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James Hamilton

James Hamilton

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Differences in the Price of Oil: Brent-WTI Spread

The puzzling differential between the price of oil in different markets seems to be persisting.

For most of the last decade, there was very little difference between the price of West Texas Intermediate traded in Cushing, Oklahoma and that for North Sea Brent in Europe. But a $10-$15 spread between the two developed at the end of January and has remained ever since.

Brent and WTI Prices
Weekly price of WTI and Brent in dollars per barrel, Jan 1, 2010 to Apr 8, 2011. Data source: EIA.

The new gap is essentially a geographic difference between the price paid for oil in the central United States and that paid on the U.S. coasts and anywhere else in the world. For example, Chevron is currently offering $123.25 for a barrel of Louisiana light sweet, $17 more than it is willing to pay for Oklahoma sweet. A year ago the differential was only $3. That gap means that U.S. refiners on the coast are paying a huge premium to buy imported oil, when there are plenty of inland domestic producers who'd love to sell it to them at a significantly lower price.

Gail Tverberg noted that the lower price at the Oklahoma hub resulted in part from pressure of new supplies from North Dakota and Canada. But there's still a deep puzzle of where the violation of the Law of One Price is coming from-- why are producers selling the product in Oklahoma when there's such a much better price to be obtained at the Gulf?

The cheapest way to transport oil from Cushing to Chevron's or somebody else's refinery in the Gulf of Mexico is by pipeline. The Seaway pipeline has the capacity to transport 430,000 barrel a day between the Gulf and Cushing. But currently, the pipeline is carrying oil from the Gulf, where it is so expensive, to Cushing, where it is cheap. Updating Craig Pirrong's welfare triangle calculations, if we assume a pipeline transportation cost of about $1/barrel and that reversing the pipeline at full capacity would be just enough to eliminate the spread, running the pipeline in the reverse direction would generate a combined surplus for oil producers and consumers on the order of (1/2)(17 - 1)(430,000) = $3.4 million every day. If, on the other hand, the added flow was still not enough to reduce the spread, the gain in surplus could be up to twice as big-- $6.8 million per day.

So why does ConocoPhillips, part owner of Seaway, say that using the pipeline to transport crude from Cushing to the Gulf is not in its interests? At its recent analysts call, the company offered this explanation:

the issue there is we have a mid-continent refining center in Ponca City [Oklahoma], and we also want crudes that allow us to make what we call "premium coke" at Ponca. So if there's a need for us to bring crudes into the mid-continent, the other piece on it, everyone talks about reversing Seaway as being a very quick solution. And I would tell you that it's not, you can't do it overnight. The timeframe could be six months, it could be a year. The dollars are not free either, it costs money to be able to reverse it.

Presumably running the crude from the Gulf to Cushing does protect the profitability of ConocoPhillips's refining operations by keeping inland crude cheap. But Professor Pirrong claims that

reversal of the smaller but longer Spearhead pipeline cost $20 million. The reversal of Line 9 in Canada cost $100 million.

Pirrong concludes that any potential benefits to ConocoPhillips are smaller than the potential gain to other market participants from reversing the pipeline. That leaves room for a consortium of upstream oil producers to profit by offering to buy the pipeline outright, or alternatively to pay a sum to ConocoPhillips to persuade it to reverse the flow, in the spirit of Professor Coase's theorem.

An alternative is a new pipeline extension proposed by TransCanada that would carry oil from Canadian oil sands all the way to the Gulf. That's another option that would clearly cut the Brent-WTI spread, but which has yet to receive U.S. approval.

If you can't ship the product by pipeline, the next best alternative is rail. It should be possible to get oil all the way from North Dakota to a Gulf refinery for $7 a barrel, leaving a very healthy profit for each barrel you ship. The problem here appears to be the infrastructure of rail tanker cars and loading facilities necessary to handle the volume.

But plenty of people are working hard to fix that. U.S. Development Group opened a new 60,000 b/d crude-by-rail unit train terminal in St. James, Louisiana for this purpose last summer, and plans to double the capacity and build two more. Savage Companies and Kansas City Southern plan a huge new terminal for Port Arthur, Texas for completion in 2012:Q2. A dozen other rail facilities for transporting oil from North Dakota and surrounding areas are also under construction. Jim Brown speculates that this may have been part of what Warren Buffett saw that others didn't when he decided to buy Burlington Northern railroad last year.


And even transportation by truck may be profitable at current spreads. If I had any physical assets in this business, I'd be looking into every way imaginable to try to sell North Dakota oil in the higher-priced markets, for the good of North Dakota and for the good of America, not to mention for the good of my own profits. Since I'm only a pixel-pushing college professor, I'll instead just offer a prediction-- arbitrage is eventually going to succeed in driving the Brent-WTI spread down, and nobody-- not even ConocoPhillips, not even the U.S. president-- can prevent it.

But they do have the power to slow it down.

By. James Hamilton

Reproduced from Econbrowser

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