«The Incidence of an Oil Glut: Who Beneﬁts from Cheap Crude Oil in the Midwest? Severin Borenstein* and Ryan Kellogg** ABSTRACT Beginning in early ...»
2011. Because estimates of the cost of railroad transportation ($0.12 to $0.24 per gallon (Peters and Lefebvre 2011)) are smaller than the observed PADD 2 to PADD 3 price differential, it appears that either railroad transportation is capacity constrained (on the track or at loading/unloading terminals) or that railroad owners are exerting market power.
6. During 2011, the bottleneck between PADD 2 and the Gulf Coast likely reduced supply outside PADD 2 by an average of less than 500,000 barrels per day (this value is the total increase in North Dakota’s and Canada’s daily crude oil production between January and December 2011, according to the EIA and Canada’s National Energy Board) in a global market of about 90 million barrels per day. The small impact of this supply restriction is unlikely to be detectable in world oil prices (such as that for Brent crude). Relieving the bottleneck would almost surely reduce Gulf Coast and rest-of-world crude prices very slightly and increase the Cushing crude price substantially, until it was once again very close to the Gulf Coast price. For similar reasons, relieving the bottleneck is also unlikely to raise overall U.S. (i.e., not just PADD 2) and world gasoline prices. A recent report (Swift 2012) claims that the increase in the PADD 2 oil price following a debottlenecking would reduce PADD 2 reﬁnery utilization, and that because PADD 2 reﬁneries are particularly tuned to produce large amounts of gasoline (rather than diesel), the resulting decrease in PADD 2 gasoline production will increase overall U.S.
gasoline prices by decreasing the world supply of gasoline. However, as with the crude oil market, the large size of the world gasoline market implies that the price effect of a decrease in PADD 2 reﬁnery utilization would be very small in magnitude. Moreover, our ﬁndings suggest that the change in PADD 2 reﬁnery utilization following debottlenecking would itself be very small, as utilization increased only slightly when the Midwest oil glut began in 2011 (see Figure 8).
Figure 5: Simple Model of Four Cases for the PADD 2 Reﬁned Product Market We assume that transportation has a simple technology of sunk pipeline costs and zero marginal costs, though the qualitative analysis isn’t changed if there are small marginal transport costs (relative to the value of the product). For a given cost of crude, reﬁneries have essentially constant marginal cost (MC) for quantities well below their capacity constraint, strictly upward sloping MC as quantity approaches capacity, and then vertical MC at capacity. For the purpose of this theoretical discussion, we refer to all reﬁned product output as “gasoline,” though the term is meant to include diesel and other reﬁned products.
In Figure 5, D2 is the native demand for gasoline in PADD 2. There is pipeline export capacity for gasoline and a different import capacity. These capacity constraints are shown as horizontal segments in Dnet, the net demand for gasoline in PADD 2, accounting for imports and exports. These segments are horizontal because if the price in PADD 2 is less than the price in ROW, PROW, the export pipeline will be used to capacity and the net demand for gasoline in PADD 2 will be the native demand shifted out by the capacity of the export pipeline. If, on the other hand, P2 PROW, the import pipeline will be fully utilized, and net demand in PADD 2 will be shifted in by the import pipeline capacity.
We consider four distinct possible supply situations, labeled a, b, c, and d in Figure 5. For all four cases, we assume that the constant MC for PADD 2 production quantities well below capacity is at a level below the ROW price of gasoline. This assumption is likely to hold for two Copyright 2014 by the IAEE. All rights reserved.
22 / The Energy Journal reasons. First, we are considering only cases in which crude in PADD 2 is as cheap or cheaper than in ROW. Second, reﬁneries are very capital intensive so that equilibrium prices will typically include some quasi-rents to capital owners in the short run.
As shown in Figure 5, the equilibrium PADD 2 gasoline price and trade ﬂows depend on where the PADD 2 gasoline supply curve is relative to net demand. In case (a), the gasoline reﬁning capacity in PADD 2 is small relative to demand so that, even utilizing the full import capacity for gasoline, the gasoline price in PADD 2 is still higher than in ROW. In case (b), PADD 2 reﬁning capacity is larger so that, even though PADD 2 must still import gasoline, the import pipeline capacity is unconstrained. In this case, arbitrage implies that the PADD 2 gasoline price must equal the ROW price. Case (c) is similar to case (b) in that pipelines are unconstrained, except now reﬁning capacity is sufﬁciently large that PADD 2 is a net exporter of gasoline rather than a net importer. Finally, in case (d) the PADD 2 reﬁning capacity is so large that the export pipeline is at its capacity. In this case, the PADD 2 gasoline price will be below the ROW price.
To see how the different cases have different implications for pass-through, consider an exogenous shock (such as an improvement in crude oil extraction technology) that creates a large increase in oil production in PADD 2 so that the PADD 2 crude price falls relative to ROW.7 Will this price decrease be passed through to the PADD 2 gasoline price? The decrease in the PADD 2 crude price will shift down the reﬁners’ supply curve. Thus, if the market is initially in case (b) or (c) and remains in one of these two cases following the crude oil shock, then pass-through will be zero because the PADD 2 gasoline price will remain tied by arbitrage to the ROW price. PADD 2 reﬁnery throughput may, however, increase to the extent that reﬁners are on the upward sloping rather than vertical part of their supply curve.
If, on the other hand, the market is initially in case (d), there will be at least partial passthrough: the export pipeline constraint prevents gasoline market arbitrage so that the PADD 2 supply curve shifts down along the downward sloping PADD 2 demand curve, reducing the PADD 2 gasoline price and increasing PADD 2 reﬁnery throughput. Pass-through will be 100% if both the initial and ﬁnal equilibria are such that reﬁners are operating on the ﬂat part of their supply curve (the speciﬁc case shown in the ﬁgure). Partial pass-through occurs when reﬁners are on the upward sloping part of their supply curve (or if the market is initially in case (c) but is pushed by the supply shock into case (d)).
If the market is initially in case (a), in which the gasoline import pipeline is capacity constrained, there are two possibilities. If, as drawn in Figure 5, PADD 2 reﬁneries are also initially capacity constrained, the decrease in the PADD 2 crude price will not pass through to the PADD 2 gasoline price, nor will reﬁnery throughput be affected. Partial pass-through is possible, however, to the extent that PADD 2 reﬁneries are initially on the upward sloping portions of their supply curves. In this case, reﬁnery throughput will increase.
To summarize, so long as there is unconstrained gasoline pipeline capacity between PADD 2 and ROW, we would expect to see essentially no pass-through of PADD 2’s decrease in crude oil prices. If pipeline export of gasoline from PADD 2 is (or becomes) constrained, some or all of the crude price drop will pass through to PADD 2 gasoline prices. In the ﬁnal case (a) in which pipeline imports of gasoline to PADD 2 are constrained, zero or partial pass-through may occur. In
7. We recognize that the realized decrease in the PADD 2 oil price may be partially mitigated by downstream responses, particularly increases in PADD 2 reﬁnery throughput. That response would not change the qualitative effect of the increased crude oil supply, however.
Copyright 2014 by the IAEE. All rights reserved.
The Incidence of an Oil Glut / 23 each of these cases, PADD 2 reﬁnery utilization may increase. Thus, an examination of trade ﬂows will have more power to discern which case is in effect than will an examination of reﬁnery throughput.
Finally, the different cases have implications for how PADD 2 gasoline inventories may be expected to change following the decrease in PADD 2 crude prices. The incentive to inventory gasoline arises from the difference between the expected future gasoline price and the current price in PADD 2. If import and export capacities are unconstrained (cases (b) and (c)), then these prices will be the expected future and current prices in ROW. Thus, in these cases we should expect that changes in PADD 2 inventories will be similar to changes in ROW. Further, to the extent that ﬁrms hold no-change forecasts of future ROW prices, we should see essentially no change in inventories.8 In case (d), however, the decrease in the PADD 2 crude price reduces the PADD 2 gasoline price relative to ROW. In this case, the change in PADD 2 inventories will be determined by beliefs about the future gasoline price in PADD 2. Given a belief that investments in crude export pipeline capacity will increase the future PADD 2 oil price back toward parity with the ROW price— increasing the future PADD 2 gasoline price as well—ﬁrms will have an incentive to increase their gasoline inventories more in PADD 2 than in ROW. A similar incentive will exist in case (a) to the extent that the initial decrease in the PADD 2 oil price is passed through to the PADD 2 gasoline price.
3. DATA AND ANALYSIS OF PASS-THROUGH
In this section, we test directly whether, and to what extent, the decrease in PADD 2 oil prices was passed through to PADD 2 prices for reﬁned products. Section 4 then examines PADD 2 trade ﬂows, reﬁnery throughput, and inventories to assess the extent to which they change in a way that is consistent with the theoretical model discussed above.
Most of the data for this study come from the U.S. Energy Information Administration (EIA). Data on wholesale prices for reﬁned products (called “sales for resale” in the EIA data) are available monthly at both the state and PADD level.9 Spot prices for crude oil were obtained from Bloomberg; we calculate monthly spot crude oil prices by taking unweighted averages of the daily raw data. All data cover the period 2006 through 2011.
Inspection of Figures 1 and 2 suggests that pass-through of the post-2010 decrease in PADD 2 crude oil prices has been very limited. Here, we study pass-through more formally with two types of regression-based tests. Our ﬁrst test is that given by speciﬁcation (1) below, which examines the extent to which changes in the difference between PADD 2 and PADD 3 crude oil prices correlate with changes in the difference between PADD 2 and PADD 3 reﬁned product prices.
G2t – G3t = β0 + β1(C2t – C3t) + et (1)
8. Alquist, Kilian, and Vigfusson (2010) shows that no-change forecasts for real crude oil prices generally outperform all other forecasts, at least at horizons greater than one year, and Anderson, Kellogg, and Sallee (2011) shows that consumers generally have no-change forecasts of the future price of gasoline.
9. “Sales for resale” denotes prices for sales on wholesale markets to “purchasers who are other-than-ultimate consumers” according to the EIA. We use the “motor gasoline” price series for gasoline and the “no. 2 distillate” series for diesel.
Monthly average prices are volume weighted.
Copyright 2014 by the IAEE. All rights reserved.24 / The Energy Journal
In (1), G2t and G3t denote the average prices of gasoline in PADDs 2 and 3 in month t, while C2t and C3t denote the WTI and LLS prices, respectively, for crude oil in month t. The parameter β1 denotes the extent to which changes in the PADD 2 to PADD 3 crude price differential are passed through to the PADD 2 to PADD 3 gasoline price differential.10 Estimating equation (1) by ordinary least squares raises the issue of the endogeneity of the crude price differential. If there is a shock to local demand for reﬁned product in PADD 2 relative to PADD 3 that affects the relative reﬁned product prices, then that shock also may change the relative crude prices between the PADDs. Such endogeneity, however, would clearly bias estimates in the positive direction. It is hard to see how an endogenous crude price could incorrectly lead to the conclusion that the pass-through is zero. Moreover, given the substantial increase in crude oil production in PADD 2 during the time period under study, it seems likely that regional shocks to crude oil markets are much more substantial than regional gasoline market shocks during this time. We therefore treat these regressions and those that follow as measuring the impact of shocks to crude oil differentials on reﬁned product differentials.
Estimates of speciﬁcation (1) are given in Table 1, column 1. The estimate of β1 is small in magnitude at –0.003, statistically insigniﬁcant, and precisely estimated, with a standard error of 0.026.11 The 95% conﬁdence interval bounds the impact of a $1 per gallon increase in the WTI – LLS crude price differential on the PADD 2 – PADD 3 gasoline price differential at between –$0.05 and + $0.05. This result accords with Figures 1 and 2 and supports the inference that the decrease in Midwest crude oil prices that began in 2011 has not passed through to gasoline markets.
One potential concern with the estimate of speciﬁcation (1) is that it matches PADD-level
averages of gasoline prices to prices for crude oil that are for delivery to very speciﬁc locations:
Cushing, Oklahoma and St. James, Louisiana. We address this concern by re-estimating speciﬁcation (1) using only gasoline prices for Oklahoma and Louisiana. The results of this regression are given in column II of Table 1. Again, the estimate of β1 is small in magnitude, statistically insigniﬁcant, and precisely estimated, consistent with no pass-through.
Columns III and IV repeat columns I and II but use prices for diesel rather than prices for gasoline. In line with our gasoline price results, we ﬁnd no evidence that low Midwest crude oil prices have passed through to markets for diesel.