Short

Has Gasoline Price Already Peaked?

While the U.S. stock market performed miserably lately, energy commodities have a banner year. According to the American Automobile Association (AAA), the national average gasoline price reached an all-time high of $5.016 a gallon on June 14th. Diesel logged its own record on June 19th, at $5.816 a gallon.

Crude oil price hike is certainly a major contributing factor. However, refined products have been rising a lot faster. AAA gasoline was at record high $4.114 in July 2008 when WTI crude oil made history at $147 a barrel. Last month, WTI peaked at $123, at 16% below the 2008 high. However, gasoline broke $5, a whopping 22% above its 2008 record.

Since mid-June, WTI lost steam and entered a downturn. It trades below $110 today. Meanwhile, gasoline price barely moved and still stands above $4.80 per AAA data.

In my view, the gasoline market has already peaked, and a downtrend would follow. RBOB gasoline wholesale price, currently at $3.68 a gallon, could fall 30% or more in the next year. I came to this assessment based on two key factors:

Firstly, refining margins could decrease significantly due to mean reversion.

Refinery is the process to turn crude oil into gasoline, diesel, heavy fuel oil and other petrochemical byproducts. Refining margin measures the revenue from selling refined products, subtracting the cost of crude oil and natural gas going into the process. Below is a simple formula:

Refining margin = revenue (94% of crude processed) - costs (crude oil + natural gas used)
Whereas refining revenue = 23% gasoline + 63% diesel oil + 8% heavy fuel oil

A barrel of 42-gallon crude oil is processed into 40 gallons of refined. For each barrel, you would get approximately 25 gallons of gasoline, 9 gallons of diesel, and 3 gallons of heavy fuel oil.

According to Polish oil refiner LOTOS Group, the latest daily model refining margin is $59.06 per barrel of crude oil. Before the Russia-Ukraine conflict, refining margin was below $10 in February. Margins were in single digits throughout 2021 and sometimes even turned negative.

Crack Spread is a “quick and dirty” way to measure profit margin of a U.S. refinery. To calculate the 3:2:1 crack spread for a Gulf Coast refinery that processes Louisiana Light Sweet (LLS) crude oil, add the spot price for two barrels of Gulf Coast conventional gasoline to the spot price for one barrel of Gulf Coast ultra-low sulfur diesel. Then subtract the spot price for three barrels of LLS crude oil. Finally, divide the result by 3 to produce a crack spread in dollars per barrel.

Once the summer driving season is over, I expect crack spread to go down due to a combination of market force (reduced demand) and political pressure.

Secondly, gasoline demand could decline significantly in a U.S. economic recession.

In the past 15 years, gasoline market has crashed three times. The first was in 2008, following the subprime crisis. The second time in 2014, driven by a 60% crude oil price fall. The latest was in March 2020 when COVID-19 broke out in the U.S., leading most states to travel restrictions, lock-down or social distancing.

Today, a Federal Reserve tracker suggests that the U.S. has already entered a recession. The Atlanta Fed’s GDPNow, which tracks economic data in real time, sees second-quarter GDP contracting by 1%. Coupled with the first-quarter’s 1.6% decline, two consecutive quarters of negative GDP fits the technical definition of a recession.

Gasoline market is very sensitive to changes in consumer spending. Automobile driving, which shows clear “seasonal patterns”, is the dominant demand factor. In my view, this is the defining price driver in RBOB. For viewers who read my previous writings, you would understand why I prefer RBOB over WTI in forming a trading strategy – it’s more straight-forward with fewer moving parts.

A short position in NYMEX RBOB Gasoline Futures (RB) is a way to express this bearish view. The January (RBF3) contract is quoted at $2.779 on July 1st. RBOB futures is based on wholesale gasoline price. We could add $1 to RBF3 to get to a ballpark estimate of retail price in January. For the month after the Christmas holiday seasons, $3.80 a gallon seems to be overpriced.

RBOB futures is quoted at USD per gallon. Each contract has a notional value of 42,000 gallons (1,000 barrels), equivalent to $116,760 in current market value. To place an order, $8,500 margin is required per contract. A move of 1 cent in gas price will result in $420 gain or loss to your account.

Alternatively, if you are uncertain of which direction gasoline price would go, but agree that refining margin could revert to mean, we could Short the Crack Spread. A 3-2-1 short crack spread can be constructed by placing 3 Short WTI, 2 Long RB and 1 Long HO contracts.

We can also monitor the following data points to be released to test the validity of these two trade set-ups:
• Holiday driving data (July 4th, Labor Day, Thanksgiving and Christmas)
• Q2 and Q3 earnings releases from the retail sector (Walmart, Target, Dollar General, etc.)
• Q2 and Q3 GDP data
• Monthly CPI data
• Fed rate decisions (JUL 26-27, SEP 20-21, NOV 1-2, and DEC 13-14)

Russia-Ukraine conflict poses the biggest risk to our trade. If the contagion risk intensifies and ripples through Europe, energy prices could hike sharply again.

Happy Trading.

Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.

JimHuangChicago

Jim W. Huang, CFA
jimwenhuang@gmail.com

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