Crude/gasoline price disparity and the 321 crack spread
Posted by ML on April 1st, 2007
Frugal, I finished my taxes last week. Ha!
My post on oil generated some nice comments, including this one from Mike:
it’s $3.50 per gallon at the pump here in San Jose. anyone figured out yet if their profits made in oil related investments actually get eroded in the high prices paid at the pump? sheesh….
While the question itself may be a little facetious, it serves well as a launching pad for two points I want to make. Oh, btw, I drive about 12k miles a year. At 24 mpg and $2.50/gal for regular around here, it’s just over $100 a month. Even if you assume my wife’s car consumes twice that, it’s still more than covered by the nice dividends from my CanRoys.
Sector allocation
The first point I want to bring up is on asset allocation. When one is trying to cover living expenses with capital gains or more commonly dividend income from one’s portfolio, it makes sense to have the sectors match. In the example I gave, dividends from the oil/gas sector covers our actual energy expenses. The same guideline can be applied to utilities, food, etc. Consequently, the sector allocation is determined by one’s actual expenses and dividend rates rather than the sector weighting in some index which is what one gets by buying an index fund. This is an excellent way to hedge the inflation as experienced by each individual.
Crude/gasoline price disparity
The second thing I want to point out is the faster appreciation of gasoline ($GASO) over crude ($WTIC) in the last couple month, which can be seen from the following two charts. Specifically, $GASO has seen 10 consecutive weeks of increases. Obviously, it means the consumer’s pocket book is being hit a lot harder than the headline oil price is suggesting.
A while back, I wrote Sweet and Sour on different grades of crude and petroleum products. It was a primer written by a layman for laymen, if you will. In it, I mentioned the 3-2-1 crack spread which is a very rough approximation of an oil refiner’s profit margin. Basically, 3 barrels of crude is assumed to produce 2 barrels of gasoline and 1 barrel of heating oil. Below is a chart of the crack spread along with crude prices courtesy of Chris Puplava from Financial Sense. Obviously, the refiners are minting money lately. It’s too bad I didn’t pay attention to the names that I mentioned myself. Tesoro (TSO) especially, has gone from $53 to $100 in 6 months.
Although I believe there is considerable political risk from a Democratic congress, I’m looking to increase exposure to refiners. Our energy needs depend on refining capacity as much as crude supply. As the supply of Arab light wanes (due to maturation of the Saudi Abqaiq and Berri fields), refiners geared towards processing heavier and sourer grades of crude will see their margins increase.
More about supply capacity
I cannot overemphasize the importance of refining capacity or petroleum extraction capacity in general. The Canadian oil sands which contain trillions of barrels of oil is being billed to be the savior of world’s energy problem. However, the mining and in situ extraction required are daunting tasks. The oil sand (bitumen) needs to be upgraded into a synthetic crude. The largest oil sands operator, Syncrude, has been expanding capacity in order to increase their production to 350,000 barrels per day (bpd) in 2007. According to this report (pdf, section 3.5) from the National Energy Board of Canada, even if all oil sand projects currently planned move forward, by 2010 total output will amount to little more than 3 MMbpd. Keep in mind that world energy needs are ~85 MMbpd currently and growth is projected to be 1.4-1.5 MMbpd for 2007-2008. Those number should put the promise of oil sands into perspective.
For now, the EIA is forecasting a world surplus production of 2 MMbpd. So even if you think it’s not consistent with the forecast of inventory reduction, there is no need to rush and get your own 1,000 gal tank. I showed that chart on declining Saudi production in the last post. It is entirely possible that they were shutting down wells voluntarily to rest those fields. For now, I’m still expecting oil prices to decline following detente of the Iranian situation coupled with normal seasonality effects. The real test for Saudi production will come this summer when demand picks up again.
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April 1st, 2007 at 2:44 pm
In my opinion, the sector investment strategy that you propose is far from optimal. Here is my point: you are trying to cover certain expenses from dividends generated from the specific related industry sector. However, your optimal investment returns do not necessarily come from the sectors that best match your expenses.
Your goal should be to maximize investment returns, not to cover specific expenses. Would it matter to you if your asset appreciation came from the tech sector even though you have practically no tech related expenses? In addition, the strategy you outline can lead to a portfolio that is not sufficiently well diversified if you have higher expenses that you attribute to a given industry sector.
So my advice is to optimize total portfolio returns for your acceptable level of risk, not to try to assign portions of the portfolio to cover specific expenses.
April 1st, 2007 at 5:09 pm
While I believe most people don’t need to use an asset to expense allocation plan, I think on basic level it can make lot sense as there are fundamentally many different types of risk. The common risk we talk about as regards to investing is volatility risk, and that’s where diverisfication is important. However the other type of risk is exposure risk. Matching Assets to Expenses is form of hedging or insurance. Just in the same way I don’t go ahead any buy insurance to cover all the houses in my neighbordhood, I might want to buy assets (or more likley avoid assets) related to either my income or my expenses. This is why I don’t buy significantly in the energy sector as I have significant exposure already via my job, and why I might have higher exposure to the personal technology industry if I were an enourmous consumer of personal electronics. I’d hardly recommend using this a basis of investing, but I do think it’s good way of thinking about risk. Risk is individual and people should tailor their portfolio not only to their level of risk tolerance (volatility tolerance), but also to their personal situation (risk exposure)
April 2nd, 2007 at 4:29 am
Shadox,
ML is not invested in Canadian Oil Trusts specifically to offset higher gas prices. I believe you are reading into his statement that he is able to offset higher gas prices which the dividends from trusts.
You do have a point in your post on investing to optimize total portfolio returns, but in ML’s case he is just pointing out that his trusts offset the cost of the higher gas.
April 2nd, 2007 at 8:54 am
Shadox,
I understand the point you’re making and readily admit that matching dividends to expenses may not optimize the portfolio return. However, as Doug pointed out, the “sleep at night” factor also needs to be considered. This is especially true for someone banking on investment income for living expenses.
I would not and do not use such an allocation for my entire portfolio. But I think quantifying and hedging one’s individual inflation exposure has a lot of merit.
September 3rd, 2008 at 12:36 am
The second thing I want to point out is the faster appreciation of gasoline over crude in the last couple month, which can be seen from the following two charts. Specifically, $GASO has seen 10 consecutive weeks of increases. Obviously, it means the consumer’s pocket book is being hit a lot harder than the headline oil price is suggesting.
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reetha
Crack Cocaine