John Hofmeister heads up Citizens for Affordable Energy. But before he founded the group in 2008, he used to be president of Shell Oil Co., the American affiliate of Royal Dutch Shell (NYSE:RDS).

So when Hofmeister said a few days ago that gasoline could reach $5 a gallon by 2012, a lot of people sat up and took notice.

The markets responded, however, by moving in the opposite direction…

The retreat in crude oil prices over the first four trading days in 2011 actually tells us less about oil and more about the tight correlation the market has crafted between the level of the dollar and perceptions about economic recovery.

[ad#Google Adsense]The 3.3% decline in the NYMEX futures contract this week follows an almost 9% gain in December. In explanation, pundits point to two overall factors as being primarily responsible for the move.

The first – a rising dollar – is true, but hardly sufficient to explain such a decline in trading prices.

The second tells us that concerns over market growth are depressing prices. This second rationale has always been a generic rule of thumb. But it really does not tell us anything beyond somebody’s view of a broad market direction.

Oil does trade in dollars, and (absent any other considerations) a strengthening dollar will mean fewer are needed to obtain a barrel of crude. A U.S. currency weakening against others – especially the euro – will mean it takes more greenbacks to make the same purchase, thereby increasing the price.

Yet the exchange value of the dollar is only one aspect of our approach to analyze where oil is going.

Volatility Is the New Force to Be Reckoned With

As you will recall, in addition to a range of geopolitical and short-term issues that tend to affect oil pricing, I follow five separate conventional influences: the currency exchange (or forex) consideration providing the relative strength of the dollar; constraints in availability and quality of supply; stockpile and refinery inventories; mergers and acquisitions (limiting competition); and demand – specifically industrial usage, the last holdout from the demand destruction cycle of the financial meltdown of 2008 to 2010.

The preferred sound bite these days to “explain” a price decline is a concern over market growth, while higher prices are often regarded as the result of a weakened currency.

Neither factor tells us very much… and they certainly do not reflect what is really happening in the trade in futures contracts – the real mover of pricing consignments of actual oil.

In addition, the market price moving forward will not simply be a result of my five “traditional” indicators. A pronounced wave of uncertainty in setting trading points will reflect the new force requiring adjustment – volatility.

Now, it is this volatility that will present the single greatest obstacle to stable pricing. Some of the instability may result from the way my five indicators relate to each other and to events. But most of it comes from the trading system itself.

Both traders and those actually producing or consuming product need to protect their investment returns or cost margins by hedging contracts. But volatility makes that more difficult.

Refineries end up at the center of these considerations. They buy the crude oil sold by the operating companies; and they then sell oil products to the retail customer.

However, there is one way to follow how the buyers and sellers of oil actually view what the market is doing. It is how both the traders in paper barrels (the future contracts) and wet barrels (the actual underlying crude or oil products) attempt to wrestle with less predictable moves up and down in the price.

It’s called a “crack spread.” This is the term for the difference in the profit margin of crude versus the profit margin of the various petroleum products that can be extracted from it – how much a refinery can expect to make from “cracking” the petroleum.

It involves playing futures contracts in crude oil against contracts in the products produced from the crude.

While any oil products can be used to determine the spread, low-sulfur-content heating oil and reformulated gasoline are the ones most often relied upon.

Crack spreads tell us what the entire gamut of buyers and sellers actually thinks about where pricing is going. That is because the usage of futures contracts in this way comprises a major way to hedge against pricing changes in the actual products bought and sold.

As of the close of trade yesterday, the near-month (February) crack spreads are telling us something very interesting…

The heating oil crack spread (heating oil versus same-duration crude oil contracts) has widened to $17.09 a barrel, the highest level in a year. Meanwhile, the February gasoline crack spread (once again, priced against crude) has risen to over $14 a barrel.

Some of this results from the impact of perceived inventory levels at refineries of both crude for processing and finished product. But the primary explanation is pointing in a very different direction…

To hedge their contracts, both buyers and sellers need to factor in higher forward prices. Further, these crack spreads are widening during the same period in which oil prices are declining.

What Crack Spreads Are Telling Us Now

[ad#ChinaBlankCheck]The talking heads may fret about economic recovery or express the opinion that credit problems in the Eurozone will lead to a strengthening dollar. Both are certainly valid concerns, as far as they go.

But the crack spreads are telling us that traders, producers, and refineries have already made two overarching conclusions.

First, demand is moving back into the market and has been in developing sectors of the global economy for some time.

Second, there is a basic reason why oil companies have committed more money to 2011 drilling than any other single year in history: Crude oil prices are heading north. And that will result in higher retail prices for oil products, regardless of current inventories.

Hofmeister may not be correct in predicting near-term prices of $5 a gallon. But he is certainly right about the direction.


— Kent Moors

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Source:  Oil and Energy Investor