Streetwise Professor

March 11, 2011

Professor Coase Call Your Office

Filed under: Commodities,Derivatives,Economics,Energy — The Professor @ 9:48 pm

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.

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  1. [...] and crude oil at Cushing, each barrel delivered on the pipeline loses about $10-15 of value. The Streetwise Professor does a little back of the envelope calculation to conclude reversing the flow of the pipeline would create substantial economic gains. The (part) [...]

    Pingback by Reversing the Seaway Pipeline « Knowledge Problem — March 11, 2011 @ 10:06 pm

  2. Conoco has about 270,000 b/d of refining capacity directly linked to Cushing (half-stake in Borger through WRB, plus Ponca City). The difference between 3-2-1 WTI cracks in the midcontinent compared with 3-2-1 LLS cracks on the Gulf coast has been averaging nearly $18/bl since the start of February. So, notionally, if a Seaway reversal equalised the two crude markets, Conoco would be looking at the loss of nearly $5mn/d on margins. (You’d have to adjust this figure down a bit to reflect the output of non-gasoline/diesel output from the refineries, but it gives you a sense of the scale of it.)

    Also, the recent drop in midcontinent utilisation rates is more likely to be maintenance than run cuts. It’s still incredibly profitable to run WTI crude if you can.

    Comment by Down with this sort of thing — March 15, 2011 @ 6:12 am

  3. @DWTSOT–that sounds about right. The main thing is that COP’s loss would be the producer’s gain (smaller, actually because they are only a fraction of the Padd II refining capacity). Hence, in theory anyways, it would be possible to pay COP to compensate it for its lost margins and something more (due to the increased size of the pie–the welfare triangle). For instance, a producer could agree to sell to COP for several years out at the current WTI forward curve in exchange for COP’s 50 pct of Seaway. Win-win.

    The ProfessorComment by The Professor — March 15, 2011 @ 1:15 pm

  4. [...] 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 [...]

    Pingback by Brent-WTI spread | Bear Market Investments — April 19, 2011 @ 10:07 am

  5. I am not an economist, but I fail to see how reversing the Seaway pipeline increases the pie for all. Right now Mid-Con and Midwest refiners are effectively getting a $20/bbl discount on their crude purchases. This is coming at the expense of inland US producers, who are effectively selling their crude at a $20/bbl discount.

    Reversing Seaway would have zero impact on US gasoline prices in the South, Mid-Con or Midwest. You are correct in saying that these prices are set by the marginal barrel of production from the Gulf, but both before and after a Seaway reversal these prices would be based on global crude prices, so no change.

    The only thing that reversing Seaway would do help inland E&P’s and harm inland refiners. But the impacts would offset. How would there be a gain overall?

    Comment by not an economist — June 14, 2011 @ 1:55 pm

  6. @not an economist–there is definitely a gain to be divided. Let’s say that the marginal cost of transportation, once the pipeline is reversed, is $1/bbl. Use $10/bbl as a current price differential between the Gulf and Cushing. Therefore, market participants are willing to pay $10 to make the shipment, but it only costs $1. This is a $9/bbl to be split. As additional barrels are shipped, that difference narrows: diverting oil from Midcon to the Gulf raises the former price, and lowers the latter one. Thus, the gain to be split is decreasing with the amount of oil shipped. If the price impacts are such that prices (net of transport costs) are equalized before the pipe hits capacity, the marginal gain to be split on the last barrel sent is zero. The total gain is the sum of the gains calculated in this way across all barrels shipped. In economics, this is called a “welfare triangle”–long story.

    This is a pretty much textbook analysis. Re your calculations, the gain to be split would be *bigger*, the less responsive Gulf and Midcon crude prices are to additional shipments.

    The ProfessorComment by The Professor — June 14, 2011 @ 4:18 pm

  7. At the moment the Brent (Shoreside) WTI (Midwest) spread is $20 per barrel.
    If I assume
    1)All crude oils are exactly the same except for location.
    2)The pipe is big enough that when reversed it will reduce the spread to $1 per barrel
    3)Pumping oil in the pipe costs $1 per barrel in either direction
    4)All refining has a constant MC equal to AVC equal to some number
    5)The shoreside (Brent) market is big enough that Bent price is independent of the direction of flow in the pipeline.
    6)Refinery capacity in the Midwest is too small to supply the Midwest
    7)The owner of the pipeline owns Midwest refineries buying more WTI crude than the pipeline capacity
    Then the owner of the pipeline would gain by running the pipeline from shoreside to midwest as the owner’s gain from the refinery proficts would be greater than the loss on buying Brent pumping it north and selling WTI.
    But the oil producers could afford to make him a payment larger than his net profit to bribe the refiner and pipeline owner to switch the pipeline.

    Comment by Levis Kochin — July 28, 2011 @ 7:22 pm

  8. Under the conditions I outlined the demand curve for WTI is vertical so long as the price of WTI is lower than $1 per barrel more than Brent.

    Comment by Levis Kochin — July 29, 2011 @ 4:41 pm

  9. [...] The Coasean challenge is that reversal of the Seaway pipeline currently flowing from the Gulf to the Midcontinent would cost one of the owners–ConocoPhillips–money by raising input costs for its Midcontinent refineries.  Even though there are more than enough gains on the table to compensate CP for any losses arising from a rise in the price of Midcon crude, so far no one has been able to craft a deal whereby the winners (primarily Canadian and US producers) can make it worth CP’s while to agree to the reversal. [...]

    Pingback by Streetwise Professor » A Tale of Two Contracts — August 28, 2011 @ 2:27 pm

  10. [...] because ConocoPhillips, part owner of the pipeline, wants to protect its Midwest refining margins. Craig Pirrong looked at this and suggested the logical solution would be for oil producers to buy the pipeline [...]

    Pingback by Implications of the Recent Rise in Oil Prices — Clearing and Settlement — November 20, 2011 @ 8:24 pm

  11. [...] because ConocoPhillips, part owner of the pipeline, wants to protect its Midwest refining margins. Craig Pirrong looked at this and suggested the logical solution would be for oil producers to buy the pipeline [...]

    Pingback by Implications of the recent rise in oil prices | Bear Market Investments — November 21, 2011 @ 10:02 am

  12. [...] because ConocoPhillips, part owner of the pipeline, wants to protect its Midwest refining margins. Craig Pirrong looked at this and suggested the logical solution would be for oil producers to buy the pipeline [...]

    Pingback by Implications of the Recent Rise in Oil Prices | — November 22, 2011 @ 1:33 pm

  13. [...] because ConocoPhillips, part owner of the pipeline, wants to protect its Midwest refining margins. Craig Pirrong looked at this and suggested the logical solution would be for oil producers to buy the pipeline [...]

    Pingback by Implications of the Recent Rise in Oil Prices « Mortgage Debt Reduction « Mortgage Debt Reduction — November 27, 2011 @ 6:02 am

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