A lot of people are bracing for huge effects of the latest Gulf storm on energy markets. I see reasons for hoping things won’t be that bad.
Still trying to recover from the wounds of Katrina, here comes another big one. Minerals Management Service is currently reporting 92% of crude oil production and 66% of natural gas production from the Gulf of Mexico shut in, though the lasting effects on oil production predicted for Rita by Kinetic Analysis Corporation/University of Central Florida are less severe than those they had fairly accurately predicted for Katrina. A significant number of critical refineries could also be affected by the storm.
A rough prediction of the effects of such disruptions on energy prices can be obtained by dividing the percentage drop (after inventory adjustments) in the quantity produced by the elasticity of demand. The market for crude oil is a global market, and the entire production from the Gulf of Mexico represents far less than 2% of the world total. On the other hand, it is much harder to make rapid changes in imports of gasoline or natural gas, and 20% of U.S. refinery capacity is currently shut down as a result of the effects of the last storm and fear of the next one. Details on affected refineries have been reported by the Oil Drum and Outside the Beltway. Since Rita’s threat to the oil patch became clear, the near futures price for crude oil has risen 5%, natural gas 15%, and gasoline 20%.
This threat has James Joyner of Outside the Beltway, among others, talking about the possibility of $5 a gallon gas. Personally, I share the skepticism of Steve Verdon (another writer for Outside the Beltway) about such claims. For one thing, the Texas refineries, unlike many in Louisiana, are above sea level, one of those little details that become important at a time like this. And it was the break in the levee, rather than the wind and the rain, that caused the real damage in New Orleans. Admittedly, it’s no trivial thing to stop and restart a refinery. But if things do return to normal quickly enough, a week of shut down is something that we could forget soon enough.
The graph above relates the U.S. average retail gasoline price to the NYMEX gasoline futures price for the nearest month; (data from EIA). The retail price had averaged about 60 cents a gallon above the futures price for most of the summer, reflecting state and local taxes plus the wholesale and retail markups. With Katrina, the retail price went well above the value predicted by this usual relation. This was a feature of the very short-run nature of much of the supply disruption from Katrina. The spot bulk price in New York actually reached $3.00 a gallon at the end of August, which from the 60 cent rule would have meant $3.60 a gallon retail. The futures price curve was very sharply sloped downward as one went from the September futures contract to the October futures contract, with the retail spot price moving to a point in between the very high bulk spot price and the more modest October futures spot price. As this graph shows, and as I pointed out here and here, in the absence of the most recent resurgence of gasoline futures prices from Rita, we could have expected to see another 20 cents per gallon drop in the retail price below its current value. With the futures price coming back up before the retail price had the chance to complete that downward move, at the moment there’s not much pressure from fundamentals for retail prices to make any further move, up or down, from where they are right now. What that means is that one possibility is that motorists may not see any effect of Rita at all.
To be sure, the NYMEX traders may have this all wrong, and the multitude of worried pundits quoted by the media could have it right. But let me just point out that the futures traders could be wrong in either direction. Another possibility is that the damage will be even lighter than the market is expecting, and you’ll soon be getting that price break after all.
Rita undeniably has the potential to be the energy Armageddon that many people are talking about. But my guess is that it probably won’t be.