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«The Incidence of an Oil Glut: Who Benefits from Cheap Crude Oil in the Midwest? Severin Borenstein* and Ryan Kellogg** ABSTRACT Beginning in early ...»

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Our second specification is given by equation (2) below, which studies how PADD 2 gasoline prices are determined by PADD 3 oil prices and the difference between PADD 2 and PADD 3 oil prices. We estimate this equation in first differences both because we are interested in the relationship between gasoline and oil prices in the short-run rather than long-run (when pipeline construction will tend to arbitrage spatial price differences away) and because oil and gasoline prices are generally found to be very persistent, so that a unit root cannot be rejected (see, for example, Borenstein, Cameron, and Gilbert 1997 and Chen, Finney, and Lai 2005).

DG2t = β0 + β1DC3t + β2D(C2t – C3t) + e2t (2)

10. We have also estimated a version of equation (1) that includes a one-month lag in the crude oil price differential. Results are qualitatively similar to those from estimating (1) without the lagged term: there is no economically or statistically significant relationship between the crude price differential and the gasoline price differential.

11. Standard errors for specification (1) are Newey-West with 12 lags to account for seasonal correlation in the residuals.

These standard errors are sometimes smaller and sometimes larger than when only Eicker-White standard errors are used.

For example, the Eicker-White robust standard error for β1 in both columns I and II is 0.031.

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Notes: Crude prices are monthly averages of daily spot prices, all in $/gallon. Delivery points are Cushing, Oklahoma for WTI and St. James, Louisiana for LLS. Gasoline and diesel prices are month-level prices for “sales for resale” obtained from the EIA. Data span 2006–2011. Standard errors are Newey-West with 12 lags.

–  –  –

Notes: Crude prices are monthly averages of daily spot prices, all in $/gallon. Delivery points are Cushing, Oklahoma for WTI and St. James, Louisiana for LLS. Gasoline and diesel prices are state-month level prices in PADD 2 for “sales for resale” obtained from the EIA. Data span 2006–2011. The difference in the number of observations between columns I and II is due to a missing gasoline observation for Kansas in 2006. Standard errors are clustered on month-of-sample.

As with specification (1), C2t is given by the WTI crude oil price, and C3t is given by the LLS crude oil price. We estimate equation (2) using state-by-month level gasoline prices as the dependent variable so that the regression uses a panel across the 15 states in PADD 2 over 2006–

2011.12 We cluster standard errors on month to account for cross-sectional correlation of residuals.

Results from estimating equation (2) are given in Table 2. Column I uses gasoline prices as the dependent variable, while column II uses diesel prices. While the estimates are somewhat imprecise, we find in both regressions that changes in the PADD 3 crude oil price pass through essentially completely to PADD 2 refined products prices (the estimate of β1 is statistically indistinguishable from one) but that pass-through of the difference between PADD 2 and PADD 3 crude prices, β2, is statistically indistinguishable from zero.

12. The first-differencing in equation (2) automatically controls for differences in fuel price levels across states. We have also estimated (2) while adding fixed effects that control for state-specific linear time trends. Including these fixed effects has virtually no impact on the estimates of the coefficients of interest.

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Figure 6: PADD 2 Net Flows of Gasoline and Distillate (diesel) Notes: Data are PADD-month level net imports (by tanker, pipeline, and/or barge) from other PADDs. The data do not include international trade.

Source: EIA.

These results are consistent with cases (b) and (c) in section 2, in which Midwest refined product prices are tightly linked to the Gulf Coast, and therefore to world crude oil prices, because the pipelines carrying refined products between these areas are not constrained. As a result, changes in Midwest crude oil prices do not move Midwest refined product prices. Section 4 below provides additional evidence in support of these cases by studying data on product flows, refinery throughput, and inventories.

In the appendix, we present additional evidence showing that the pass-through results we obtained for Midwest refined product prices also hold for PADD 4, the Rocky Mountains area.

Because PADD 4 is connected to the Gulf Coast only through PADD 2, PADD 4 has also experienced a relative decrease in crude oil prices, though not as large a relative decline because PADD 4 crude prices have been lower than elsewhere in the U.S. throughout our sample period. Figures A1 and A2 and Tables A1 and A2 show that this decrease in PADD 4 crude oil prices has not passed through to PADD 4 prices for refined products.

4. WHY HASN’T CHEAP CRUDE IN THE MIDWEST LOWERED GAS PRICES?

Why did the decrease in PADD 2 crude oil prices fail to pass through to PADD 2 gasoline and diesel prices? To some, this outcome may raise concerns of nefarious behavior on the part of PADD 2 refiners. The economic evidence, however, supports a benign explanation: Figure 6 shows that PADD 2 has been a net importer of refined product for the entire period of our sample.13





13. Flow data for crude oil show that PADD 2 is also a net importer of crude. At first glance, these data appear to contradict the premise that PADD 2 is export-constrained in the crude oil market. However, the PADD 2 crude imports come from the Permian Basin in West Texas. While this area is technically part of PADD 3, it is economically part of PADD 2 in that

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Figure 7: Inventories of Gasoline and Distillate (diesel) in PADDs 2 and 3 Notes: Data are PADD-month level stocks held at, or in transit to, refineries and bulk terminals, and stocks in pipelines.

Source: EIA.

Moreover, net imports to PADD 2 were lower in 2011 than in the previous 5 years, suggesting that import pipelines were not constrained. This outcome corresponds to case (b) from section 2: the marginal gallon of refined product sold in PADD 2, both before and after the PADD 2 oil price decrease, has been produced outside of PADD 2 and therefore reflects the marginal cost of more expensive crude that is processed elsewhere. The crude oil market has become separated between the PADDs, but the refined product markets have remained integrated.

This conclusion is also supported by data on inventories of refined product. Cases (b) and (c) predict no change in PADD 2 refined product inventories relative to other locations outside the Midwest, while case (d)—which implies substantial price pass-through—is likely to be accompanied by an increase in PADD 2 refined product inventories. Figure 7 shows that both gasoline and diesel inventories were fairly constant in PADD 2 during 2011, while they rose somewhat in PADD

3. There is no evidence of a buildup of PADD 2 product inventories in response to temporarily depressed product prices, as suggested by case (d).

The discussion in section 2 indicated that refinery utilization data would not help to distinguish among the possible cases because utilization could increase in any of them. Figure 8 does not reveal an obvious pattern in PADD 2 utilization versus PADD 3. At the end of 2011, however, PADD 2 utilization was nearly 5 percentage points higher than in PADD 3, and PADD 2 utilization there exists substantial pipeline capacity to carry oil from the Permian Basin to Cushing, Oklahoma but very little direct capacity to the Gulf Coast. Indeed, the industry broadly considers the price for Permian crude to be the WTI price at Cushing (see Alpert 2012, for instance). In contrast, the Permian Basin does not, to the best of our knowledge, export significant quantities of refined product to PADD 2.

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Figure 8: Operable Refinery Utilization in PADDs 2 and 3 Notes: Data are PADD-month level operable refinery utilization.

Source: EIA.

was higher than it had been in the previous 5 years. This increase in PADD 2 utilization is consistent with the increase in PADD 2 refining margins since early 2011.

These observations fit together in a unified picture. The increased production of crude oil in the upper Midwest and Canada over the past two years has led to a bottleneck in shipping crude out of PADD 2. PADD 2 has reduced net imports of refined products, but it has not become a net exporter, let alone a large enough net exporter to congest transport of refined product out of PADD

2. The ability to arbitrage refined product prices, but not oil prices, between PADDs has resulted in essentially no pass-through of the reduction in the PADD 2 oil price to PADD 2 product prices.

This situation has created very large refining margins in PADD 2 and also appears to be causing higher utilization of refineries in PADD 2 relative to other parts of the U.S. This does not imply that refineries in PADD 2 have exercised market power; in fact, the high utilization of operable capacity suggests that they have responded to the higher margins by trying to squeeze out more output.14

5. CONCLUSIONS AND IMPLICATIONS

Beginning in early 2011, increases in crude oil production from North Dakota’s shale resource and Canada’s tar sands created a transportation bottleneck as the pipelines capable of

14. The story for PADD 4 is similar, except PADD 4 has varied between being a small net importer and a small net exporter of refined product. In 2011, PADD 4 net flows were close to zero. As in PADD 2, refined product inventories were flat in PADD 4 during 2011.

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carrying oil from the Midwest to the Gulf Coast reached full capacity. This constraint caused the benchmark Midwest crude oil price to fall substantially below the “world” oil price on the Gulf Coast, despite the fact that these two prices have historically been very close to one another. We show in this paper that this relative price change has not passed through to markets for refined products: Midwest wholesale prices for gasoline and diesel have not fallen relative to those along the Gulf Coast. This result is explained by the fact that the marginal gallon of gasoline (and diesel) in the Midwest is being imported from the Gulf Coast, where it is refined using relatively expensive crude oil. In other words, while trade in crude oil between the Midwest and Gulf Coast is capacity constrained, trade in refined products is not, and in fact the Midwest is actually importing rather than exporting gasoline and diesel.

Our results imply that the primary beneficiaries of depressed Midwest crude oil prices have been Midwest refiners rather than Midwest consumers. We emphasize that this outcome does not imply that Midwest refiners are exerting market power. While our analysis doesn’t rule out that possibility, the empirical findings are equally consistent with refiners operating at or near their production capacity while benefitting from the fact that the marginal refined product suppliers in PADD 2—refineries on the Gulf Coast—are producing from more-expensive crude oil.

A simple “back of the envelope” calculation suggests that the rents accruing to Midwest refiners are substantial, relative to a counterfactual in which crude oil pipeline capacity were sufcient to equalize Midwest and Gulf Coast crude prices. The average Midwest to Gulf Coast crude price differential during 2011 was $17.45. Given the average 2011 Midwest (PADD 2) refinery throughput of 3.39 million barrels per day, Midwest refiners therefore earned rents of $59.2 million per day. Rents also accrued to holders of crude oil transportation rights: given average exports from the Midwest to the Gulf Coast of 195 thousand barrels per day, these rents are $3.4 million per day.

The countervailing losses of $62.6 million per day have of course been borne by Midwest and Canadian crude oil producers.15 The substantial rents accruing to Midwest refiners and to holders of the limited Midwest crude oil export capacity strongly suggest that the present situation is not a long-run equilibrium.

In fact, several investment projects have already been announced or are underway that would increase Midwest crude oil export capacity,16 including construction of the southern segment of the controversial Keystone XL pipeline (the northern segment would expand capacity from the Canadian tar sands to the Midwest). These projects will relieve the Midwest crude oil export bottleneck as they come on-line, bringing the Midwest oil price closer to, if not ultimately back into equality with, the Gulf Coast price. This re-equilibration will primarily increase the Midwest crude oil price rather than decrease the Gulf Coast price because the Gulf Coast is tied to the very large world oil market, of which the Midwest is only a small part.

The merits of these capacity expansions—particularly the Keystone XL project—have been a matter of public debate on both environmental grounds and the extent to which it will impact U.S. gasoline prices. While this paper is silent on environmental impacts, it does imply that the impacts on gasoline prices will be extremely limited. Because expanding Midwest crude oil export

15. To the extent that refinery demand and Canadian and PADD 2 crude oil supply are elastic, refineries’ gains and producers’ losses will be lower and greater, respectively, than these estimates. Given that most produced and refined crude is inframarginal and that demand and supply are likely to be quite inelastic, at least in the short to medium run, accounting for these elasticities will have only a very small effect on our calculations.

16. Another type of investment that would dissipate these rents would be additions to Midwest refinery capacity. The fact that investors are sponsoring crude oil pipeline projects rather than refinery projects suggests that the latter option is relatively expensive and/or time consuming.

Copyright 2014 by the IAEE. All rights reserved.30 / The Energy Journal



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