Why Are Gas Prices So High? 3 Stocks That Benefit

8th July, 2022.      //   Market Intelligence  // 

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Gas prices have reached record highs in 2022. According to AAA data, the nationwide average for a gallon of regular unleaded gasoline hit $5.02 on June 14, 2022. That crushed the old record of $4.11 per gallon, which had been set in 2008. For truckers, things got even worse as the price of diesel hit a peak of $5.82 per gallon in June.

What’s caused these runaway gas prices? Some have labeled this “Putin’s price hike,” and not entirely without reason. The Russian invasion of Ukraine has certainly intensified the current squeeze in the energy market. However, there are broader forces of domestic supply and demand which were leading to sharply higher gas prices even before geopolitical issues made their mark.

It’s easy to think that the price of crude oil is the overwhelming factor that determines gas prices, and there is indeed strong correlation. But it’s not the be-all and end-all. Consider that in 2008, the price of a barrel of West Texas Intermediate, or WTI, crude oil topped $140, and yet gasoline only made it up to $4.11 per gallon. This time around, WTI has stayed closer to $120 but gasoline breached the $5 per gallon line. What accounts for that difference?
Refining’s Outsized Role in Gas Prices

Apart from crude oil prices, refining is the key reason gas prices have hit unprecedented levels.

Refining is a major factor in gas prices. First, let’s break down what happens to a barrel of oil as it is processed. According to a Department of Energy fact sheet, a standard American barrel of crude oil contains 42 gallons of raw unprocessed oil. Out of each barrel, a refining operation will on average be able to produce more than 44 gallons of finished petroleum products. Specifically, a 42-gallon barrel could be expected to produce roughly 19.4 gallons of gasoline, 10 gallons of diesel, 3.9 gallons of jet fuel, 1.7 gallons of liquefied natural gas, 1.7 gallons of heavy fuel oil, and 8 gallons of everything else.

At a market price of $110 per barrel of WTI crude, with each barrel of oil producing more than 44 barrels of refined products, that would suggest that each gallon of refined petroleum products would cost $2.50 per gallon on average based on the cost of the oil alone. Yet, as of July 5, per AAA data, the average price of gasoline nationally was at $4.80 per gallon, and diesel was at $5.73 per gallon.

Thus, the actual cost of crude oil is only making up roughly half the price of gasoline and diesel at the pump. Taxes might seem like the answer for the rest. However, according to American Petroleum Institute data from January 2022, the average combined total state and federal tax load on gasoline is 57 cents per gallon. That’s not nothing, but it’s just 12% of the overall average price of a gallon of unleaded gasoline today. This is why proposals such as a federal gas tax moratorium wouldn’t make a big impact on the market. Cutting gas taxes would help drivers at the margins, but overall, taxes simply aren’t a decisive factor in explaining why gas prices are high right now.

Refining is the key. That’s because there is a critical shortage of refining capacity. According to Chevron Corp. CEO Mike Wirth, the United States has not built any new refineries since the 1970s, and it is unlikely that any new ones will be built in the future. American regulatory and environmental policies have greatly discouraged new refining capacities as policymakers work to replace fossil fuels with renewables. That might make sense on a longer-term time horizon, but it’s leading to drastic supply-demand imbalances now.

A key part of the current refining squeeze has to do with a crucial feature of oil: It’s not all the same. Light crude oil is a free-flowing liquid with low viscosity. Whereas heavy oil is gunky, more closely resembling a sludge. American refining capacity was built to process tons of the heavy sludgy stuff, rather than the light free-flowing variety.

This worked fine for decades. But, the shale oil revolution turned the industry on its head. Shale drilling produces extremely light oil. Refiners have adjusted by mixing American shale oil with imports of heavy oil from other markets such as the Canadian oil sands. However, regulatory setbacks have blocked new pipelines which would deliver more heavy Canadian crude to the American refining centers.

Long story short, America can produce lots more shale oil if it puts in the capital to do so, however it’s a challenge to turn that raw crude oil into actual gasoline or diesel for drivers. In the past, there was slack in the supply chains for crude oil and shipping tankers internationally, allowing oil to arrive to markets with the right mix of refining. However, the sanctions against Russian oil have greatly reduced the wiggle room for the global market, leading to insufficient capacity at American refining operations and resulting in sky-high gas prices.

Developments such as additional production, foreign energy export limits or a cease-fire in Ukraine might greatly ease the pain at the pump. For the foreseeable future, however, the factors leading to high gas prices seem likely to remain largely in place. That’s not good news for consumers, but there’s a silver lining for investors. These three stocks in particular are benefiting from elevated gas prices.

Valero Energy Corp. (VLO)

As refining is the key bottleneck in the gas market right now, it makes sense to start there. Valero is the country’s largest independent refining company, operating 15 refineries across North America. Valero is a massive business with a scale most investors probably fail to appreciate; the company generated $132 billion in revenue within the last year alone.

The rub with refining has been that it’s historically a low-profit-margin business. When things are working properly, refineries only earn a small profit margin for turning crude oil into gasoline, diesel, jet fuel and other end products. Right now, however, things are far from normal and Valero is earning elevated profit margins for its work.

Investors sold Valero stock off sharply in June, and shares are now more than 25% below their 52-week highs. That has left the stock trading for 9 times forward earnings while offering a dividend yield of 3.6%. If the current gas price situation persists, Valero shares should trade back toward their highs given the company’s unprecedented profitability right now.

Exxon Mobil Corp. (XOM)

Exxon Mobil is the largest American oil company by market capitalization. It’s held onto that position thanks to its ability to invest through all sorts of energy cycles.

While the industry went through a push to downsize and streamline operations, Exxon Mobil held onto operations such as refineries and chemical plants that others shunned. That has paid off in spades as refining and petrochemicals earn record profit margins now. In addition, Exxon’s massive array of oil and gas production assets around the world give it significant flexibility in delivering the right grades of oil to suitable markets. Given Exxon’s massive size, it doesn’t benefit from higher gas prices as much as its smaller peers do. But at roughly 8 times forward earnings, XOM is attractively priced and offers a strong dividend to help investors offset the current pain at the pump.

Suncor Energy Inc. (SU)

Suncor is one of Canada’s largest oil companies. Its key feature is that it is focused on the Canadian oil sands, which produce exceptionally heavy crude. Recall that the North American market has an excess of light sweet crude, whereas it is lacking in heavier oils. Venezuela, for example, used to be a huge supplier of heavy crude to the U.S. market but that has dried up given the political problems there. Canadian oil sands players like Suncor can help bridge the gap.

In addition, Suncor owns a significant amount of refining capacity. Owning these key facilities helps ensure that Suncor, rather than third parties, earns the lion’s share of the profit from its production. Suncor is a value stock which trades at just over 6 times estimated 2022 earnings while paying a 4.1% dividend yield. The company is also returning capital to shareholders through large share buybacks.

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