transportation fuel.