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Just ask Congress, the President and perhaps even the regulators and they will assert that energy prices are too high. While the bears will cite speculation as the main cause for inflated energy prices, they might also throw up the fact that US crude oil stocks in 2009 have generally run roughly 50 million barrels above year ago levels. Naturally, seeing such a large physical supply surplus as the front end of the energy manufacturing chain leads many pundits to suggest that there is no reason for such lofty prices.

Of course focusing on the level of crude oil available to be refined into typical consumer usable products is a justified angle, but in a deeper analysis one might discover that a number of bull moves over the last 10 years have been the result of tightness in product stocks, which at times have taken place even though there was plenty of raw material supply available. With the recent “non operating” rate of US refineries drawing close to 1/5 of all US refinery capacity, it is clear that we might be in the early stages of a product-led rally in energy prices.

In the wake of 9/11 when the rest of the world was staggering under the weight of the temporary standstill in the economy, one big oil company managed an unheard of quarterly profit of $30 billion. With the press recently hyping up a nine-figure salary made by an oil trader, it is clear that a certain angle of reasoning is entrenched in conventional wisdom. Not surprisingly, the press and the Administration gave almost no credence to a CNN Money survey that showed 6 of the top 10 CEO’s in 2008 compensation were energy-related companies. While sectors of the oil industry will suggest that high oil prices are the result of surging world demand, geopolitical supply threats and other fundamental issues, we suspect that some refiners and or oil companies have the ability to meter the ebb and flow of profitability and in turn have an inordinate amount of influence on energy prices.

In looking ahead to Labor Day, this summer’s last “driving” holiday, we suspect that the US refinery operating rate will rise in an effort to meet demand. But it also seems as if refiners are using classic supply and demand techniques to either enhance or protect the amount of profit they can earn from turning crude oil into gasoline and other consumer friendly products. While we are not saying it is true, we see no difference between financial services companies being aggressively compensated for packaging risky mortgages and a refiner pre-buying crude oil and then announcing to the market that they intend to shut down refinery operations for extensive maintenance. While no one expects a private company to buy crude oil and refine products at a loss because the US consumer needs gasoline, it is a little odd that those capable of benefiting from the refinery operations also have the capacity to game the system. In a hypothetical situation a refiner could decide to shorten its refinery operations just to the days that are necessary to meet minimum sales requirements. If that position was also put in place at other refiners, the industry could achieve significantly higher rates of return on much smaller production runs. In the face of reduced US refined product runs, the profitability of the crack (the refinery operating margin) would expand greatly. This suggests to us that the refiners usually have an incentive to produce just enough product supply to keep some measure of tightness in place.

The US refinery operating rate currently sits at just 84%. In the past, a decline in the operating rate to the vicinity of 83% has preceded a product-led rally in energy prices. However, with the nearby crude oil market sitting roughly $5 above last month’s midpoint, a seasonal decline in energy demand expected over the next seven weeks and the outlook for the economy weakening again, we suspect that oil prices are destined for a setback. But in the event that the refinery operating rate continues to decline, we will be in the hunt for a purchase of the November unleaded or the November heating oil contract in anticipation of a recovery in energy prices before the end of September. Our picks for value zones are $1.69 for November gasoline and $1.77 for November heating oil.

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