By Tom Whipple

There are many zigs and zags, twists and turns, and unintended consequences along the path to higher priced and scarce oil. Only three months ago it seemed we were headed towards an aerial bombardment of Syria’s armed forces which would likely send oil and gas prices towards the sky in anticipation of a response. Well, the AAA reports that the current average price of regular gasoline is $3.18 and its spokesperson is saying we should be seeing $3.10 a gallon by Christmas and maybe even $3. What’s happening?

First let me disabuse you of the idea that we are seeing more than a temporary blip and that sub-$3 gasoline will become a permanent feature of life in America. The underlying forces that will cause oil production to peak – i.e. oil fields depleting faster than new ones are being found and developed at affordable prices – is still with us as will become apparent one of these days.

This fall, however, there are several factors that have come together to force oil prices down. One major factor, higher U.S. production, is unlikely to last more than a few years, while others such as steadily weakening demand may be with us for a while.

When oil prices got high enough five or six years ago, it became profitable to drill and hydraulically fracture tight oil formations in North Dakota and Texas. What made fracking feasible was that oil prices in the last decade rose from $20 a barrel to circa $100 making the drilling of very expensive fracked wells with a very short productive lifetime feasible.

From about 5 million b/d in 2007, U.S. domestic production has climbed by 2.5 million barrels a day (b/d) to 7.5 million this summer. For a time the oil industry had difficulties moving this oil to market as it was coming from regions without sufficient pipeline capacity so that a big glut of crude built up in the mid-West where the fracked oil came from. This glut drove down the value of domestic crude until at one point it was selling at $25 a barrel below world prices.

While this oil was making its way to refineries in the mid-West, it was not getting to the Gulf or East Coast. We in the East were buying our crude at world prices which have been hanging around $100 a barrel for the last four or five years. Thus while the great fracked oil boom was helping consumers in the middle section of the country it was not doing much for the coasts where most of the people live.

North Dakota where nearly a million of our 2.5 million b/d of fracked oil is coming from was, and still is, not deemed worthy of building expensive pipeline collection systems because of the rapid depletion of its wells.

The solution to this dilemma turned out to be railways which America has in abundance. It took some time to build the terminals along rail lines, but once on board trains the oil could be directed to the highest bidder anywhere in the country. Movement of oil by rail costs some $5 a barrel than that moved by pipeline, but when it still costs less than imported oil it is going to be used.

The next factor behind our cheaper gasoline prices is lower demand. Since the U.S. economy went south in 2008, demand for oil has been weak. While the average consumption of oil products in 2007 was 20.7 million b/d, by 2012 it was down to 18.5 million with an increasing share being exported. While some of this decline was due to more efficient cars and trucks, the bulk of it was simply less driving due to hard economic times.

Our next factor is a little more complicated and has to do with what happens when oil is refined. To make the story short, when you refine crude, among other products, you end up with roughly two barrels gasoline for every barrel of distillates (diesel, heating oil, kerosene, etc.) that you produce. Now this is very nice when your demand for these products is equal to your consumption, but when they get out of balance you have to import or export to avoid shortages or gluts. Now Europe taxed itself into a lot of more efficient diesel cars years ago so European refiners had been ending up with large surpluses of gasoline which they were happy to sell to America where we really love the stuff.

Currently Europe has a lot more energy problems than we do here in America. North Sea production has been dropping for decades; the economy is really bad so that oil consumption is down; refineries are closing; and to top it off Libyan oil production of 1.3 million b/d, most of which went to Europe, went down the tubes this summer amidst political chaos.

The solution to this was for Europe and other Libyan customers to import diesel and other distillates from the U.S. which led to a rapid growth in U.S. exports of finished oil products. The U.S. of course was set up to refine more oil than we currently are using, but this summer our refineries hummed at record rates cranking out distillates for export.

The problem was that for every barrel of diesel that we shipped out of the U.S., there were two barrels of gasoline left behind. The export statistics tell the story. In 2007 the U.S. exported 120,000 b/d of gasoline and 260,000 b/d of distillates. By the summer of 2013 gasoline exports had climbed to 380,000 b/d, but distillate exports were up to 1.4 million b/d.

So there is the story of our “cheap” gasoline in a nutshell. We are refining some 1.4 million b/d of distillates for export and are ending up with 2.8 million b/d of extra gasoline as a result of which we can only export 380,000. Welcome to lower gasoline prices for as long as this imbalance lasts

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