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The villain behind rising gas prices

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The continuing surge in oil prices has Answer Desk readers looking at both sides of the coin. Cecelia in L.A. is steamed that gas prices are rising when oil companies are still posting record profits. Adam down in San Diego has a different perspective: he's wondering if it's time to buy oil stocks.

Why are gas prices continuing to rise when all the major oil companies had record-breaking fourth quarter profits in the end of 2004? — Cecilia C.,  Los Angeles

Well, those two developments certainly are connected. But gas prices aren't rising because oil industry profits are up -- it's the other way around. And there are a number of factors at work at the pump.

For starters, gasoline prices almost always rise as summer approaches because demand goes up as people go on vacation and use more gas. Refiners anticipate this and starting about now, they begin building up stockpiles of gasoline. If they make enough, and can keep running at full capacity through the summer, gas prices may not rise too much from here.

But if demand gets too high and/or they can’t make enough gas, prices will go higher. Sometimes this is because a big refinery has to shut down for maintenance or fire. Last year, the string of hurricanes interrupted deliveries of crude oil to Gulf refineries, which hurt supplies.

Some parts of the country also see local spikes in prices because some states require “reformulated” gasoline in the summer months to meet clean air standards.  So you can only sell a specific blend for a particular region. If supplies of that blend get low, the price goes up.

But the real villain at the pump is rising oil prices, which have roughly doubled in the past 18 months to recent highs of $55 a barrel. Oil companies didn’t set those prices (much as they’d love to be able to), the market did. Demand for oil is rising worldwide, and older oil fields are drying up. So prices are going up. And gasoline prices have risen even slower than crude oil so far this year, so they still have to “catch up” a bit.

The question we'd ask you is: why should an oil company -- or refiner, or gasoline dealer -- charge less than the market price? And, if they did, who should they give all those profits back to? Should the government set price caps on gasoline prices? If it did, why would oil companies continue to make gasoline? Without profit, what's their motivation?

Contrary to popular belief, oil companies don't always leave the table with huge winnings. When they made similar bets in the late 1990s -- and oil prices crashed to $10 -- they got clobbered. For a time, it was cheaper to find new oil on Wall Street -- by just buying up another oil company -- than it was to poke new holes in the ground. That's why so many oil companies these days have two names: ExxonMobil, ChevronTexaco, etc.

And that's also one reason oil supplies are tight today: not enough money has been invested in drilling new wells. We'd rather see oil companies making the cash they need to poke new holes in the ground. Unless they do, oil supplies will remain tight and prices will continue to move even higher.

And sure, oil company executives and investors are pocketing a nice chunk of change with their $50-oil-price windfall. But most of the money you're spending to fill up your gas tank is going to big oil producers like Saudi Arabia and Iran. The United States produces about 10 percent of the world's oil supplies (and falling). OPEC produces four times that much.

Wouldn't you rather have the money going to U.S. oil companies?

So what the outlook on energy stocks/futures in general? Pretty good I'd imagine!
—Adam L., San Diego

Well, as every broker loves to remind us, past performance is no guarantee of future results. These stocks have already surged along with oil prices: up 17 percent in 2004 and another 19 percent so far this year. (By comparison, the S&P 500 index was up 9 percent for 2004 and just 1 percent so far this year.) So even if oil prices stay at $50, it’s hard for any stock to keep growing at the rate of these shares.

And there is certainly reason to believe that the recent surge in oil industry profits may be a hard act to follow. Major oil companies invested in new production over the past three to five years when oil was selling in the low- to mid-$20s. They figured, at that price, they'd make money on the wells they chose to drill. With oil above $50 a barrel, the difference is pretty much pure profit.

But oil companies now have a happy problem -- where to invest all those profits?  There are certainly plenty of places left to drill for oil, but many of them are in countries where the political risk (war breaking out, countries suddenly deciding to renege on contracts or nationalize oilfields developed with private investment) is just too great to justify the investment.

Further, there’s no guarantee that prices will stay at $50. If you invest in a high-cost field assuming $50 oil – and oil prices crash – you lose. That happened big-time in 1998, when oil prices hit $10 a barrel. The losses forced many oil companies to merge. (That’s one reason why so many oil companies these days have two names ExxonMobil, ChevronTexaco, etc.)