Buying High and Selling Low : Pipeline Ownership and the Price Gap between WTI and Brent Crude Oil

The 2011 price gap between the West Texas Intermediate and Brent crude oil benchmarks was caused primarily by the lack of pipeline infrastructure connecting the American Midcontinent to the Gulf Coast. An analysis of the profit-maximization function for a crude oil refiner with control of an inter-regional pipeline shows that by shipping crude oil from a high-price to a lowprice region, a refiner can lower the cost of its inputs sufficiently to offset the trading loss on pipeline flows. This paper then explains how transporting crude oil to the low price region enabled the price gap to remain for most of 2011 and why the price gap ultimately shrank again. † University of Michigan, dtigge@umich.edu Special thanks to Professor Stephen Salant for considerable guidance throughout the researching and writing of this paper and to Yulan Chen and Levi Redmond for significant assistance in the paper’s early stages 2 1. The Pipeline Paradox The difference in crude oil spot prices between the Brent and West Texas Intermediate benchmarks grew to $19.84 per barrel on June 15, 2011. From February 1, 2011 until November 15, 2011 the price difference stayed above $10.00. Historically the price difference has been much smaller due to the similarity between the two crude oil benchmarks. The fact that the price gap remained for nearly 10 months is surprising and in the last decade unprecedented. This paper examines why the price gap persisted for so long. ConocoPhillips, a major crude oil producer and refiner, had the capability to reduce the price gap considerably. As owner of the only major pipeline between the American Midcontinent and the Gulf Coast, ConocoPhillips could decide the direction that oil flowed along the pipeline, either from north to south or from south to north. Despite the price gap of nearly $20 per barrel, ConocoPhillips kept sending oil from the high-price region in the south to the low-price region in the north. At first glance it appears that large rents could have been earned by ConocoPhillips if it had allowed some level of arbitrage to occur. Despite the potential benefits, ConocoPhillips waited until November 2011 to announce that Enbridge Inc. would buy a 50% stake in the pipeline and then reverse the flow (ConocoPhillips kept the remaining stake in the pipeline). Why did ConocoPhillips spend a year buying high and selling low before deciding to reverse the pipeline? What is at first surprising is found to be sensible once ConocoPhillips’ situation is understood. The oil industry is one of the largest sectors of the global economy. Nearly all of the world’s crude oil is priced according to one of the two major benchmarks. West Texas 1 http://online.wsj.com/article_email/SB10001424052970203699404577041901234224874lMyQjAxMTAxMDEwNjExNDYyWj.html?mod=wsj_share_email 3 Intermediate (WTI) is priced in Cushing, OK and is the price of crude oil in most of the United States and Canada. Brent is the world’s other major benchmark and is sourced in the North Sea. Changes in the price of crude oil could have important macroeconomic effects. James Hamilton says that it is likely that oil shocks “were a contributing factor in at least some of the U.S. recessions prior to 1972” (Hamilton 1983). Conversely Robert Barsky and Lutz Kilian conclude that “disturbances in the oil market are likely to matter less for U.S. macroeconomic performance than has commonly been thought” (Barsky and Kilian 2004). Excluding the possible macroeconomic effects of lower oil prices, most of the economic loss from the price divergence falls to crude oil producers in the United States, Canada, and Latin America who benchmark the price for their crude oil sales to the West Texas Intermediate price. The price divergence is beneficial for crude oil refiners, who are the primary consumers of crude oil in the United States. The current price divergence also has theoretical implications. It shows that market efficiency for intermediate goods can be highly dependent on ownership of transportation networks. The fact that the price gap is caused largely by vertical integration between midstream and downstream operations is highly relevant to antitrust law and whether one company should be allowed to engage in both intermediate good refining and transportation. The primary result is that when firms exhibit both monopolist power in the transportation of an intermediate good and engage in the refining of that intermediate good, they may have an incentive to transport the intermediate good from the high price region to the low price region. The surprise is that buying high and selling low is generally believed to be unprofitable. The model for this effect is then shown to be consistent with the present crude