There has been a spate of world-turned-upside-down stories about the US as a potential exporter of oil and refined products. The explanation is quite simple. Supposedly menopausal North American geology has produced a surprise energy baby. Or, I should say “babies”, for this is a multiple birth, in fact: oil and gas in different locations.
This has resulted in substantial changes in price relationships in oil and gas. The most visible of these is the Brent-WTI spread, which blew out again to over $20/bbl (better than 20 percent of the WTI price). But all sorts of spreads have reached record or near record wides. Canadian oil sells at a deep discount to WTI at Cushing, which sells at a deep discount to the price in the Gulf. Refining margins are wide.
Commodity trading is all about transformations in space, time, and form. Spreads price transformations: they are the shadow prices of transformations. Time spreads price the cost and benefit of transformations in time (through storage). Locational spreads measure the marginal cost of transformations in space (through transportation). Spreads between processed and raw materials price the costs of refining/processing.
The spread blowouts in energy are highly visible evidence of how the spike in domestic energy production, and notably its location and quality, has been at odds with the energy transformation infrastructure that has developed in the US in the past decades. That transformation infrastructure was-and crucially still is-configured to transform foreign and heavier/sour crudes into refined products for domestic production. The main direction of movement of crude was south to north, from import points at the Gulf to refineries in the Gulf and Midcontinent.
The new production is in the north, or in Eagle Ford in Texas. It is sweeter and lighter than the oil that most domestic refineries are configured to process. Refineries in position (in the Midcon) to process this new output (especially the Bakken) are operating at capacity, giving them fat margins. The transportation capacity to bring the oil to the Gulf (and to East Coast refineries, many of which have been shuttered in recent years) is highly limited because it was structured to bring oil inland, not ship it to the coast either for refining or (when the law permits), export.
Meaning that in the short run, quantities cannot adjust in response to the oil output shock: there are bottlenecks in transportation, storage, and refining. Since quantities cannot adjust, prices bear the burden, leading to dramatic movements in spreads that price these transformations.
These spreads are signals about the locations of bottlenecks in the value chain, and the value of making investments in transportation, storage, and refining capacity to ameliorate them. These investments are expensive, and take time. Hence, historically anomalous spread levels are like to persist for some time.
Moreover, some investments can exacerbate other bottlenecks. For instance, building Keystone XL (which will bring oil from Bakken and Canada to the Midcontinent) without adding more Midcon refining capacity and/or more capacity to move oil from Midcon to the Gulf (and perhaps the East Coast) would actually exacerbate the refining and outbound transportation bottlenecks in the Midcontinent. This would, most notably, cause the Brent-WTI spread to widen further. There is essentially a race between production capacity in the Midcontinent on the one hand, and the outbound transportation and refining capacity there. Right now production is winning. This will tend to cause spreads to change in ways that discourage too much output expansion, and encourage expansion in the ability to consume what is produced in the Midcon. But there will be a minuet between production and consumption that will go on for years: prices/spreads will play conductor of the music that producers and consumers dance to.
There are economic considerations that limit the speed with which quantities will respond to these price signals.
For one, investment takes time. You can’t snap your fingers to build a pipeline or add refining capacity, and have it arrive instantaneously in a puff of smoke.
Uncertainty is another. The ability to invest in refining or pipeline or production capacity is a real option: in the face of uncertainty, it is often optimal to delay decisions to invest pending the arrival of new information about the economic value of those investments.
Sadly, politics is another. Whether it is a politicized pipeline approval process, Byzantine environmental laws that give enviros and nimby-ists the ability to impede energy investments, or laws that restrict exports, the legal and regulatory systems in the US inflate the cost of investment in energy infrastructure, and crucially add an element of considerable uncertainty that also slows investment due to the real option considerations I just mentioned: the vagaries of politics and political influence are volatile, hard to predict, and can have first-order effects on the profitability (or not) of an investment. It would have taken some time regardless to make the investments necessary to reconfigure America’s energy infrastructure to accommodate the huge shock to the location and quality of oil production. Politics and regulation will only slow that response, and make it less efficient and complete than it should be.
And it should be noted that even though much of the law and legislation will be cloaked in the language of public interest, notably environmental paeans and invocations of “jobs, jobs, jobs”, it is largely the product of nakedly self-interested calculations. This is most notable in the debate over natural gas exports, in which domestic petrochemical producers are trying to prevent-or at least sharply constrain-in order to reduce the cost of their feedstocks and thereby increase their margins. Similar arguments are already starting to appear in oil just as the prospect of oil exports is being mooted. It is also notable in transportation: is it any surprise that oil pipelines (notably Keystone) are the target of much opposition, given that Warren Buffett is making oodles of money transporting oil by rail, due to his ownership of the BNSF RR and a major manufacturer of rail tank cars. (Sort of OT: speaking of Buffet, could the fact that the USDOJ is going after S&P but not Moody’s, despite the fact that their conduct during the pre-crisis period was almost identical, have anything to do with the fact that Saint Warren has a big stake in Moody’s?)
In other words, naked rent seeking is going to play a big role in the speed and efficiency with which firms make the investments necessary to respond to the unexpected domestic energy production shock. Sadly, the intensely politicized nature of energy, and the swollen nature of the US government and regulatory apparatus (which deems that everything is its business) will dramatically impede this adjustment process. Meaning that we are likely to be in a world of wide spreads for some time to come.
When the government is the bookie, it’s very hard to beat the spread. Especially when that government is all too often indistinguishable from the mob.