V. 11 no. 5 • May/June 2008

What is the Price of Oil? Joeri de Wit and Aaron Smith

il prices first hit $100 per which describes the grade of oil deliver­ barrel on January 2, 2008. On able on this market. In the remainder of A quoted price for a commodity such as that day, a single trader look- this article, we describe how the WTI oil is specific to a particular location at O ing for notoriety bid $100 to buy the spot price relates to world crude oil a particular time. This article describes minimum 1,000 barrels before unload- prices and California gasoline prices. how the crude oil prices reported in ing the position immediately for a the media relate to world oil prices Cushing, Oklahoma: and local gasoline prices. small loss. This trader did not physically take possession of any oil and, being a An Oil Pipeline Hub floor trader on the New York Mercantile Oklahoma is a natural choice for deliv­ Exchange (NYMEX), did not have the eries on futures and spot crude oil con­ capacity to take possession of 1,000 bar­ tracts because of its close historical ties rels of oil. How do NYMEX futures with the oil industry and proximity to prices relate to prices of physical barrels Texas and the Gulf Coast. Cushing is a of oil in world markets, and how do they hub at which WTI and other domestic relate to the price of gasoline at Califor­ crude oils come together with supplies nia pumps? imported through the Gulf Coast and NYMEX operates a futures market are re-distributed mostly northward in crude oil, among other commodities. to Chicago-area refineries. The Gulf Also in this issue Contracts in this market constitute the Coast is not only the largest producer of promise to buy or sell crude oil in the crude oil but also the largest importer, Farmland Conversion in city of Cushing, Oklahoma at a fixed currently importing 50 percent of all California: Evidence from the price in a particular month in the future. foreign crudes. This oil needs to be Williamson Act Program The media usually quotes the nearby directed northward and is divided price, i.e., the price for delivery next equally between deliveries to the East Kent Kovacs...... 5 month. Thus, the buyer of $100 oil on Coast and to the Midwest. Cushing, California’s Water Problems: January 2 specifically entered a contract lying en route right above the two larg­ Why a Comprehensive Solution to buy 1,000 barrels of oil in Cushing est producing states, is well-situated Makes Sense for $100 per barrel in February. Instead for delivery across the United States. of following through on this commit­ Two-thirds of all domestic ship­ Leo Simon and Susan Stratton...... 9 ment, the trader canceled it by enter­ ments of petroleum (crude oil and ing an offsetting contract to sell exactly refined products) are transported by In the next issue the same quantity of oil in February. a 1,000-mile network of underground Although most futures contracts do pipelines (see Figure 1). Pipelines usu­ Correct (and Misleading) not end in delivery, the nearby NYMEX ally provide the cheapest mode for Arguments for Market-Based futures price is almost identical to the transporting petroleum products over Pollution Control Policies spot price for immediate delivery at land. To speed up delivery, most trunk Larry Karp Cushing. This spot price carries the lines tend to operate in “fungible” mode, label West Texas Intermediate (WTI), in which the shipper receives the same wax content) and sweeter (less sulfur) Figure 1. Select Delivery Lines than Brent crude, properties that make WTI more desirable for the produc­ tion of refined products. Therefore, this episode reveals the significant limita­ tions of short-term price arbitrage in the current oil distribution network. There is anecdotal evidence that WTI has become more sensitive to local market conditions in recent years, to the extent that some market analysts view WTI as no longer an appropriate bench­ mark for pricing international crude streams. One reason for this increased sensitivity may be reduced flexibility in Cushing, pipeline transport arising from increas­ Source: API Oklahoma ingly heterogeneous fuel formulations. State and local government regulations quality of product that it tendered for Brent crude is produced in North­ specify different formulations in many transport, but not the same molecules. ern Europe and is used as a pricing parts of the country. These formulations The alternative is batch mode, in which benchmark for 60 percent of crude need to be transported over pipelines the shipper receives the exact mol­ streams around the world. It can be in batch mode, effectively reducing the ecules that it tendered for transport. thought of as a measure of world capacity of the refinery and distribution Flexibility in oil supply through the crude prices. By taking the difference system in a number of ways: batching pipeline system is essential for suppliers between the WTI and Brent spot prices, produces more downgraded product and to be able to respond to price signals. we filter out movements in the WTI costly transmix as fuels of increased het­ Storage tanks at logistics hubs enhance spot price that result from changes in erogeneity come into contact with each the flexibility of supply by reducing the world crude prices, thereby illuminat­ other; tanks must be completely emp­ average distance and therefore time until ing the relationship between Cush­ tied before being filled with products oil can be supplied to consumers. Their ing stocks and the WTI spot price. that meet more stringent requirements; central role is to enable markets to clear Figure 2 shows evidence of an inverse batch schedules for trunklines need to because their storage and supply options relationship between the WTI–Brent be established months in advance so allow market participants to respond price spread and stocks at Cushing. In that more formulations make planning to price signals by adjusting their other words, high levels of stocks at ahead more complex. This last point demand and supply to restore balance. Cushing tend to depress the WTI spot is illustrated by the fact that the Colo­ price relative to the Brent spot price. nial Pipeline, a major trunk line from Limits to Arbitrage In the time frame of Figure 2, stock­ Texas to New York, currently transports The flexibility of petroleum supply is piles at Cushing reached their highest over 100 distinct grades of gasoline. limited by pipeline and storage tank level in April–May 2007 due to a com­ capacity and by the time it takes to bination of three factors: the shutdown California Gasoline Prices and WTI move oil from one place to another. of Valero Energy Corporation’s McKee Although WTI may be losing its status As a consequence, local supply gluts refinery in Texas on April 13, high as an international benchmark, it and shortages affect local prices. For volumes of Canadian imports, and low remains the predominant benchmark example, increases in stock of crude refinery throughput in general. These in the United States. Figure 3 plots oil in Cushing put downward pres­ factors caused a slump in the spot price the WTI spot price, the spot price of sure on the WTI spot price. To bring of WTI which traded at $8.34 per barrel regular conventional gasoline in LA, out this relationship, Figure 2 plots less than Brent on May 24, 2007, a and the average retail price of refor­ the stock of crude oil in Cushing record price difference. This difference mulated gasoline in California. The (excluding the Strategic Petroleum is especially notable because WTI trades LA spot gasoline price represents a Reserve) against the difference between at an average premium of about $2 per wholesale price for gasoline in Cali­ WTI and Brent crude oil prices. barrel over Brent. WTI is lighter (lower fornia. Figure 3 shows that wholesale

2 Giannini Foundation of Agricultural Economics • University of California gasoline prices have increased at Figure 2. Prices and Supply at the Cushing, Oklahoma WTI Spot Market the same rate as WTI crude oil. California retail gasoline prices 30 10 have increased at a slower rate than the 8 other two prices. In the last five years, 25 both the WTI price and the LA spot 6 4 gasoline price have tripled, whereas 20 retail gasoline prices only doubled from 2 about $1.70 to about $3.40 per gallon. 15 0 Put another way, the retail margin has Barrel per Dollars -2 remained about $0.80 per gallon over Barrels of Millions 10 the last five years, which means that -4 it has declined from about 50 percent -6 of the retail gasoline price to about 5 30 percent. This result suggests that -8 retail margins are determined mostly 0 -10 by factors unrelated to oil prices. Jul-07 Jul-05 Jul-04 Jul-06 Jan-07 Jan-05 Jan-06 Jan-08 Oct-07 Oct-05 Oct-04 Oct-06

Figure 3 also shows that California Apr-07 Apr-05 Apr-04 Apr-06 Apr-08 Apr-08 gasoline prices exhibit higher volatility Stock Crude OK (Millions of Barrels) WTI minus Brent Spot Price (in Dollars per Barrel) than crude oil prices. Moreover, Cali­ Figure 3. WTI as a Benchmark for Refined Products fornia has more volatile gasoline prices than the rest of the country because 4.5 the state’s unique product-quality 4.0 requirements reduce supply flexibility. Essentially all of California’s refined 3.5 product demand is met by output from 3.0 the state’s refineries. Although there is one pipeline carrying refined petro­ 2.5 leum products from the Gulf Coast to Dollars per Gallon California, its supply capacity is not 2.0 sufficient to enable arbitrage of price dif­ 1.5 ferentials between the West Coast and the rest of the country. Other modes of 1.0 transportation also do not offer short- run supply flexibility. For example, it 0.5 takes 14 days to travel from the Gulf 0 Coast to the West Coast by barge. 1995 1996 1997 1998 1999 2001 2007 2005 2003 2002 2004 2006 2008 2000 Price Dynamics WTI Crude LA Spot Gasoline CA Retail Gasoline Data source: www.eia.doe.gov/oil_gas/petroleum/info_glance/petroleum.html Figure 3 reveals the long-run rela­ tionship between California gasoline the Brent spot price, the WTI spot gasoline. Thus, we interpret shocks markets and the WTI crude oil price. price, the LA spot gasoline price, and to the LA gasoline spot price as repre­ How do average retail gasoline prices the CA retail gasoline price itself. senting shocks to the refining margin. in CA respond to week-to-week fluc­ We define each shock conditional Each shock represents a one-time, one- tuations in crude oil and wholesale on those before it in the production standard deviation unanticipated price gasoline markets? We answer this process. For example, a shock to the increase. We use weekly data, with question by plotting impulse response LA spot price of gasoline represents an the spot prices recorded every Friday functions in Figures 4.1-4.4. These unanticipated change in the wholesale and the retail price measured from an plots illustrate the predicted dynamic price of gasoline after observing the EIA survey on the following Monday response of CA retail gasoline prices Brent spot price and the WTI spot price, morning. We plot the responses over to unanticipated shocks in four prices: but not the CA average retail price of a period of 26 weeks, all series are in

Giannini Foundation of Agricultural Economics • University of California 3 natural logs, and our sample runs from are small (about one percent), but they Figure 4. Predicted Responses of CA Retail Gasoline Prices to Upstream Price Shocks January 1, 1995 to January 7, 2008. tend to persist. This persistence reflects A one-standard deviation shock to the declining percentage retail margin Figure 4.1. Shock to the Brent Spot Price 5 the Brent spot price is equivalent to a over time. Specifically, when the per­ 4 five percent hike of this price in one centage retail margin decreases, it tends 3 week and represents a shock to world to stay at that lower level rather than 2 crude oil prices. After a five percent reverting back to its previous level. 1 shock, the Brent spot price tends to 0 pull back somewhat and settle about Conclusion 0 2 4 6 8 10 12 14 16 18 20 22 24 26 -1 three percent above its initial level. In When the media report the latest crude

Percent ResponsePercent -2 response, Figure 4.1 shows that CA oil price, they refer to a futures price -3 retail gasoline prices increase gradu­ that closely matches the spot price in -4 ally over a seven-week period, eventu­ the town of Cushing, Oklahoma. Much -5 ally increasing by about two percent. of the short-term variation in this price Figure 4.2. Shock to the WTI Spot Price This predicted two percent response reflects local crude oil supply condi­ 5 to a three percent long-run increase in tions near Cushing. Such variation has 4 oil prices is consistent with the declin­ little or no effect on California retail 3 ing percentage retail margin revealed gasoline prices. Nonetheless, California 2 in Figure 3. The predicted response gasoline prices exhibit much greater 1 curve also suggests that gasoline prices volatility than crude oil prices. This 0 0 2 4 6 8 10 12 14 16 18 20 22 24 26 may start to decline at around the volatility reflects supply inflexibility -1 20-week mark, but the large confidence caused by California’s unique gasoline Percent ResponsePercent -2 interval around this prediction means formulation regulations. It illustrates -3 that it is statistically insignificant. the inefficiencies generated by the cur­ -4 Figure 4.2 shows that California rent system, which allows states and -5 gasoline prices hardly react to WTI counties to set their own fuel standards. Figure 4.3. Shock to the LA Gasoline Spot Price 5 price shocks. Because we define a WTI Long-run changes in crude oil prices 4 price shock conditional on a fixed affect California retail gasoline prices 3 Brent price, this shock represents an gradually over a couple of months. 2 unanticipated change in the WTI price After this adjustment period, the 1 without a change in world prices. Such final percentage change in California 0 shocks have little effect on California gasoline prices is less than the cor­ 0 2 4 6 8 10 12 14 16 18 20 22 24 26 -1 gasoline prices for two reasons. First, responding oil price change because

Percent ResponsePercent -2 they are short-lived, disappearing retail margins do not increase with -3 within a few weeks as WTI and Brent oil prices. Overall, month-to-month -4 prices come back together. Second, variation in crude oil prices provides -5 almost all of the West Coast crude oil a much better signal of future Cali­ Figure 4.4. Shock to the CA Retail Spot Price supply comes from the Alaskan North fornia gasoline prices than day-to-day 5 Slope oil fields or from California. or week-to-week price movements. 4 California retail prices also do not 3 respond immediately to shocks to the 2 Joeri de Wit is a Ph.D. student in the Department LA spot price. As shown in Figure 4.3, of Agricultural and Resource Economics at 1 it takes about six weeks for these shocks UC Davis. He can be reached by e-mail at 0 [email protected]. Aaron Smith is an 0 2 4 6 8 10 12 14 16 18 20 22 24 26 to fully affect retail prices. The initial -1 associate professor in the ARE department at one-standard deviation shock is about UC Davis. He can be reached at asmith@primal. Percent ResponsePercent -2 6.6 percent, and it disappears after ucdavis.edu. -3 about 12 weeks. The retail price reaction -4 peaks at about 2.5 percent before fading -5 The dashed lines represent 95% confidence intervals to zero after about 20 weeks. Figure 4.4 for the impulse response estimates. Based on weekly shows that shocks to retail prices that data spanning 1995-2007. Data Source: http://tonto. eia.doe.gov/pet/pet_pri_top.asp are uncorrelated with upstream prices

4 Giannini Foundation of Agricultural Economics • University of California