Released on February 23, 2006
(Next Release on March 1, 2006)

Inventories and Prices Forging a New Relationship
Many people have questioned why oil prices are so high, given that U. S. inventories are above average levels for crude oil, gasoline, and distillate fuel (which includes both diesel fuel and heating oil). For example, the last time total gasoline inventories were as high as they are now was the week ending June 4, 1999, when the average price for regular gasoline was $1.11 per gallon. For a long time, analysts have postulated that when inventories are at high levels, it is indicative of a situation in which excess supplies are being added to inventories, which would imply a market where lower prices would be expected. So why is it different now?

Some analysts point to the fact that the market is in contango, which is defined as a market in which prices for commodities delivered in future months are increasingly higher than for those delivered in months closer to the present. When contango exists, it provides an economic incentive for inventory holders to store more oil, as they will be able to recoup the extra cost of maintaining inventories by buying now and selling for a higher price later, if the contango is steep enough. Currently, contango is most extreme for gasoline. While analysts would expect some contango for the summer months, as this is when gasoline demand peaks, there would usually not be much contango between March delivery and November delivery. For example, on February 22, 2005, the futures price for March 2005 delivery settled at 130.89 cents per gallon, while the price for November 2005 delivery was 132.92 cents per gallon. With such a small difference, it would not make economic sense for a stockholder to buy gasoline in late February with hopes of storing it to be sold in November. But as of yesterday, February 22, 2006, the situation was very different. Gasoline for March 2006 delivery settled at 147.45 cents per gallon, but delivery in November 2006 settled at 161.24 cents per gallon, a gap of nearly 14 cents per gallon. This is certainly a large enough difference to make it economic for some stockholders to add extra inventory now for sale later. Of course, some of the contango in gasoline futures relates to the contracts themselves, which are for reformulated gasoline (RFG). With the phasing out of MTBE in nearly all RFG likely to occur before November, there may be some market confusion, or near-term disincentive, to holding RFG supplies blended with MTBE that may be depressing the March 2006 delivery price for RFG. Limited volumes in the November 2006 delivery contract may be making that price more volatile than it would otherwise be. Nevertheless, the contango exists, which does provide an incentive for stockholders to increase their inventory holdings.

But contango only tells part of the story, and not the most important part either. There have been times in the past when contango existed and we did not see absolute price levels this high. The other key factor is the lack of spare capacity throughout the supply chain. Beginning from the wellhead, where spare global oil production capacity remains relatively low, to transportation, where spare tanker and pipeline capacities are limited, to the refinery, where refinery utilization continues to increase across all major regions of the world, capacity is relatively tight. When put in context to an oil market where uncertainties about future supply abound (e.g., Iran, Nigeria, Iraq, Venezuela, the elimination of MTBE in gasoline, etc.), market participants are concerned about being able to get needed supplies, should something cause a drop in supply. As a result, many of them may be storing up additional inventories as a buffer should there be a supply problem at some point in the future. In other words, where markets have traditionally relied on available spare capacity to provide a part of the response to any unexpected supply problems, under current tight capacity conditions, inventories must play a relatively larger role in buffering the market. Because of this, many market participants are apparently opting for a larger inventory cushion.

Thus, until either spare capacity increases significantly across the entire supply chain, or many of the perceived uncertainties in the market are removed, oil markets could see high inventories coexist with high prices for the foreseeable future. Oil market analysts used to the old, inverse relationship between inventories and prices need to understand that new market dynamics (lack of spare capacity and contango) have significantly altered this linkage.

U.S. Average Retail Gasoline Prices Fall for the Third Week in a Row
The U.S. average retail price for regular gasoline dropped 4.4 cents to 224.0 cents per gallon as of February 20, which is 33.5 cents higher than last year. Prices were down throughout the country, with the East Coast seeing the largest decrease of 6.6 cents to 225.6 cents per gallon. Midwest prices dropped 2.2 cents to 216.7 cents per gallon. West Coast prices, the highest in the nation, were down 4.6 cents to 241.0 cents per gallon, while California prices lost 4.9 cents to 247.3 cents per gallon.

Retail diesel fuel prices decreased by 2.1 cents to reach 245.5 cents per gallon as of February 20, which is 43.5 cents higher than last year. This is the second week in a row that diesel prices have fallen nationally. Prices were down throughout the country, with West Coast prices dropping the most quickly, down 2.7 cents to 259.4 cents per gallon. West Coast prices were still the highest in the nation, with California prices falling 3.5 cents to 267.4 cents per gallon.

Residential Heating Fuel Prices Decrease
Residential heating oil prices decreased for the period ending February 20, 2006. The average residential heating oil price dropped by 2.0 cents last week to reach 239.7 cents per gallon, an increase of 41.3 cents from this time last year. Wholesale heating oil prices increased by 4.3 cents to reach 171.4 cents per gallon, an increase of 29.9 cents compared to the same period last year.

The average residential propane price decreased 0.7 cent, to reach 200.1 cents per gallon. This was an increase of 28.4 cents compared to the 171.7 cents per gallon average for this same time last year. Wholesale propane prices decreased 1.3 cents per gallon, from 97.6 cents to 96.3 cents per gallon. This was an increase of 13.5 cents from the February 21, 2005 price of 82.8 cents per gallon.

Propane Inventories Continue Sharp Decline
The late-winter cold spell in many parts of the nation continued to push propane inventories sharply lower last week, with inventories moving down by 3.1 million barrels to an estimated 40.4 million barrels as of February 17, 2006. In contrast to the relatively mild weather during January, temperatures during February have been colder, with inventory withdrawals during the first two weeks of the month approaching nearly 80 percent of the entire monthly draw averaged for February over the most recent 5-year period. Despite the rebound in imports last week, inventories in the East Coast and Gulf Coast regions fell by 0.2 million barrels and 2.8 million barrels, respectively, while inventories in the Midwest region managed a small stockbuild that measured 0.1 million barrels. During this same time, the Rocky Mountain/West Coast regions posted a modest 0.1-million-barrel drop in their combined inventories. For the second week in a row, propylene non-fuel use inventories posted a sizable stockdraw that totaled 0.4 million barrels, moving inventories down to 3.3 million barrels to account for an 8.2 percent share of total propane/propylene inventories.

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