The Incidence of an Oil Glut: Who Benefits from Cheap Crude Oil in the Midwest?

• Author: Borenstein, Severin

1. INTRODUCTION

   It is often said that the crude oil market is "global". That is, the relative ease with which oil can be shipped around the world implies that prices for oil in different locations (but of a similar grade) will be closely tied by an arbitrage condition. Beginning in early 2011, however, a substantial, persistent differential arose between the price of crude oil in the United States' Midwest and international prices at "on the water" locations. In particular, the two most well-known benchmark crude oil prices--Brent and West Texas Intermediate (WTI)--diverged substantially. Brent crude oil contracts have a delivery point in the North Sea, and most other on the water pricing points, including those on the U.S. Gulf Coast, follow Brent closely. WTI is priced at Cushing, Oklahoma, which is connected to water via pipelines to the Gulf Coast.

   Figure 1 shows spot prices for WTI, Brent, and Light Louisiana Sweet (LLS) crude oil from 2006 through 2011. The LLS price, set near the Gulf Coast, closely matches Brent throughout the sample. The WTI price, however, falls significantly below the LLS and Brent prices in 2011, and a gap of 20 to 65 cents per gallon persists to the present (in contrast, LLS and Brent prices have stayed within 7 cents of one another). This gap is generally attributed to substantial increases in crude oil production in North Dakota (driven by technological advances in production of shale oil such as hydraulic fracturing or "fracking") and oil from the Canadian tar sands, combined with constrained pipeline capacity between Cushing and the Gulf Coast.1 The resulting excess supply of oil in the Midwest has therefore decreased the WTI price relative to on the water benchmark locations.

   This paper studies the implications of this unusual spatial crude oil price divergence for prices of refined products in the U.S., focusing on prices for gasoline and diesel. In theory, a range of outcomes are possible. At one extreme, regional differences in crude prices might pass through completely to regional gas and diesel prices, so that wholesale prices for these refined products in the Midwest are substantially lower than prices along the coast. At the other extreme, the decrease in Midwest crude oil prices may not be passed through at all. As we discuss below, the realized outcome depends primarily on the availability and locations of refining capacity and refined product pipeline capacity.

   We find strong evidence that the decrease in the U.S. Midwest crude oil price has not been passed through to the price of gasoline or diesel. This result is shown graphically in Figure 2, which plots monthly average wholesale gasoline prices for both the Midwest and Gulf Coast (we will later discuss the source of these data in more detail). These two gasoline price series follow each other closely, and we will later show that, per this figure, there is no evidence that depressed oil prices in the Midwest caused gasoline or diesel prices to decline in the Midwest relative to other U.S. locations. We show that this lack of pass-through is closely related to several other empirical findings: (1) Midwest refiners are operating at or near their capacity; (2) there has been no buildup of refined product inventory in the Midwest despite a build-up of crude oil inventory; and (3) the Midwest continues to be a net importer of refined product from coastal areas. These facts together are consistent with a model in which Midwest refiners are consuming as much low-priced Midwest crude oil as they have capacity to handle, yet imports of gasoline and diesel from the coast are still necessary to satisfy demand for refined products in the Midwest.

   Our results have two main implications. First, the lack of pass-through implies that refiners, not consumers, are receiving the rents generated by depressed crude oil prices in the Midwest.2 This outcome does not imply that Midwest refiners are exerting market power, but rather that they are operating at a near-vertical part of their supply curve given by their capacity constraint. Second, concern has been expressed that investments in pipeline capacity intended to allow Midwest crude oil to reach the Gulf Coast will increase not only crude oil prices in the Midwest but gasoline and diesel prices as well (Verleger 2011). Our analysis indicates that, because Midwest crude oil price shocks are not passed through to refined product markets, increasing the price of crude oil in the Midwest will not increase gasoline prices there. Instead, the increase in crude prices will be borne by Midwest refiners.

   The remainder of the paper proceeds as follows. Section 2 provides institutional background and lays out a simple theory of pass-through in local crude oil and refined product markets. Section 3 presents our main evidence that the locally depressed crude oil price in the Midwest has not been passed through to refined product prices. Section 4 presents supporting evidence that: (a) the marginal gallon of refined product in the Midwest is imported; (b) refinery utilization in the Midwest is very high and likely constrained; and (c) while inventories of crude oil in the Midwest have risen, inventories of refined product have not. Section 5 concludes by discussing implications of our results.

2. INSTITUTIONS AND MODEL

   For most of the last century, the most cost-effective way to transport crude oil and refined petroleum products to and from landlocked parts of the U.S. has been in pipelines. A complex web of petroleum pipelines covers the country. For technical reasons, crude oil and refined products must travel in separate pipelines and those pipelines can flow only in one direction. Both of these attributes can be changed, but doing so requires months or years and costs millions of dollars. Where water borne transport is available, it is quite cost effective, but that is not an option for transport to landlocked locations. Crude and refined

   products can also be transported by rail and truck, but these are much more expensive options and are generally used only for short distances and in areas with sparse demand.

   During World War II, the U.S. government designated Petroleum Administration for Defense Districts (PADDs) to aid in planning and allocation of oil and refined products. The country was divided up into five PADDs, of which the Northeastern PADD has since been divided into three sub-PADDs. The result is shown in Figure 3. The PADDs correspond roughly to areas within which transportation is relatively unconstrained and between which bottlenecks or transport barriers potentially exist. Until recently, however, PADDs 1, 2, and 3 were considered to be quite well integrated with one another at nearly all times. PADD 3 (New Mexico, Texas and most of the Gulf Coast) has been the primary oil production and refining area of the U.S. as well as the primary receiving point for imported crude oil, receiving about half of all crude imported to the U.S. Historically, PADD 3 has exported both crude oil and refined products to PADDs 1 and 2, which have had very limited oil production and modest refining capacity. The prices of crude oil at the major pricing locations across these PADDs have until recently stayed very much in sync with one another, as shown in Figure 1. In fact, the primary crude oil pricing point in the U.S. and the delivery point for futures contracts traded on the New York Mercantile Exchange (NYMEX) has been Cushing, Oklahoma, in PADD 2, because many pipelines that carry crude converge at Cushing.3 This location was therefore thought to minimize basis risk due to its minimal transportation constraints to major oil markets.

   Beginning around January 2011, the tight link between crude oil prices in PADDs 2 and 3 changed with greatly increased oil production from the Bakken oil shale formation in North Dakota and the tar sands area of Alberta, Canada. Figure 4 illustrates this production increase and shows that it accelerated, particularly in North Dakota, in early 2011. The primary transport route for oil produced in these regions is through pipelines that carry it to Cushing and from there to the Gulf Coast. The increased production has created a glut of supply at Cushing that exceeds the pipeline capacity from there to the Gulf Coast.4 As a result, the price of crude oil in Cushing has declined relative to the Gulf Coast (and North Sea) price, as shown in Figure 1. (5)

   We study the economic incidence of this bottleneck, which has caused virtually identical quality crude oil to be 20 to 65 cents per gallon less expensive at Cushing and elsewhere in PADD 2 than along the Gulf Coast since the beginning of 2011. While the costs of this bottleneck are borne by oil producers, it is not clear a priori who benefits from the reduced price of crude oil in the Midwest. To the extent that this local price reduction is passed through to prices for refined products--primarily gasoline and diesel fuel--then Midwest consumers benefit. Otherwise, the benefits are captured by Midwest refiners.

   A Simple Model of Refined Product Supply and Demand

   To see how a broad range of pass-through rates are theoretically possible and to understand how pass-through relates to other observables such as PADD-level trade flows, refinery throughput, and inventories, we consider a simple two-region model in which production...