The spread between Gulf Coast oil prices (such as Louisiana Light Sweet) and West Texas Intermediate (at Cushing, OK) remains wide. The March LLS-WTI spread is $14.42/bbl, and is above $10/bbl through October, 2011.
The key to restoring spreads to more typical levels is breaking the logistical bottleneck south of Cushing, thereby permitting Canadian oil that is weighing on prices in the Midcontinent to flow to the Gulf. The extension of the Keystone pipeline will help do that, but not for a couple of years. Another way to ease the logjam is to reverse the Seaway Pipeline, now flowing from the Gulf to Cushing, to carry crude in the opposite direction.
This can have large social payoffs. Here are some back of the envelope calculations. Assume the marginal cost of moving oil on Seaway is $1/bbl, and a LLS-WTI spread of around $12/bbl when no oil flows south. Also assume that the relevant derived demand curve for oil in the Gulf and the supply of oil to Cushing are linear. The capacity of Seaway is 350,000 bbl/day. The standard welfare triangle analysis implies that the opening of the pipeline would increase the sum of consumer and producer surplus by at least $1.925 million per day.*
I have been digging for estimates of the cost of reversal, and haven’t found any. I did find that the reversal of the smaller but longer Spearhead pipeline cost $20 million. The reversal of Line 9 in Canada cost $100 million.
At a reversal cost of $20 million, the investment would pay for itself in 10 days. Even at $100 million, it would pay for itself in less than two months. From a social perspective, this is a no brainer.
But the half-owner of Seaway, Conoco Phillips, says it is not interested in reversal:
ConocoPhillips isn’t interested in reversing the Seaway pipeline that brings crude from the U.S. Gulf Coast to the fuel hub in Cushing, Oklahoma, where inventories of crude oil reached a record high last month.
“We don’t really think that’s in our interest because we need more crude in the area” to supply the company’s refineries in the Midcontinent, Jim Mulva, ConocoPhillips’s chief executive officer, said during a conference call hosted by ISI Group today.
“We don’t think that’s in our interest.” Which points out that the opening of the pipeline would have distributive effects. Those are fairly straightforward to figure out. Opening Seaway would raise crude prices in the Midcontinent, and reduce them in the Gulf, although probably only slightly (as the marginal barrels will be imported). Gulf refineries are suppliers of the marginal refined barrels in most markets in the Midwest, South, and East, so product prices would probably fall slightly too.
These changes would benefit Gulf refiners (probably slightly), and harm Midcontinent refiners. Due to the crude price differential, Midcon refiners are operating at higher rates of utilization than Gulf refiners; through February PADD II refiners were working at mid-90s utilization, PADD III in the low 80s, although that differential narrowed in the last couple of weeks with Midcon utilization falling into the mid-80s, probably due to the rise in crude costs resulting from the Mideast turmoil. Opening Seaway would raise Midcon crude prices, harming refiners there (which would be reflected in reduced utilization).
The main beneficiaries of the rising Midcon prices resulting from a Seaway opening would be Canadian and Bakken crude suppliers. So the opening of Seaway would transfer wealth from Midcontinent refiners to firms supplying crude to the Midcontinent.
Although the opening would redistribute wealth, the calculations above show that the pie would get bigger. This means that there is the potential for a Coasean bargain** that could make refiners (including Conoco) and crude suppliers better off. Roughly speaking, the deal would involve crude suppliers buying Conoco’s 50 percent of Seaway.
Easier said than done, of course. There are costs of assembling the coalition of buyers (because there are multiple suppliers of crude), and costs of negotiating a deal with Conoco. The negotiating costs exist in part because there are information asymmetries: Conoco, for instance, knows more about how the profitability of the refinery varies with the price of crude than would the purchasers of Seaway.
But the potential for the expansion of the pie is an enticement for doing an deal. Perhaps Conoco’s expressed indifference is just a bargaining pose. Perhaps somebody will make a bid that will make it worth Conoco’s while. The money is there–on the order of $2 million per day. Who will structure the deal to make it happen?
* .5 x 350,000 bbl/day * ($12/bbl-$1/bbl)=$1.925 mm. Note this assumes that when Seaway operates at full capacity, the LLS-WTI spread equals the marginal cost of shipment. This means that the shadow price of capacity is zero. If at full utilization the difference between LLS and WTI exceeds the marginal cost of shipment, the shadow price of capacity is positive and the welfare gain from opening Seaway is greater: there is a welfare trapezoid that contains the welfare triangle whose area I just calculated. If in equilibrium Seaway operates below capacity, the welfare gain is smaller that I calculated.
** A phrase Coase dislikes, but which is widely used.