Some observations from the physical market

--Market observers tend to play this little game where they try to decide which of the three-headed monster is leading the market up, and/or which is leading it down. The three-headed monster, of course, is the crude market, as represented by the NYMEX light sweet crude contract; the NYMEX No. 2 oil contract and the ICE gasoil contract, representing the middle distillates; and the NYMEX RBOB contract, representing gasoline.

There's no doubt that the distillate indicators have been the strongest for several months. But how have they fared during this decline in overall prices? At first glance, diesel appears to be just as strong as it has been relative to the other two parts of the three-headed monster, but may be starting to slip. On June 2, US Gulf Coast conventional gasoline assessed by Platts was 88.3% of the price of ultra low sulfur diesel (ULSD). That got down to almost 81% just a few weeks ago, but has climbed back to almost exactly where it started; yesterday, it stood at 88.87%.

This actually is good news for consumers. It's difficult to imagine that gasoline could lead the market considerably higher, given the slide in demand and the steady growth in the supply of ethanol, which displaces gasoline. But if gasoline is getting stronger relative to diesel, it could mean that the strength in the market led by diesel has run its course.

In Europe, the ratio of crude to gasoil also indicates some diesel weakness relative to the rest of the barrel. Platts' Dated Brent assessment relative to ARA CIF ULSD on June 2 was 79%. Yesterday, it was more than 82%, again, a possible indiciation that diesel's ability to drive the market higher has peaked.

--You think prices on the NYMEX are volatile? There is no more volatile market than ethanol. Consider this: while crude benchmarks have been plunging in recent weeks, ethanol in the NY harbor, the most active arena for trade, according to Platts' Robert Sharp, has actually risen. It rose from about $2.39/gal on June 2 in NY harbor, peaked at about $3.21 on July 3, and has since dropped back to about $2.75/gal, still more than it was two months ago. As a percentage to RBOB gasoline -- the semi-finished gasoline product that it is blended with to produce finished reformulated gasoline -- it stands at 90%, one of the highest levels during those two months.

The spread against gasoline is extremely important, because it is the key factor determining whether the suppliers of conventional gasoline will blend it in their finished product. In reformulated areas, there is almost no ability to avoid it. But conventional gasoline areas that had not used it in the past have been encouraged by its price fall to do so. So the ethanol rise relative to gasoline is always a spread to watch. Some people may not like ethanol policy, but just ask any refiner, fresh off reporting poor quarterly second quarter earnings, whether the price of ethanol is holding down the price of gasoline relative to crude and diesel. There's no doubt about it.

--One of the more interesting stories of the week came out of Europe. The European Union has proposed giving Brazilian exports of ethanol cheaper access to the European market as part of a trade deal, the EU's trade commissioner Peter Mandelson said on his blog. Brazil has been pushing to gain better market access for exports of ethanol to the US and Europe. Europe currently levies an Eur0.19 ($0.26)/liter tariff on Brazil's sugarcane ethanol, which is actuall less than the US tariff. However, there appears almost no chance the US will change its tariff.

But if the Europeans were to lower their tariff, it's easy to see where this would take the market. Europe already is a significant exporter of gasoline to the US. If ethanol displaces more of Europe's gasoline, that would almost certainly mean that more gasoline would come from Europe to the US. Bad news for refiners, but theoretically good news for consumers...unless the US margins on gasoline get so miserable that diesel margins can't compensate for them, and refiners reduce operating runs in response.

And so the saga of ethanol's outsized impact on the gasoline market would have another chapter.