Current / Economics / History

The Coming End to the 40-Year Market Failure

Today marks a special anniversary of sorts for the economics section of In The Corner, Mumbling and Drooling. 42 years ago today the U.S. dollar and connected currencies in the Bretton Woods system were floated for the first time as one, finally marking the end of the gold standard. Closer to home, Bill Saporito on 19 March 2012 in Time Magazine published the paragraphs that eventually launched this blog:

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.

Well, the Brent-WTI spread has reemerged, but the market reaction has been…different, to say the least:

WTI crude (CLJ15.NYM) prices are taking another leg down, hovering at the $42 a barrel level after the U.S. Energy Information Administration reported that “U.S. crude oil inventories are at the highest level for this time of year in at least the last 80 years.”

EIA reported commercial crude inventories increased by 9.6 million barrels from the previous week. Now at 458.5 million barrels. This follows a huge inventory build of 10.5 million barrels, reported late Tuesday by the American Petroleum Institute. Analysts were expecting just 3.5 million.

WTI is leading the oil price charge southward, and some are speculating $10-a-barrel oil is right around the corner. Who can Americans thank for their unexpected good fortune?

WTI in, Brent VERBOTEN!!

Americans consumers won’t be thanking anyone once gas prices rise into the stratosphere during the spring and summer due to the bottleneck (see below), but oil refiners will thank their lucky stars for the Cushing Marketlink:

NEDERLAND, TEXAS–(Marketwired – Jan. 22, 2014) – TransCanada Corporation (TSX:TRP) (NYSE:TRP) (TransCanada) announced today that at approximately 10:45 a.m. CST on January, 22, 2014, the Gulf Coast Project began delivering crude oil on behalf of our customers to Texas refineries. The completion of this US$2.3 billion crude oil pipeline provides a safe and direct connection between the important oil hub in Cushing, Oklahoma and delivery points on the U.S. Gulf Coast.

The Cushing pipeline (also known as Phase 3a) connects West Texas Intermediate (WTI)-central to Port Arthur, TX:

File:Keystone-pipeline-route.png

Phase 3b will absolutely crater the crude oil market (just for crude; gas will still rise exorbitantly) this summer:

The 77-kilometre (48-mile) Houston Lateral and Terminal is a project under development to transport crude oil to refineries in the Houston, Texas, marketplace. The Houston Lateral and Terminal will become an integrated component of the Keystone Pipeline System.

The facilities will double the U.S. Gulf Coast refining market capacity directly accessible from the Keystone Pipeline System to more than four million barrels per day by providing access to the key refining market in the Houston area.

The Houston Terminal is expected to have initial storage capacity for 700,000 barrels of crude oil. Associated facilities include the necessary receipt, delivery, pipeline, pumping, monitoring, control and ancillary facilities required to increase capacity.

The final route of the Houston Lateral, which involves building a pipeline through the counties of Liberty, Chambers and Harris to Houston’s refining centre, has been selected to minimize impacts to the land, environment and landowners.

Route selection involved balancing different factors such as length; sensitive environmental features (rivers, wetlands, endangered and protected species), construction issues, paralleling existing infrastructure such as roads and other pipelines and considering stakeholder concerns.

Construction activities began in 2013 and commercial operation of the Houston Lateral and Terminal is expected to commence in mid-2015.

The environmental movement targeted the wrong part of Keystone in the effort to combat further global warming. Phase 4 (Keystone XL) will connect two points that are already connected by Phase 1; until 14 months ago Keystone couldn’t supply the refining complex that accounts for 45% of American petroleum refining capacity and 51% of the nation’s natural gas processing plant capacity. The Canadian tar sands are nothing compared to the massive Gulf Coast refinery complex, the world’s largest:

The Gulf Coast complex of chemical plants and refineries is the largest petrochemical complex in the world, home to over 200 chemical plants.

 Three years ago, the Gulf Coast refiners shut down for lack of access to cheap domestic WTI, sending oil and gas prices soaring. With 3a online, the entire U.S. refinery industry is connected to the WTI terminal in Cushing, OK. Once 3b (Cushing to Houston) comes on line, supercharging refinery inputs…

Brent used to rule the Gulf Coast complex, as WTI until this decade tended to trend up to $10 a barrel higher than the international benchmark. That’s right—the U.S. commodity markets gave short shrift to domestic production for decades; having and continuing to favor LOOP and the supertankers it services while ignoring the highly erratic booms and busts in global shipping:

The world’s supertankers are sailing at the fastest speeds in 2 1/2 years as a collapse in crude oil prices spurs demand for cargoes and drives up daily returns owners can make from deliveries.

Very large crude carriers, each about 1,000-feet long and able to transport 2 million barrels of oil, sailed at an average of 12.57 knots this month, according to data from RS Platou Economic Research, an Oslo-based firm. The fleet, whose steel weight is about 27 million metric tons, last moved that fast in August 2012.

Tanker rates have surged amid signals that China accelerated purchases of crude to fill its stockpiles after Brent crude, the global benchmark, collapsed last year. Prices plunged in part because the Organization of Petroleum Exporting Countries pledged to keep pumping oil amid a global oversupply. The ships earned an average of more than $71,000 a day since the start of January, the best start to a year in Baltic Exchange data that begin in mid-2008.

This was exactly a month ago. Shipping was riding high…

The daily average rate to hire a VLCC on the benchmark Middle East-to-East Asia route was $71,772 so far in the first quarter, compared with an average of $47,614 in the fourth quarter, according to Baltic Exchange data.

VesselsValue Ltd., a London-based firm that provides shipping data, also estimates VLCCs are sailing at the fastest since 2012. The acceleration is in part because falling oil prices have cut fuel costs and made it more profitable for owners to transport cargoes, said Kaizad Doctor, analytics director. Ship fuel is known as bunker.

“This can be attributed to the simultaneous decrease in the oil prices and the consequent reduction in bunker prices but also due to the increase in rates caused by the Chinese re-stocking cut-price crude,” Doctor said.

Contrast with two and a half weeks later. Supertanker economics had swung to the other extreme

Supertanker owners are coping with the second-highest fuel costs on record by sailing ships at the slowest speeds in at least three years, reducing vessel supply and bolstering charter rates.

The carriers, each bigger than the Chrysler Building, moved at an average of 10.7 knots last month, about a knot slower than a year ago, according to data compiled by Bloomberg. The drop cuts the fleet’s capacity by 9 percent, according to Pareto Securities AS, an Oslo-based investment bank. Frontline Ltd., A.P. Moeller-Maersk A/S, Overseas Shipholding Group Inc. and Euronav NV, which control 16 percent of all supertankers, told investors in recent weeks they are cutting speeds.

…what a change 18 days had made.

An empty supertanker burns about 90 metric tons of fuel, known as bunkers, a day when traveling at 14 knots, according to Riverlake Shipping SA, a broker in Geneva. Hamilton, Bermuda-based Frontline, the world’s biggest supertanker operator, can cut that to about 25 tons when sailing at 10 knots on the empty leg of a journey, said Jens Martin Jensen, chief executive officer of the company’s management unit in Singapore. That means saving about $42,000 a day at the global average price.

“If I was a ship owner, I would be bending over backwards to operate at the slowest speed I could get away with,” said Martin Stopford, the London-based managing director of Clarkson’s research unit. “With today’s bunker prices, slowing down is going to be very high on their agenda.”

Pipelines often are the cheapest transport option and are invariably a more stable financial bet; especially when the distance to Port Arthur is 487 miles overland from Cushing versus 2,000 miles from Puerto Miranda, Venezuela or 7,500 miles from Yanbu, Saudi Arabia (those distances to major oil ports in the Middle East and South America being as the airplane flies no less). With Keystone Phase 3a/b, the insanity of the decades-long oil market failure is slowly coming to an end, thanks to KSA no less.

The International Rise of the Refineries

I have heard numerous conspiracy theories about dropping oil prices, usually revolving around an assertion that Saudi Arabia is first aiming to drive Montanan and North Dakotan oil producers out of business before forcing OPEC to raise prices when American production is decimated. In reality, the Kingdom of Saudi Arabia (abbreviated KSA) has completely shifted their business focus and strategy:

Saudi Arabia plans to become the world’s biggest exporter of refined oil products, after the US, by 2017. According to Oil Minister Ali al-Naimi, the plan forms parts of the Kingdom’s strategy to diversify its economy and increase its share of the global crude and petroleum products markets. Currently, Saudi Arabia is the world’s top exporter of petroleum liquids, but much of that is refined elsewhere.

Nothing a powerful petro-state cannot fix:

State-owned Saudi Aramco has also invested in refinery capacity in key markets of Asia, with a stake in Fujian Refining and Petrochemical Company in China, and a two-third stake in S-Oil Corp., South Korea’s third-largest refiner. Aramco is also looking to set up a refinery in Vietnam for USD 22 billion.

“This not only gives Saudi Arabia a captive market for its crude but also helps to channel regional refined product exports to markets where Saudi crude is finding it hard to gain market share,” Barclays analyst said.

No, KSA is not limiting themselves to Chinese and Korean investments:

“By building local refineries and increasing stakes in refineries globally (South Korea, China, US), Saudi Arabia has a growing captive market for its crude. It is uniquely positioned relative to other oil producers in a highly competitive market.”

Saudi Arabia is an equal partner with Royal Dutch Shell in Motiva refinery, the United States’ largest refinery. The investment has helped Riyadh maintain its market share – in percentage terms – in the United States, even as other OPEC producers such as Algeria and Nigeria have seen their market share drop on the U.S. Gulf Coast.

The International Energy Agency predicts the Middle East will establish itself as a major downstream player, with Saudi Arabia leading the way.

KSA also has a plan to directly recapture its traditional energy market dominance and put the whole planet in a stranglehold:

“Saudi Arabia is on track to join the club of major oil-product exporters following the completion of two grassroots refineries within the kingdom and the start of a new product trading company, Saudi Aramco Product Trading Company, in 2012,” the IEA said in its latest medium-term outlook report.

SAUDI’S MEGA-REFINERIES

Over the next five years, the Middle East will add more refinery capacity than any other region in the world, with nearly 1.7 million barrels per day (bpd) of new capacity. It will also add 1.2 million bpd of desulphurization capacity additions and 712,000 bpd of upgrading capacity, the IEA forecasts.

Rising Middle East product exports will have an even greater impact on global oil product markets than the transformation of the U.S. downstream sector in years to come, with outflows coming from two new mega-refineries: Saudi Arabia’s 400,000 bpd Satorp plant in Jubail and the Yasref facility in Yanbu on the Red Sea, also 400,000 bpd.

Saudi product exports got a first boost in December 2013, when the Satorp refinery started exporting products. Net exports surged to an average 370,000 bpd in the first 11 months of 2014 from 85,000 bpd in the corresponding period a year earlier. Since then, the Yasref plant shipped its first fuel cargoes in January.

Note: refined fuels, unlike crude, are highly volatile. Shipping gasoline and kerosene (diesel, jet fuel, etc.) over long distances carries far greater risks than just the specter of another Exxon Valdez.

Last year, the country’s refined product exports rose by 262,000 bpd – up 43% compared to the previous year, while production from refineries hit a record 2 million bpd.

Other petro-states are taking notice. Oman and Nigeria are increasing refining capacity; countries on the opposite end of the spectrum are also acting. Europe and the United States, however, are mired in a market failure they cannot understand:

U.S. crude snapped a six-day losing streak Wednesday, after the Federal Reserve’s cautious stance on interest rates sent the U.S. dollar lower and sparked a late-day rally for oil and stocks.

The gain reversed midday trading that sent U.S. crude to a six-year low after the government reported that crude oil inventories rose to another modern-day high.

U.S. benchmark West Texas Intermediate crude gained $1.20 to $44.66 per barrel on the New York Mercantile Exchange. London-traded international Brent crude gained $2.40 to $55.91.

The headline tells all you need to know—‘Fed move sends oil futures higher despite supply increase.’ The cluelessness of financial “experts” is amusing to behold:

Because crude is priced in dollars, a weaker dollar makes oil more attractive to buyers. The lower dollar also can boost energy consumption by encouraging growth in the U.S. economy, said Rob Haworth, senior investment strategist at U.S. Bank Wealth Management.

“The market is really interpreting this last statement as meaning they’re going to keep rates lower for longer,” Haworth said, “It’s a big deal for oil because it’s a measure of how much demand you’re going to get in the U.S.”

The market isn’t interpreting anything, you fools. American business interests want to see the Fed keep monetary policy loose (as it should). Janet Yellen steers a sound course, and Wall Street blowhards rejoice by investing in oil futures that are almost certainly going to crash as the crude glut gets larger and larger. Brilliant.

Before a non-existent commentator asks, what if KSA is betting on the wrong horse? Trust me, betting on refineries is the smartest move anyone can make.

Bottleneck

If logic prevailed in the energy business, there would be no international market for crude oil—only extremely local markets at each individual oil refinery complex. Crude is worth precisely 0 in whatever currency one prefers until impurities, chief amongst them sulfur, are removed in the refining process. To be fair, the impurities are also very valuable:

In the simplest and crudest of terms, bunker fuel is the gunk that is leftover after refineries have processed all the more valuable fuels from the crude source. It is thick and heavy and must be heated before it can be used in an engine. It is difficult to store and transport. And it is ideal for large marine going vessels that have the heavy engines and fuel capacity to handle bunker fuel.

Not even maritime engines burn crude oil, including the supertankers that transport oil in its rawest form. Ships could conceivably burn crude in their engines if they run out of bunker oil, but combustion releases highly explosive waste gases (which is why bunker fuel is used in the first place). The international market is in reality for refined petroleum products only. Yet somehow, gas prices break down into this nifty little graphic:

Gas vectors: © VoodooDot/Shutterstock.com

Refining looks roughly co-equal, until one notices crude oil is 5700% more important. How about the EIA’s most current numbers?

What We Pay For In A Gallon Of Regular Gasoline (January 2015) Retail Price: $2.12/gallonWhat We Pay For In A Gallon Of Diesel (January 2015) Retail Price: $3.00/gallon

This is far more telling–refining costs calculate to 12.7 cents a gallon for regular versus 39 cents per gallon for diesel in January (the EIA doesn’t have more current data broken down yet as their spreadsheets have a 2-3 month lag). Diesel is far less refined than 87 octane, yet refinery costs are three times as high? Oh wait, using December numbers refining diesel was 16.7 times more expensive than gasoline. Who came up with this demented system?

As many may know, the oil refining business is mostly a low-margin operation, despite the all-familiar headline news on higher gasoline prices at times, supposedly something favorable to refiners. Refining profitability can be roughly measured by something called crack spread, a margin that refiners can add on top of their crude costs. Current crack spread for gasoline is under $19 a barrel when compared to West Texas Intermediate. Since one barrel equals 42 gallons, a crack spread of $19 translates to about 45 cents per gallon of gasoline in potential refining profits. Actual earnings, however, will be less after deducting all refining costs.

Rising crude prices benefit oil producers but often cost refiners more for the same gallons of gasoline produced. The extra cost may or may not be fully absorbed by changes in the price of gasoline, potentially further lowering refining margins. Assuming $100 a barrel for crude, it would be $2.38 in base crude cost for a gallon of gasoline. After adding all refining costs including expenses on transporting crude and other logistics, plus allowing certain pricing room for retail markup, there seems to be little margin of profits left for refiners.

No, the refining business is a no-margin operation. Refiners purchase crude (priced in Brent, Dubai, Western Canadian Select, WTI, or another of the multitudes of the crude indexes), remove impurities, and sell refined fuels…at the exact same crude oil prices. The crack spread is a contrived method that was invented (poorly) to calculate refining costs because oil refineries, according to commodity market mathematics, add no value to their product.

Crude oil has no business setting gasoline prices—refined oil, the product of oil refineries, is the proper benchmark. The commodities markets are close to recognizing this rather massive oversight:

U.S. benchmark West Texas crude sank to $42.85 early Monday before settling off 2.1% to $43.88 on the New York Mercantile Exchange, a six-year low. Brent crude, the international benchmark, eased 2.3% to $53.44 in the wake of a burgeoning global supply glut and prospects of even more oil coming to market with a possible nuclear accord with Iran paving the way for higher Iranian exports.

The renewed slide in crude pushed U.S. wholesale gasoline prices for mid-April delivery down 2% to $1.72 a gallon. Currently, retail prices, down nine straight days, average $2.42 a gallon, up from $2.25 a month ago, after falling to $2.02 in late January.

WTI slid from $69 a barrel on 1 December 2014 to less than $45 currently, yet gasoline rose precipitously since New Year’s 2015. Anyone hazard a guess why?

HOUSTON, Feb 21 (Reuters) – The U.S. refinery strike widened on its 20th day, with workers at the nation’s largest refinery walking off jobs and joining picket lines on Saturday as the United Steelworkers union (USW) pushes for a new contract that improves wages and safety.

Strikes are underway or have been called at 15 plants, including 12 refineries with a fifth of U.S. crude processing capacity. The stoppages, which have forced companies to rely on trained temporary workers to keep plants running close to normal, are the largest in the refining sector since 1980.

Lousy refinery workers, wanting more money…wait, what the…

“The industry’s refusal to meaningfully address safety issues through good faith bargaining gave us no other option but to expand our work stoppage,” USW International President Leo Gerard said in a statement.

Oil workers perishing on the job is a clear and present danger.

As of Saturday, no new talks had been scheduled between the two sides.

Motiva was targeted for the strikes because it is a 50-50 joint venture of Royal Dutch Shell Plc and Saudi Aramco.

Sorry, KSA. If a filthy-rich foreign corporation wholly owned by even more filthy-rich foreign country owned by an even more filthy-rich royal family buys an American oil refinery, you collectively become the target of the long-suffering, abused oil workers regardless that they work in a business “paradise” like Louisiana and Texas. But the arrogance seeping up from the domestic oil industry is telling:

Gasoline prices can spike for all kinds of reasons that make skeptical drivers roll their eyes: “tension” in the Middle East, a refinery suddenly shuts down for maintenance, or the annual springtime switch to summer blends of gasoline.

A refinery strike, however, would seem understandable. Yet three weeks into a walkout at 11 refineries around the country, the impact on the prices of gasoline, diesel and other fuels is barely discernable.

Gasoline prices have gone up this month, but mostly due to a sharp increase in the price of oil and because gas prices almost always rise at this time of year, according to Tom Kloza, chief oil analyst at the Oil Price Information Service

Gas prices have climbed markedly since Jonathan Fahey wrote that a month ago. It could be coincidence, but I’ll wager it might have something to do with the fact that refinery capacity utilization stood at 94.2% at the end of December 2014.

Lose 159

Since the EIA began tracking refinery data in 33 years ago, total refinery capacity declined during the 1980s oil glut before crossing the 1982 baseline…in 2014. Stunningly, the number of refineries in the United States has decreased from 301 in 1982 to 142 in 2014.

Before another non-existent commentator pipes up, EPA regulations had nothing to do with the closure of these 159 oil refineries (the U.S. hasn’t commissioned a new refinery since 1976). Brent and WTI killed the industry. In the time-frame of 1 June-1 September 1998, WTI only rose above $15 in the first week of the period. Brent refused to cross $14. In August 1999, both benchmark indexes had crossed the $20 threshold in the inflationary run-up prior to the 2000-01 crash.

The significance of these two summers? American refineries operated at 99.1%, 99.2%, and 99.9% capacity in June-August 1998, and 95.5% in August 1999. Again, crude oil has but a single customer—oil refineries. With no reserve capacity available at all in 1998, refiners nevertheless had no impact on the price of American or European crude oil. The refining industry took note. American refineries have not operated at more than 95% capacity since June 2005 despite oil (Brent and WTI) reaching more than $140-a-barrel during the summer of 2008. American oil refineries for decades has been gobbled up, chewed up and spit back out by the commodities markets. It’s time to stop letting this happen, before KSA buys up the entire refining industry and the world has a repeat of the Chinese rare earth metals fiasco.

Split the Indexes

Oil is practically the lifeblood of the world economy, and markets have mispriced it for at least 40 years. There is a very simple solution to this problem—first split Brent into Brent Crude & Brent Refined, WTI into WTI Crude & WTI Refined, and when time permits (splitting the first two should take but a keystroke, but we’ve waited for decades so you never can tell) continue with the process and split the rest of the crude indexes.

Oil demand is for refined fuels, so the pertinent index for spot prices and futures would be the new refined index of each former benchmark–the new benchmarks would become Brent Refined, WTI Refined, or something to that nature. Crude does have a role to play, though it would depend whether the resurgent refining industry would impose the poverty margins on crude extractors that refiners suffered underneath for decades.

In the past, the suggestion to split the indexes was merely a request. Today, it is inevitable. Unless North America and Europe desire to be bled dry by petro/refining states led by the Kingdom of Saudi Arabia, commodities traders would be advised to create the refined indexes posthaste.

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2 thoughts on “The Coming End to the 40-Year Market Failure

  1. Pingback: Onset of the Stagflation | In The Corner, Mumbling and Drooling

  2. Pingback: Stagflation, 1973-1981 | In The Corner, Mumbling and Drooling

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