Surprise! A Cooler Summer for Pump Prices

by Aaron Levitt | May 25, 2012 7:00 am

Surprise! A Cooler Summer for Pump Prices

American motorists may finally catch a break at the gas pumps — just in time for the critical summer driving season. Prices for gasoline continue to inch downward as some of the geopolitical premium[1] on the price of a barrel of crude oil begins to dwindle. So far, the U.S. average price of regular gasoline has dropped to just over $3.78 per gallon in the past two weeks. That’s down more than 12 cents from a year ago and more than 18 cents [2]from its April peak.

However, that drop could just be the beginning.

According to AAA, prices at the pump this weekend should average about $3.66 a gallon[3]. That’s certainly welcome news for the estimated 34.8 million drivers that AAA predicts will travel this Memorial Day weekend. The travel club forecasts that there’s plenty of room for prices to drift even further down.

Overall, falling prices gasoline prices at the start of summer is a huge positive development for consumers’ pocketbooks. The average American household will spend nearly $3,000 on fuel this year at current prices. So, any reduction in the average price will provide much-needed funds to power discretionary spending or to go toward household balance-sheet repair.

Falling prices also serve as a psychological boost. The $4 a gallon price point seems to be when most Americans “feel” like they’re getting squeezed.

So with the odds of seeing $5 a gallon gas this summer continuing to lessen, two questions remain for consumers and investors alike: How did we get here, and will the price drop last?

Iran Plays Nice, So Far

Over the last few months, geopolitical tensions stemming from the Middle East have kept the heat on the price of Brent crude, which winds up becoming a lot of the gasoline that fills Americans’ tanks, especially on the East Coast. The Arab Spring revolution in Egypt followed by the uprisings in Libya put pressures on global supplies. It took almost a full year for Italian energy giant[4] Eni (NYSE:E[5]) to restart pumping from its operations in Libya.

Perhaps the biggest Mideast threat to prices has been Iran’s continued saber-rattling. The nation’s uranium-enrichment programs are at the center of a global dispute, with Tehran denying allegations that it’s trying to build nuclear weapons.

In response to the nuclear threats, the U.S., European Union and a variety of other nations have imposed strict economic sanctions on Iran. In turn, Iran has continually vowed to close the Persian Gulf’s vital Strait of Hormuz[6]. No wonder crude prices rose so sharply earlier this year.

However, Iran may be finally starting to play nice. This Wednesday in Baghdad, Iran along with six major powers began talks and exchanged proposals aimed at ending the dispute. International Atomic Energy Agency officials expect to sign a deal with Tehran soon in order to start an investigation into the Islamic nation’s nuclear activity. As tensions with Iran[7] have come down to just a simmer rather than a boil, much of the geopolitical premium on crude prices has been erased.

At the same time, other factors are sending crude — and ultimately gasoline — prices downward. First, the U.S is awash in oil[8] — at least the middle of the country is. Thanks to increased production from the Canadian oil sands, North Dakota’s Bakken shale and fields across the Midwest, oil has been piling up in nation’s storage hub of Cushing, Okla.

As we’ve said before, energy prices are about logistics as much as demand[9]. With inadequate pipeline capacity to transport that glut of crude, refineries on the U.S. coasts have had to buy more expensive imported Brent crude. However, with Enbridge’s (NYSE:ENB[10]) Seaway pipeline reversal fully underway, as well as other logistics projects in the works, alleviating much that glut of crude is becoming a reality.

A Global Slowdown

Second, some major economic forces are at work. With Europe’s debt problems ever-worsening, the drop in crude prices also is a direct reflection of that fact. Analysts now worry that the continent will enter a recession. That would certainly put a damper of oil demand for the near future.

Also restraining demand is emerging-market leader and No. 2 crude consumer China, where data in recent months has suggested that growth is weakening. The interdependent relationship between China, the U.S. and Europe will play havoc with Chinese crude demand. After all, China relies on those other two markets as a major destination of its exports. With Europe falling into recession, China will see less demand for its goods, and therefore it’ll need less energy. According to investment bank HSBC’s (NYSE:HBC[11]) latest Chinese manufacturing report[12], factories in the Asian Dragon contracted in May for the seventh consecutive month.

Indeed, Beijing has set a target of 7.5% GDP growth this year. That’s down from 9.2% in 2011 and 10.4% in 2010.

Add these factors together, and it’s no surprise that oil futures have plunged around 15% in just three weeks. Currently, West Texas Intermediate crude (WTI) is around $90 a barrel, while Brent crude sits at around $105. Prices for both benchmarks are near seven-month lows.

So, that’s how we got here. Now …

… Will It Last?

Over the short to near term, most likely. If everything continues to play out as it has for the past several weeks, 2012 could be a great summer driving season. Crude demand from Europe and China should keep dropping as their economies slow, although 7.5% GDP growth for China is still quite impressive compared to the rest of the world.

So, yes, we’re quite likely to see somewhat lower gasoline prices for the remainder of the summer.

However, the long-term story could be completely different. While China’s demand is ebbing a bit, a whole host of other emerging nations are getting their first tastes of petroleum. That’ll continue to put pressures on long-term demand.

Second, even as U.S. pipeline build-outs relieve the Midwest oil glut, some analysts say previously landlocked WTI will once again become a global benchmark. That could result in higher prices as firms sell their production on the global markets.

Finally, though tensions with Iran seem to be cooling, things could get ugly quite quickly. Talks may fail again to create a resolution. And Israel is wary[13] of recent nuclear negotiations with Tehran and has voiced its stance on stopping hostile neighbors. All of these pressures could easily push crude and gasoline prices higher over the long run.

In the meantime, enjoy the lower gasoline prices while you travel this holiday weekend and get ready to plow some of that cost savings into energy stocks for the long term. They’ll get cheaper, too, as crude continues to drift lower, for now.

As of this writing, Aaron Levitt doesn’t hold any securities mentioned here.

Endnotes:
  1. geopolitical premium: http://investorplace.com/2012/04/why-100-oil-is-the-new-80/
  2. more than 18 cents : http://www.cnn.com/2012/05/20/us/gas-prices/index.html
  3. average about $3.66 a gallon: http://www.csmonitor.com/Business/2012/0523/Memorial-Day-good-news-on-gasoline-prices-and-it-may-get-better
  4. Italian energy giant: http://investorplace.com/2012/05/italys-eni-dont-overlook-this-energy-giant/
  5. E: http://studio-5.financialcontent.com/investplace/quote?Symbol=E
  6. Strait of Hormuz: http://www.bloomberg.com/news/2012-01-19/iran-s-un-envoy-says-closing-strait-of-hormuz-is-an-option-if-threatened.html
  7. tensions with Iran: http://www.reuters.com/article/2012/05/23/markets-energy-nymex-idUSEAP10NN0020120523
  8. U.S is awash in oil: http://investorplace.com/hot-topics/energy-independence/
  9. energy prices are about logistics as much as demand: http://investorplace.com/2012/04/energy-independence-first-the-pipelines/
  10. ENB: http://studio-5.financialcontent.com/investplace/quote?Symbol=ENB
  11. HBC: http://studio-5.financialcontent.com/investplace/quote?Symbol=HBC
  12. Chinese manufacturing report: http://dawn.com/2012/05/24/china-manufacturing-slows-hsbc/
  13. Israel is wary: http://www.reuters.com/article/2012/05/22/us-nuclear-iran-israel-idUSBRE84L0WV20120522

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