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Why It's Not $100 Oil We Should Be Worried About


Oil is not $100 per barrel. It is far greater than that, and is approaching levels that caused a great deal of economic havoc just three years ago.

Editor's note: For additional commentary, visit the website of Atlantic Capital Management.

Only a few months ago West Texas Intermediate Crude (or WTI) was at $87 per barrel and falling. It made no difference to anyone in the media that Brent North Sea Crude (Brent) was already over $100 per barrel and rising. Now that WTI has passed through $100 and hit $104 the media is paying attention. From Alan Greenspan to Ben Bernanke to CNBC, the "experts" are out in force trying to "talk down" these high oil prices or any potential effects.

The first problem I have with $100 oil is simply that WTI is not really reflective of the true cost of oil. Not that long ago WTI traded at a premium to Brent, reflecting the higher quality of oil. Normally WTI traded at a slight premium to Brent reflecting that quality difference and the fact that WTI was pipeline delivered instead of tanker delivered.

Around late August 2010 the premium disappeared and WTI began trading at a discount to Brent. At first it was only a few dollars per barrel but by early December the premium exploded. Currently the premium of Brent to WTI is over $12 per barrel.

Why has there been such a change in these benchmarks?

TransCanada (TRP) completed its Keystone Pipeline Phase II and on February 7, 2011, began pumping oil to Cushing, OK, from oil sand production facilities in Alberta. Since Cushing is one of the storage facilities for WTI there has been a notable increase in supply stored there. With a landlocked facility there is limited use for the oil stored there, typically supplying only the refineries in the midwest. So the WTI price began reflecting future deliveries back in September and the price discount from the rest of the world grew the closer the supply got to actual delivery.

So until the glut of supply in Cushing is relieved through usage or another form of transportation, we should expect to see WTI continue to trade at a steep discount. In economic terms, however, it also means that WTI is only reflecting a small section of the oil/refinery complex.

Only a few hundred miles away in Louisiana, Louisiana sweet crude (tanker delivered) is trading over $120 per barrel. Tapis light sweet (Malaysian oil used as a benchmark in Singapore and Australia, and among the best oil grades in the world) is currently at $118 per barrel. Another top grade oil, Bonnie Light from Nigeria's oil facilities, is over $119 per barrel. Three top-grade oil benchmarks are trading at least $15 per barrel above what used to be a benchmark for high-grade oil (WTI).

The takeaway from this is that oil is not $100 per barrel. It is not even $104 per barrel. It is far greater than that and is approaching levels that caused all sorts of economic havoc just three years ago.

Of course, the chief complication of high oil prices is the follow through to high gasoline prices. And it is here that the problem is only beginning to build. The US average price per gallon has gone from about $3.13 in mid-February to $3.47, a $0.34 jump in just three weeks. If we go back to early September 2010, gas prices averaged $2.70 per gallon, a 28.5% increase in six months.

The worst part of that increase is that gasoline retailers have absorbed a lot of the input cost of rising oil prices. We know from the Bureau of Labor Statistic's PPI report that operating margins for gas stations and retailers were down 3.4% in January 2011, and down 12.4% since January 2010. But these businesses cannot continue to absorb rising costs forever. At some point, just like 2008, they will pass the price increases on in full. The price action in just the past month suggests that we may already be there.

What rising gas prices will do to the economy is relatively straightforward, but it bears repeating. Not only will consumer spending have to suffer, particularly now that there are 7 million fewer employed people than in 2008, but remember that $4-per-gallon gasoline nearly killed the entire domestic auto industry.

Despite the very high-profile and public effort to push small cars and hybrids, light trucks and sedans have exclusively driven the industry's turnaround since 2009. These are the profit centers for all car companies, especially Ford (F), Chrysler, and General Motors (GM).

In reality, though, a lot of the total economic recovery since 2009 has been due to inventory rebuilding at auto dealers. As much as inventory accumulation has driven overall economic growth, auto inventory has accounted for the vast majority.

We know that GM alone has dealer inventory levels above half a million vehicles. In 2010 alone, dealer inventory grew by 110,000 units. That's a lot of cars and trucks sitting on dealer lots -- and they are not hybrids and SMART cars. If gas revisits the $4-per-gallon level it does not take much imagination to figure out what happens to GM dealers' cumulative financial position, and then GM's production schedule.

Egypt and Libya will be blamed for much of the rise in oil prices as long as the Middle East remains on the front pages. But the real rise in prices began right at the same time Ben Bernanke gave his now (in)famous August speech at Jackson Hole that first hinted/confirmed another round of quantitative easing. As long as the dollar continues its descent, oil prices will continue to rise -- Middle Eastern revolutions will only enhance that basic trend.

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