No help for gas buyers -- or oil investors

Why it's different now

But these aren't normal times. The nasty civil war in Nigeria's major oil-producing region, the Niger River delta, has cut 700,000 barrels a day from that country's production. Not just any 700,000 barrels a day either, but 700,000 barrels a day of premium light sweet crude.

The result -- added to the decline in the mature fields of the North Sea and the United States that also produced lighter grades of crude -- has been a supply crunch so severe that it has erased much of the normal discount on heavy sour grades of crude. Arab Extra Light now sells at a premium to the OPEC benchmark price of all Middle Eastern oil. In the first week of July, the discount for Arab Light, which makes up the biggest part of Saudi production, shrank to $4.90 a barrel and then continued to fall to $3.20 a barrel the following week. That's the lowest discount since late 2004. On average the discount was $6 a barrel in 2006.

Heavier grades, such as Arab Heavy, have seen discounts shrink, too.

This creates a nightmare scenario for anyone who buys gasoline. Shrinking discounts give oil refiners a legitimate reason to pass on rising costs in the form of higher prices. But because the cost structure behind the final retail price of gasoline is completely opaque, consumers have no way of knowing if the higher price at the pump is justified by an increase in crude prices and a drop in heavy crude discounts or simply oil-company gouging.

Certainly with demand for gasoline continuing to grow even as prices at the pump soar, refineries have no reason to cut prices. Refinery profit margins are running about three times above their average for the last three years and profit margins continue to climb. Margins at the beginning of June were about double margins in the first quarter. Refinery profits hit a record in 2006 and look headed to beat that record in 2007.

No new U.S. refineries

Don't look for any relief at the gas pump from U.S. refiners putting some of those profits to work by building new refineries. U.S. refiners are expanding capacity by upgrading existing refineries, a capacity creep that has added an average of about 1% to industry capacity for the last few years, according to Oppenheimer & Co. (OPY, news, msgs). But no new refinery has been built in the United States since 1976.

There is new refining capacity being built elsewhere in the world -- in Saudi Arabia, China, Egypt and Qatar, for example. That will eventually add enough capacity to the global gasoline market to at least slow the rise in prices at the pump. But painfully enough for U.S. consumers, that construction of new refineries elsewhere pretty much guarantees that very few refineries will be built in the United States. If refiners haven't broken ground already, they're not likely to do it now -- just in time to get whipsawed by new capacity in the Middle East already under construction that will get into production first.

New capacity elsewhere should give U.S. drivers some relief in about five years -- if the cost of importing more gasoline from overseas doesn't more than negate lower prices from rising supply. Gasoline imports to the United States have climbed by 60% over the last 10 years. That trend isn't about to reverse.

I'm certainly not a big fan of this scenario when I fill up at the gas station. But all these profits don't fill me with joy as an investor, either.

I don't want to pay a high price for current profits if the company I'm buying a piece of doesn't have a profitable place to reinvest today's money. Without that reinvestment, I'm buying an annuity at growth-stock prices.

The oil industry is stuck in exactly this tight spot. Oil companies are generating record profits -- but they don't have a good place to put those profits back to work. A big share of today's oil exploration and development capital expenditures are unlikely to earn back a reasonable return on the money invested. The prices paid for today's assets are too high, the costs of development are rising too fast and the risk that politics will prevent full production in the future is too great. That's why you see companies across the industry buying back shares or increasing dividends and waiting – hoping, really -- that the price of investing in future production growth will fall.

The more profitable an oil company is, the bigger the problem. If an oil company earning an 8% return on its capital can find a project that will pay back 10%, that's a win. But if the oil company is earning 24% on its capital, as ExxonMobil (XOM, news, msgs) is right now, a project with a 10% return is a complete nonstarter.

Look for reinvestment opportunity

The challenge for today's investor in oil stocks -- besides looking past the anger we feel at these companies personally -- is finding companies that have big opportunities for reinvesting today's cash. Devon Energy (DVN, news, msgs), with big new fields to drill and develop, and Apache (APA, news, msgs), with a steady supply of declining fields to reinvigorate, both fit that description -- and that's why they're in Jubak's Picks.

In the refining space, I've found another company that fits this profile. Frontier Oil (FTO, news, msgs) is a regional refiner with refineries in Kansas and Wyoming. Prices for gasoline in the region are always among the highest in the United States because a combination of a lack of refinery capacity and a lack of pipelines limits supply and pushes margins way above the national average.

That's the source of Frontier's current huge cash flow -- and of its future opportunities for reinvestment. Two trends in North American energy production are pointing in Frontier's direction. First, the development of Canada's oil sands will turn the Rocky Mountain West from a refinery backwater far away from the sources of oil into a hotbed of refinery growth. Second, the growth of a U.S. corn-based ethanol industry will create a new business that's a natural fit with an existing oil refiner. Frontier has already begun actively investing in that direction: In February 2007, it acquired Ethanol Management, the owner of a 25,000-barrel-per-day blending facility near Denver for $3.1 million.

With this column I'm adding Frontier Oil to Jubak's Picks.

Continued: Update to Jubak's Picks

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