Will Gas Prices Hit $4 a Gallon?

In a recent interesting article by the Fool it was asked and answered why gas prices won’t break anytime soon the $5 a gallon mark.  The author made some interesting and convincing arguments; however, based on the recent developments in the oil market, gasoline price might resume their rally and break the $4 a gallon mark in the coming months. Let’s examine the recent developments in the gasoline market and see why this could become a reality.

Will oil pass $100, again?

This will be the main (and obvious) driving force behind the rise in gas price – the price of oil. The chart below shows the weekly changes in gasoline and oil prices in the past several years.

U.S. Regular Conventional Retail Gasoline and Oil Prices 2005-2013

As indicated above the correlation between the two price sets is very strong. Moreover, the price of oil accounts for 65% of the price of gas. So for every 1% gain in oil price, gasoline price will increase by 0.65%.

To analyze the oil market let’s examine the oil supply and demand.

From the supply side, in the U.S oil production slowly declined in recent weeks and oil imports are still low compared to last year. OPEC’s oil production remained stable in recent months, but it could change course if the situation in the Middle East will erupt again.

From the demand side, the International Energy Agency projects the growth in demand will decline compared to previous estimates. On the other hand, recent reports (including GDP growth and manufacturing conditions surveys) from China and U.S – the two leading importers of oil – suggest these economies are slowly progressing, which could eventually lead to a rise in demand. Based on the above,  oil price could start to pick up in the coming months and pass the $100 mark, which will bring gas prices closer to the $4 mark.

Even though oil price might rise in the coming months, during 2013 (up to date) the price of oil declined by more than 7% compared to the same time frame in 2012. The drop in oil prices adversely affected leading oil companies such as Chevron (NYSE: CVX): The company’s gross profit margin fell by 0.8 percent points to 32.1% in the first quarter of 2013. Moreover, net sales declined by 6.4% (year-on-year). Despite the drop in revenues, the company might bounce back in the coming quarters. The recent win the company’s subsidiary had in Argentina’s high courts could pave its way to develop shale oil in the country. Moreover, if oil price will start to pick up, it will positively affect the company’s revenues.

Refineries profits

Another factor that affects gasoline prices is refinery costs and profits that account for roughly 13% of the price of gas.  Distribution and marketing account for additional 10%. Refinery companies such as Valero Energy (NYSE:VLO) haven’t benefited from the drop in oil and gas prices as the company’s net sales fell by 4.8% during the first quarter of 2013. On the other hand, Valero’s gross profit margin rose from 6.1% in the first quarter of 2012 to 8.3% in the first quarter of 2013.

Marathon Petroleum (NYSE:MPC) also experienced a rise in its profit margin as it rose from 7.4% in the first quarter of 2012 to 7.6%. Further, this company’s revenues also rose by 15.4% during the first quarter of 2013 (year-over-year). But the company’s growth in sales was mainly driven by its acquisition of Galveston Bay refinery at the beginning of February.

If these leading refineries and other refinery companies were to raise their profit margins, this could pressure up gasoline prices. Nonetheless, since refinery costs account for only 13% of total price of gasoline the effect of rising profit margins or costs of refinery companies will be very marginal. For every 1% gain in cost of refineries, the price of gasoline, assuming all things equal, will rise by 0.13%.

Is the demand for gasoline falling?

According to the recent retail sales report for May (opens pdf), gasoline station sales declined by 0.9% in the first five months of 2013 (year-on-year). Moreover, in May, gasoline station sales dwindled by 0.2% (month over month). Was the decline in sales related to the drop in gasoline prices?

The average price of gasoline declined by 2.5% during the first five months of 2013 compared to last year.  Furthermore, the average weekly consumption of gasoline slipped by 0.2% during the first five months of 2013. Therefore, most of the drop in sales was related to decline in gas prices. Nonetheless, the demand could pick up if the U.S economy will continue to grow at a faster pace. In the first quarter of 2013, the U.S GDP grew by 2.5%, which is a faster pace than in the same quarter in 2012. The drop in demand for gasoline in the first quarter of 2013 also had an adverse effect on sales of companies such as Chevron, which has gas stations throughout the U.S.

The third rail – taxes

I will just mention that taxes account for roughly 12% of the price of gasoline. Even though U.S policymakers are trying to find ways of cutting the budget deficit I think it’s safe to say they will stay clear from hiking gas prices.

Take away

Based on the above, gasoline price might resume its rally and perhaps even break the $4 mark, if the demand for oil will pick up, OPEC will change its oil production quota, imports to the U.S will dwindle, or refinery costs will rise.

For further reading:

Is This Oil Company Recovering?