Current / Economics

Yelling at the Heavens (on the futility of energy economic reporting)

I have no expectation that anyone else will ever read this, but I’ll feel better after writing it, so here goes.

From many sources, finally the real story concerning rising fuel prices is coming out.  Rightly, the shutdown of oil refineries is receiving the much deserved blame for escalating prices at the pump.  Bill Saporito in the March 19, 2012 issue of Time Magazine mentions that 19 oil refineries have shut permanently in the U.S., Caribbean and Europe, for a loss of 1.7 million barrels per day of capacity.  Yahoo News also reported the same month that 20% of East Coast refineries had shut down in the face of massive losses.  The massive commodities market failure that allows crude oil prices to force oil refineries into oblivion should be incredibly obvious, but that fact doesn’t appear to be on the cusp of anyone’s lips other than my own.  Because I apparently am the only one saying this, let me be clear: CRUDE OIL PRICES REPRESENTING BOTH REFINED FUEL DEMAND AND THE PRICE OF CRUDE OIL ITSELF IS COMPLETELY INSANE.  How can oil refineries turn any sort of profit if their primary input and product is priced exactly the same?

From Wikipedia’s oil refinery entry:

In 2009 through 2010, as revenue streams in the oil business dried up and profitability of oil refineries fell due to lower demand for product and high reserves of supply preceding the economic recession, oil companies began to close or sell refineries.

This isn’t a new phenomenon.  The same entry lists American oil refineries numbering at 301 with a total of 17.9 million barrels per day refining capacity in 1982, the earliest year data was available.  In 2010, that number had dropped to 149 oil refineries with a total capacity of 17.6 million barrels per day.  Also noteworthy is the fact that the last oil refinery constructed on American soil broke ground in 1976.  This is important because every gallon of gasoline, diesel, jet fuel or heating oil that is sold is processed through an oil refinery—crude oil has virtually no customers other than the refining industry.  As JPMorgan related through Bill Saporito’s Time piece, a loss of capacity of 1.7 million barrels per day has occurred since 2009.  The usual suspects already are blaming environment regulations as the culprit behind the crash in refining capacity.  Forgive my incredulousness, but for 35 YEARS?  Twelve years of Republican control of both the House of Representative and the Senate (1995-2007), six years overlapping the administration of George W. Bush and Richard Cheney?  Four years of “Drill, baby drill?”  What on Earth is going on?

If I may conjecture, maybe the answer lies with supply and demand.  If demand for crude oil increases, for instance if the demand for gasoline, diesel and Jet A in China and India rises precipitously in the 2000s, crude oil prices naturally must increase.  If the reverse happens, crude oil plummets.  So the demand curve represents gasoline, diesel, jet fuel and heating oil demand and the supply curve represents crude oil production.  A single world market–call it one market.  But hold on a second—cars, trucks and airplanes don’t burn crude oil.  Not even supertankers burn crude oil.  It is too laden with sulfur and other impurities.  It must be refined first.  For thirty years in the U.S., the maximum amount of fuels available has been less than 18 million barrels per day.  Worldwide, there is also finite refining capacity (unfortunately I don’t have access to numbers for worldwide refining capacity).  What is simplified onto one graph really requires two graphs—one for demand for crude by refineries versus supply of crude oil, and a second for demand of refined fuels versus supply from the refineries.  Under the two market model, if refineries reduce production or completely shut down, crude prices theoretically should fall, regardless of demand for refined fuels.  Reducing the processing of crude causes demand for crude to fall, and unless crude oil production also falls, the price of crude should become lower.  In the case of 20% of oil refineries shutting down on the East Coast, one might guess the price of crude would plummet.

I may be going out on a limb here, but I believe the commodities markets do not see the distinction.  Routinely airlines hedge against crude oil prices.  Speculation is often blamed for exceedingly high crude oil prices.  The commodities markets clearly seem to be pricing crude against demand for gasoline, diesel and jet fuel (the one market model I mentioned first, that excludes refineries completely).

I’ll concede that crude oil pricing attempts to account for refining costs, but that misses the main problem.  Pricing crude against refined fuel demand implicitly tells the commodities market refineries add or subtract nothing from their product.  I really dislike the term “value-added,” because I think it submerges the true insanity of crude oil prices—it is asking oil refineries to buy crude and sell fuel wholesale at the same price.  Is it any wonder 50% of U.S. refineries shut down over a 28-year period?  Or that under such market conditions we haven’t added additional refineries since Gerald Ford was president?

I could leave everything there, but I’ve also noticed some journalists have been searching for an answer I’m trying to scream from the rooftops.  Kevin Drum commented this morning in his Mother Jones blog about Matthew Yglesias’s take concerning Delta Airlines decision to purchase a shuttered ConocoPhillips oil refinery:

Matt paints this acquisition as a failure of the financial industry, which ought to be able to help Delta hedge the cost of jet fuel more efficiently. Maybe so. But I’m just flat confused. If a collapse in demand and tough competition from foreign refiners has crushed profit margins, then what is Delta complaining about? It sounds like it’s a buyer’s market for jet fuel these days. And what on earth makes Delta think that it can run a refinery more efficiently than someone who’s fighting tooth and nail for business in the free market? If they can really do that, it’s not a failure of Wall Street, it’s a failure of capitalism. This whole deal sounds crazy. Maybe ConocoPhillips should have bought Delta instead.

Or it might be a 35-year long market failure concerning the pricing of crude oil.  Refineries shutter, jet fuel prices jump (pardon the pun) skyward, the higher prices must (for some strange reason) reflect back into higher crude prices, and the cycle continues to grind away.  Going back to Bill Saporito’s Time Magazine article,

The problem is profits.  The refiners lost money last year.  Tesoro, a big Western refiner and marketer, dropped $124 million in its fourth quarter.  How is it possible for refiners to run in the red when retail prices are gushing?

I would argue retail prices are so high because of a squeeze on refined fuel supplies as refineries shut down.  Higher retail (actually wholesale) prices reflect back into the price of crude, causing the crude indexes to rise and put further pressure on the refineries’ margins.  But Saporito has his own answers:

It’s all about the 6-3-2-1 crack spread…The 3-2-1 means that out of one barrel you get three barrels of gasoline, perhaps two of diesel and one of a by-product.  The 6 is a cost multiplier: take the price of oil, multiply by 6, then back out the production costs of the 3-2-1.  What’s left is the crack spread.  For most refiners, that spread was negative last year.

Notice something missing?  Shouldn’t the spread take in account what the gasoline and diesel is selling for?  Oh right–that’s already factored into the price of the crude oil.  I am a little amazed at this—refiners have to rely on complicated formulas to account for the ways commodity markets fail to recognize that refining crude oil is not a free process.  I also have to quibble a little with Saporito here—how is it possible to get three barrels of gasoline from one barrel of crude oil?  But overall, I found the piece fascinating, especially here:

Most, but not all {refiners had negative spreads last year}.  Atlantic and Gulf Coast refiners lost out because they use Brent crude, which trades on the world market and recently hit $128 a barrel.  Those in the Midwest can use the West Texas Intermediate (WTI), which was a lot cheaper than Brent for most of last year, when the WTI-Brent price spread reached $28 per barrel.  In fact, WTI was piling up in Cushing, Okla., the major Midwestern oil terminal, because there are no pipelines to the Gulf from Cushing.  So Western refiners were minting money until the Brent spread narrowed.

All right, I’ve had enough.  Pipelines have almost nothing to do with this.  Refineries are basically required to exploit supply shocks on overseas indexes (precipitated here as well—remember 20% of the Eastern refineries tied to Brent shut down) to push up worldwide crude prices, and use a domestic index to turn a profit once in a while.  WTI crude starts piling up—and that doesn’t push the price of crude down?  During a glut?  Who else considers the status quo absolutely insane?

So is there a solution to this generation-long mess?  Can we really reverse this? The problem is pricing refined fuel demand in crude oil prices at all.  Refineries are operating at a loss because of a massive market failure, a pricing scheme which stupidly assumes processing a raw material is costless.  I would suggest creating a refined fuel index, a Brent Refined Index (split off refined fuel demand from Brent Crude Index if you will), for the simple reason that the market could finally acknowledge the difference in value between unrefined crude oil and the fuels we use to power world commerce.  Oil refineries must be permitted to have normal positive margins, just like any other business.

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4 thoughts on “Yelling at the Heavens (on the futility of energy economic reporting)

  1. Pingback: It’s Not All Roses… (Or is it Something Else?) « In The Corner, Mumbling and Drooling

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  4. Pingback: The Coming End to the 40-Year Market Failure | In The Corner, Mumbling and Drooling

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