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Explaining sky-high gasoline prices Add to ...

With crude oil prices hitting record highs almost daily, drivers have been warned that the price of a litre of regular gasoline may hit $1.50 this summer. That means drivers of large SUVs or higher performance cars could be paying more than $100 to fill-up their vehicles, and owners of more fuel efficient compacts could see their bills top $60.

The effect of higher gas prices will reverberate across the economy. The Tourism Industry Association of Canada, for example, warns that higher prices will push travel down by as much as 4 per cent this summer. Economists, meanwhile, say food distributors might be forced to raise their prices to cover higher gas costs, and those increases would get passed on to consumers at the grocery store.

Higher fuel prices may already be changing the way Canadians live. Statistics Canada recently reported that for the first time since it started studying how Canadians get to work in 1996, a smaller percentage of us were making the trip behind the wheel. The numbers also show gains for public transit, carpooling and cycling.

Record prices at the pump have led to confusion and finger-pointing, with consumer groups and some lawmakers blasting the oil industry's profits and criticizing it for not investing in development of alternative energy.

Michael Ervin was online Thursday to discuss rising oil prices and to try to bring more clarity to what forces are at play. He is president of MJ Ervin & Associates Inc., a Calgary-based energy consultancy.

Mr. Ervin expects gasoline prices to keep rising, even if crude prices taper off. Each week, his firm polls more than 400 gas station dealers across the country to get a national snapshot of pricing trends. The latest weekly pump price survey found that a litre of regular gasoline increased on average in Canada by nearly 5 cents to $1.23. That's up from $1.08 at the beginning of the year and $1.05 a year ago. Residents of Yellowknife paid more than anyone else in the country last week, handing over $1.38 a litre on average. Drivers filling up in Kingston, Ont., or Edmonton, meanwhile, were getting the best deal in Canada at $1.15 a litre.

Mr. Ervin's firm consults on the petroleum markets, competition and market regulatory issues for clients that include the government, industry associations, national petroleum refiners and marketers.

Editor's Note: globeandmail.com editors will read and allow or reject each question/comment. Comments/questions may be edited for length or clarity. We will not publish questions/comments that include personal attacks on participants in these discussions, that make false or unsubstantiated allegations, that purport to quote people or reports where the purported quote or fact cannot be easily verified, or questions/comments that include vulgar language or libellous statements. Preference will be given to readers who submit questions/comments using their full name and home town, rather than a pseudonym.

Simon Avery, ReportonBusiness.com: Welcome Michael Ervin and thanks for joining us today to discuss what is increasingly becoming a hot-button issue for consumers: gasoline prices.

Today we heard a new dire warning on pricing. This one from CIBC World Markets. Chief economist Jeff Rubin says crude oil prices will soar to more than $200 a barrel over the next five years, doubling Canadian pump prices to $2.25 a litre, and forcing a fundamental transformation of the North American economy. Mr. Ruben has been prescient on the subject of oil prices before. Is he on the mark today?

Michael Ervin: It's a pleasure to be able to respond to questions in this sort of medium. The subject of petroleum prices is a very complex one, as I'm sure the questions will illustrate, and I hope I can shed some light on this from my perspective.

Crude oil prices have been getting a lot of attention lately, as we've seen those prices climb above most expectations. The price of crude oil is notoriously hard to predict, since the factors associated with the price (geopolitics, demand, the economy, consumer sentiment, etc.) are themselves difficult to peg. In my view, the high price will continue to encourage growth in supply, while at the same time, discourage demand. This fundamental supply/demand concept, combined with a weakening U.S. economy, does not make a good case for $200 oil within the next five years, but again, I'd hate to bet the farm on my take on this.

Yuri Kuzyk from Toronto Canada: Any comments on the fact that the International Energy Agency's top economist, Mr. Fatih Birol, in an interview with German political magazine 'Internationale Politik' is sounding the alarm bells? He says there is a sharp decline in production from the existing oil fields, especially in the North Sea, the U.S. and many non-OPEC countries. He looked at all oil exploration projects around the world, in Saudi-Arabia, Venezuela, North-Sea, etc. Even if all those projects, which are already funded, were implemented, the overall capacity they can bring for new oil production is too little. By Birol's account 12.5 million barrels a day are still missing, or about 15 per cent of the global oil demand (the current global oil consumption is 84 million barrel a day). He says this gap means that we could face a supply shortage and very high prices during the next years. What do you think?

Michael Ervin: Thanks for your question Yuri. The issue of crude prices is an important one in discussing gasoline prices, since currently, the price of crude oil accounts for about 75 cents per litre of what you pay for at the pump. Before addressing Mr. Birol's comments, I think it's important to understand that today's crude price is not a function of a depleting resource, but rather, a function of the production/extraction rate of the resource, relative to demand (the other factors such as futures speculation, geo-political risk, and the U.S. dollar, in my view are simply catalysts, not primary factors). Crude oil resources are indeed depleting (ever since the first barrel was extracted from the ground), but when one takes into acccount new discoveries, non-conventional sources and the continued improvements in production efficiency, there are many decades of hydrocarbon reserves available at the projected demand rates.

Now directly to your question. The EIA projects a growth in global crude oil demand of about 2 million b/d (about 2 per cent), over the period 2008-2012, reaching about 96 million b/d by 2012. I think that may be overstated, partiicularly at today's prices, and given the prospect of a U.S. economic slowdown, that would likely have a degree of a ripple effect in other significant crude-consuming ecomomies such as China and India. On the supply side, production of oil and condensate in 2007 declined by about 0.4 per cent, according to a recent estimate by the Oil and Gas Journal. Based on this, one could easily conclude that we're in for a rough ride, but keep in mind that the production decline was largely artificial, as a result of OPEC restraints on its own output, and in particular, Saudi Arabia's.

LR NAV from Bath, Ontario, Canada: An e-mail is currently circulating on the internet which proposes a national boycott of Esso and Shell gas stations. The authors believe that if millions of potential customers just stop buying from these two companies they will be forced to lower their prices. And all other suppliers will then follow suit. What is your view on this? Will it work? Do the oil company's determine the price? After all we do have gas price wars. Or is it all down to Economics 101: supply and demand? Thanks.

Michael Ervin: This is a favorite question of mine. If everybody really got behind a boycott of one or more of the major oil companies in Canada, it would likely have the effect of RAISING the pump price. Here's why: All that demand for gasoline that the boycotted companies were supplying would have to shift over to the remaining petroleum marketers. None of them have any surplus supply, so as their wholesale inventories took a nosedive, their wholesale prices would rise, which of course would get passed along to the consumer, as dealers can't afford to pay higher wholesale without also charging higher retail. In Toronto, a typical markup from wholesale to retail price is only about 3 to 5 cents per litre.

As the other marketers seek alternate sources of supply, who do you think would be the only viable source of that supply, given that there is no spare refining capacity in North America? You guessed it: the very companies being boycotted! So, they would get to sell their gasoline in any event, even if not through their own branded stations. They would also be able to sell at "spot" wholesale prices - higher prices than the "business-as-usual" contract wholesale prices. Result: higher retail prices at the non-Petro-Canada stations. The increased revenues from the "spot" sales would go a long way towards compensating their dealers for the boycott (although not contractually obliged to do so in most instances).

Speaking of which... of the many major branded stations in Canada only about half are "company controlled" by the majors. The remainder are either "independent branded" outlets, or branded outlets of various third party marketers. So, as you boycott those major-branded outlets, you are causing "collateral damage" (to use a military term) to a large number of small businesses who simply buy gasoline from a major supplier and sell it at a modest mark-up. You're not hurting the supplier (who, as I've said, would still be selling just as many litres at wholesale), you're hurting the innocent local gas station operator. Even those "controlled" sites are in effect, separate businesses from their suppliers, who simply are operating on real-estate that is owned or controlled by the supplier.

The only kind of boycott that would actually work would be one where North American demand for gasoline were significantly reduced on a sustained basis. This would bring refinery utilization rates from the current levels of over 90 per cent (effectively 100 per cent during high-demand spring/summer seasons), down to the demand levels of, let's say, 1995, when refinery utilizations were about 80-85 per cent. Admittedly, this would do very little to reduce crude oil prices (since OPEC still has the ability to manage crude supply, and therefore, crude prices). It would however, reduce the volatility of wholesale gasoline prices, which since about the year 2000, have been going up (relative to crude prices) and becoming more volatile as a result of the lack of spare capacity. This capacity shortage, by the way, is not due to reduced supply, but increased demand - by consumers.

J Dunk from Toronto Canada: Just to put things in perspective, how does the current price of a litre of gas in Canada compare to what European countries are paying?

Michael Ervin:A good question. The International Energy Agency's February survey of regular gas prices (all in US dollars per litre) are:

France: 1.99

Germany: 2.02

Canada: 1.07

UK: 2.04

US: 0.80

The differences in prices for all of these countries are almost entirely attributable to taxes.

Doug Richardson from Kingston, Ont., Canada: Lately we have heard a lot about the strong Canadian dollar insulating us from rising food prices. Why does this not seem to have happened with gasoline as well?

Michael Ervin: Doug, the stronger Canadian dollar has insulated us from higher gasoline prices. Gasoline wholesale prices on both sides of the border tend to be almost identical, after factoring in exchange rates. So, with a higher Canadian dollar, our price is lower relative to the U.S. Consumers don't get to percieve the benefit because of the higher Canadian taxes on gasoline, which will always cause Canadian pump prices to be higher, no matter how strong the U.S. dollar is.

David B from Canada:According to reports, U.S. gasoline inventories remain above the five-year average for this time of the year. With the historically high stockpile, why is the price for gasoline continuing to climb so rapidly? Is the price of gasoline connected to the inventories at all, or is the wholesale price driven by the traders in the market?

Michael Ervin: Hi David. U.S. gasoline inventories have been very strong for the past several weeks, and in fact, this has kept refinery margins on gasoline (known in the industry as "crack spreads") very low. Despite this, pump prices have gone up, largely as a result of a significant rise in the price of crude oil. Also, inventories are now declining quickly, as a result of seasonal maintenance in advance of the high summer demand period, and with that, in addition to the upcoming higher demand, crack spreads are about to climb, probably by about 15-20 cents per litre for gasoline, as they usually do at this time of year. That means higher wholesale prices are on the way, even if crude prices stabilize or decline, and with the higher wholesale price, pump prices will of course go up, because dealers have very little margin with which to withstand higher wholesale prices - they have little choice but to pass along higher wholesale prices, usually within a week or two of the wholesale price increase.

Homer from Canada: There have been numerous studies and government assessments to determine whether oil companies are colluding to inflate prices. Each one has come up negative, saying there is no collusion. But if you look at gas prices at the pumps, every station in a specific area has exactly the same price. Doesn't that defy the oil companies' argument that there is near perfect competition?

Michael Ervin: Hi Homer. Price uniformity is actually a sign of a highly competitive retail market. Let's face it: as consumers, we treat gasoline as a commodity, as most of us will buy at the cheapest priced station. Dealers know this, so when one station drops its price, the competitor is forced to follow, or lose market share and revenue. Similarly, when wholesale prices are rising, causing dealers' margins to get squeezed, it is only a matter of time before one dealer is forced to be the first to raise the price in order to restore a viable margin, and when he does, others will generally follow suit, since they have been experiencing the same margin squeeze. This all happens without phone calls - the price signs on the street are the means of communicating these price movements.

Before anyone suggests that maybe price signs should be outlawed, keep in mind that the lack of price signs would lead to less competition, because consumers would be denied the most potent tool they have: the ability to comparison shop for gasoline at 60 kilometers per hour!

James S from Mississauga Canada: Hello, I am curious about diesel. It used to cost less than regular gas and now it is almost at premium levels. When I purchased my diesel car, I was told that diesel required less processing and was therefore cheaper. Thanks.

Michael Ervin: This is a very timely question James. First of all, diesel is indeed less costly than gasoline to make, although with the new sulphur specifications for diesel, it is certainly becoming more costly to make. In the case of both diesel and gasoline however, the cost of production really has never had very much to do with the price. Diesel prices are so high right now because in the winter, demand for diesel and furnace oil (which is very closely related to diesel) is high, putting upwards pressure on that commodity's wholesale price. In particular, we're seeing high diesel prices because of tight supply in Europe, causing their wholesale prices to have gone up. North American diesel prices have had to match those of Europe - if they didn't we might have low diesel prices, but there would be little available, as wholesale buyers would have taken advantage of the price differential and shipped massive quantities of diesel to Europe.

Mark Chow from Toronto, Canada: How come we aren't exploring the idea of a price ceiling? If natural gas prices are regulated in Ontario via the Ontario energy board, then can the same be done for gasoline? Also, can you explain why during a crisis gas prices increase quickly, but when the market calms down gas prices come down slowly?

Michael Ervin: Hi Mark. Price regulation in the form of a "price ceiling" already exists in some provinces, namely NB, NS, PEI, and NL. Based on our ongoing analysis of these regulations, you'd be hard pressed to see any difference in the price in those provinces compared to non-regulated markets, or compared to prices before the regulations were introduced.

You can't regulate the price of crude oil. Well, you could - this was attempted under the famous National Energy Policy of several decades ago - suffice to say that very few people see that as a viable option. Similarly, you can't regulate the wholesale price of gasoline unless you were prepared to cancel NAFTA. If wholesale gasoline prices were artificially lowered, there would be an exodus of gasoline for other markets, leaving us with inadequate supplies.

A price ceiling therefore can only regulate the retail price, but given the fact that a typical retail gross margin is only about 4-7 cents per litre (in bigger cities), trying to regulate 1-2 cents out of the retail price represents a 25-50% drop in the retailer gross margin. Regulators could do this, but you would see a lot of stations go out of business.This is why the regulations, at best, tend to simply emulate what non-regulated markets do anyway.

Gary Blades from Halifax Canada: Mr. Ervin, it is well known in the petroleum industry that production from a conventional oil field follows a definite pattern. Oil production gradually increases until it eventually reaches a peak, known as Peak Oil. Then, perhaps after remaining constant for some time, oil production begins to decline steadily until the field is essentially depleted. Every oil field ever developed has followed this same general pattern (Hubberts Peak).

Global oil production from all the world's conventional oil fields also follows the same general pattern. And a number of experts have stated that global oil production has already peaked back in 2005 or 2006. And indeed, oil production since 2005/2006 has been essentially flat. In a year, or a few years, or perhaps suddenly, global oil production will begin to decline. When this occurs, the world will experience an energy crisis. All economies need increasing amounts of crude oil to grow. Since the oil supply will continue to decrease according to the well known pattern (Hubberts Peak), a worldwide recession will become permanent.

Given the enormous implications of the decline in oil production (Peak Oil), why is this vitally important topic not being discussed anywhere in the media or on the world stage, except by a handful of industry experts ? Peak Oil has very serious implications for our civilization.

Michael Ervin: Thanks for your question Gary. I'm not sure that Hubert's Peak sufficiently recognizes that global oil reserves are a "moving target". Taking into account improving extraction methods, non-conventional sources (such as oil sands, coal-to-liquids, etc.), and new discoveries (albeit less frequent), a higher oil price has a tendency to steadily move the Hubert's Peak date further and further to the right.

Also, it is important not to confuse the rate of production with the size of global reserves. To quite a degree, OPEC has been responsible for limiting the rate of production growth, for example. In Alberta, the rate of production growth in oil sands has been affected by limitations on investment and labour, certainly not by limitations in the size of the resource, which is vast.

Admittedly, as time goes by, the costs of extracting petroleum resources, both in terms of capital, operating, and environmental, will continue to climb, and there are few viable alternatives to oil. There are really too many other variables, in my view, to be able to predict a permanent global recession, however.

Robert Wilson from Victoria Canada: The price of crude oil appears to have been rising faster than the price of gasoline for the last few months. Does this mean that refining margins are being squeezed, and does this mean that gasoline will rise more sharply in price as inventories fall here and in the US?

Michael Ervin: Robert, this is very observant. In the fall, and sometimes in the winter, gasoline prices will not rise as quickly as one might expect, if basing the expectation on the change in the price of crude oil. Of course in the spring and summer, when gas prices tend to rise faster than crude prices, consumers, the media, and politicians tend to smell a rat.

To try to understand gasoline price changes simply on the basis of recent crude price changes is a common practice, but is a very flawed approach. As you correctly infer, the effect of refining margins, and their consequent effect on pump prices, is a far more accurate way to understand pump price volatility. Pump prices are based on two commodities: crude oil, and gasoline (taxes, of course are another significant component of the pump price, as well as the dealer's margin, but these are not particularly volatile).

Gasoline inventories have already started to decline - this happens every year at this time of year, as refiners do seasonal maintenance and "turnovers" in preparation for the high demand summertime. As this continues, and then as summer demand starts to build, we will see refiner margins (aka crack spreads) on gasoline climb in North America, probably by about 15-20 cents per relative to current crack spreads. This crack spread usually peaks by June/July, stays high in the summer, then declines after Labor Day as demand abates. The higher crack spread will of course translate into higher wholesale prices and higher pump prices - even if the crude price stays steady or declines.

Simon Avery, ReportonBusiness.com: Michael Ervin, thanks for sharing your insight and time today.

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