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Opinion

Crude Oil Price Suppression

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Large US oil refiners have recently reported record profits. In their earnings calls, these companies touted the return of petroleum product demand, emphasized the improved efficiencies of their faculties and discussed the expansion of their renewable fuels capacities. But none mentioned crude oil price suppression. Yet over the last 12 months the refining sector has effected a transfer of almost $690 billion from crude producers to refiners. In rough term this represents a transfer of $20 per barrel from producers to refiners. This will likely continue in 2023, with refiner gains having recently increased to almost $30/bbl. Oil-exporting countries and producing companies have all suffered.

Refiners have succeeded in capturing a significant share of the revenue that historically would have gone to crude producers through several very sophisticated strategies. First, refiners have aggressively limited the level of product stocks. Second, some refiners have benefited from the US renewable fuels program while others have not. The refiners that are not benefiting have become the marginal buyers of crude oil. Third, the release of strategic stocks by oil-consuming countries provided refiners with a windfall at a cost to oil producers. Fourth, expansion of coking and other upgrading facilities combined with low natural gas prices offer additional ways to depress crude prices. Finally, refiners refused to bid up crude prices when the cap on Russian crude prices was imposed because they were assured that governments would step in and release more oil from strategic stocks.

Data Divergence

I measure the suppression using a little econometric model introduced years ago. The model simulates the price of dated Brent based on the changes in the cash price of diesel (or low-sulfur heating oil) and gasoline in New York Harbor. Simulations are done each day. The unique feature of the model is that no correction for forecasting errors has been made since December 1997. Thus the simulated value for yesterday is based only on the change in product prices over more than 6,000 days. Despite any correction for errors the model has done a good job of simulating the ups and downs of dated Brent until Russia invaded Ukraine.

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The graph above shows the actual and simulated average Brent price from January 2000 to January 2023. One can observe that the model’s breakdown occurred with Russia’s invasion of Ukraine. Initially, the release of strategic stocks drove a wedge between the actual and simulated price. I've written before on the impact of strategic sale. However, actual and simulated prices have continued to diverge. With the passage of time it has become clear that refiners, particularly the large US firms, have taken steps to suppress crude prices.

Inventory Management

Minimization of product inventories clearly is key to the refiners success. Most readers understand that backwardation in product prices increases with stock declines. Refiners have discovered that they can boost product margins (which can mean suppressing crude prices) by limiting stock increases either by producing fewer barrels of products or increasing volumes of products exported. The gaming of oil exports has been documented by Federal Trade Commission economists. US refiners perfected their game in 2022.

Expansion of renewable fuels production, particularly renewable diesel, adds to the ability of US refiners to control crude prices. The credits earned by selling them as well as tax incentives, cut demand for crude and put pressure on those refiners and importers who must buy the Environmental Protection Agency mandated credits. This tends to depress demand for crude at the margin.

The release of strategic stocks by consuming governments further shifts market power from crude producers to refiners. The “fear premium” that measures the amount refiners would pay for prompt crude above usual amounts rose to almost $20/bbl immediately following Russia’s invasion of Ukraine and talk of an embargo. Today there is no fear premium. Refiners understand that governments will step in and provide crude in a disruption. This confidence explains the absence of any impact from the imposition of a cap on Russian crude exports.

Lastly, low natural gas prices have enabled US refiners to import heavy crude, which they upgrade to low-sulfur diesel instead of processing light US grades. Marathon’s CEO noted, for example, that the company’s upgrading product allows it to use more heavily discounted Canadian heavy crude in its January earnings call. This strategy, followed by other companies as well, forces incremental US crude to be exported, raising transportation costs and driving down the price of West Texas Intermediate. More suppression.

Suppression of crude oil prices may increase as refiners in India and China buy increased volumes of discounted Russian crude. Products manufactured from the discounted crude are now being exported to the US by India. US refiners must worry that Indian refiners will play the game as well or better than they do. Their solution will be to pay less for the crude they buy.

Historical Roots

Refiner success can be traced to the decision to divest refining assets taken by multinational oil companies over the last three decades. Over half the global supply of products was processed by integrated companies 50 years ago at the time of the first oil crisis. In the integrated structures, refiners were required to work with the crude-producing divisions. Today, almost no oil moves in integrated systems. Refiners are really competitors of crude producers. As these firms have grown they have learned to use their market power.

This is not a new story. More than 50 years ago another capital-intensive industry aggressively opposed the entry of competition. A monopoly, AT&T complained bitterly as competitors were allowed to enter the phone business. Many of the competitors were small. However, over time they destroyed all the remnants of the once-mighty telephone system. Few noticed.

Philip Verleger is an economist who has written about energy markets for over 40 years. A graduate of MIT, he has served two presidents, taught at Yale and helped develop energy commodity markets since 1980. Kim Pederson is editorial director of PKVerleger LLC. The views expressed in this article are those of the author.

Topics:
Refining, Oil Products, Crude Oil, Oil Prices, Oil Inventories
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