Oil and the Law of One Price

Crude oil and petroleum products are among commodities like gold that follow the law of one price (LOP). With a few exceptions, the prices of these commodities vary little across geographically dispersed markets. While Russia’s actions after the G7 imposed a price cap on its crude and product exports temporarily broke the LOP for oil, markets are moving back towards equilibrium. Those who currently describe the physical oil market as tight, and infer that prices should rise, ignore the economic reality that, in commodity markets with very low price elasticities, the short-run market equilibrium swings over a wide range. Although many who follow oil believe balance can only occur with triple-digit crude, prices could fall below $40 per barrel if Russia keeps discounting its production.

In a 1996 article on the purchasing power of parity that defined the LOP, economist Kenneth Rogoff said that “simply put, LOP states that once prices [for any good] are converted to a common currency, the same good should sell for the same price in different countries."

Rogoff also noted that “the law of one price holds mainly in the breach” as transportation costs, nontariff barriers, and tariffs drive a “wedge” between prices in different countries. The wedge size depends on how much of the good is traded.

Using the “Big Mac” index first introduced by The Economist, Rogoff shows that relative prices varied across countries in 1975. That variation continues in 2023 with some exceptions. As Rogoff observed in 1996, “For some highly traded commodities, the law of one price does hold very well.” He cited gold as an example.

The LOP and Oil

Oil is also a “highly traded commodity.” Consequently, arbitrage generally forces oil prices to converge between crudes, between products and crude and between products in different markets.

The G7 cap on oil prices broke the arbitrage. Now, the market is restoring it. India and China have access to low-priced crude and are exporting products produced from it to the US and Europe. Meanwhile, Russia’s discounted diesel is displacing US exports to Brazil.

The Finland-based Centre for Research on Energy and Clean Air (CREA) has frequently reported that the European countries boycotting Russian crude oil and petroleum products are importing products refined from Russian crude by India, China, the United Arab Emirates (UAE), Singapore, and Turkey.

In recent months, those countries that have ignored the EU ban on importing Russian products have purchased products from Russian refineries at prices significantly lower than in world markets. Brazil has been a primary beneficiary, as noted in Petroleum Intelligence Weekly on Apr. 27. Discounts of 30¢ per gallon or $12.60/bbl before transportation costs have been quoted.

Refiners in the US have had to respond. In fact, over the last 60 days, the distillate price quoted for delivery on the US Gulf Coast has declined by 30¢/gallon. The prices are clearly moving together.

However, the reported prices may not include the discount received by some Brazilian buyers. Argus reported on May 23 that Russian diesel accounted for 56% of Brazil’s April imports, imports from the US accounted for 21% and imports from the UAE accounted for 12%.

The US market has corrected for the Russian discounting. The price of US diesel on the Gulf Coast on Apr. 11 was $2.63/gallon. By May 4, it had declined to $2.17, a drop of $0.46 or almost $20/bbl.

The decline in product prices carried over to crude prices. For the same period, dated Brent prices fell by $13/bbl, and Urals crude delivered to Europe decreased by $11. The crude price decrease indicates that the product arbitrage is pulling crude down as well.

The diesel price declines have spread across the world. Low-sulfur diesel prices in Europe, New York and Singapore to the Gulf Coast are moving together. In short, the LOP seems to apply to low-sulfur diesel as the arbitrage between markets keeps prices aligned.

Follow the Numbers

Crude prices tend to move with product prices. As I have noted repeatedly, the actual price of crude generally moves in tandem with the price predicted from product prices. In the chart below, I compare dated Brent prices to the crude price from a netback model, which I have followed for 40 years. The model predicts the crude price by starting with the actual 1997 Brent price and then adjusting the price based on daily changes in New York gasoline and low-sulfur diesel prices from 1997 to the present.

I adjust the projection for the US renewable fuel obligation on the assumption that, at the margin, refiners will deduct the obligation’s cost from the expected value of their products because it represents a fee or tax they must pay for selling their last barrels of output to US buyers. In essence, I am taking marginal economics to its logical limits.

The data above is based on US Gulf Coast product prices. I assume that Gulf Coast refiners will purchase incremental crude barrels if they see positive margins in the Gulf market. The assumption seems to hold. Through April, the predicted crude price has exceeded the actual Brent spot price by between $2 and $4/bbl.

Of course, Brent is not processed on the US Gulf Coast. Instead, US refiners refine heavy crudes from Canada and West Texas Intermediate (WTI). The spot WTI price on the US Gulf charged to refiners is less than the dated Brent price. On May 5, the difference was $3.40/bbl.

The Bottom Line

In my view, US Gulf refiners will likely cut runs further if product prices continue to fall. This implies that the decline in diesel prices tied to increased Russian exports and the exports from India and the UAE to Europe that have depressed diesel prices will also depress crude prices.

Oil-exporting countries will be the biggest losers from the expansion in refining capacity if Russia continues to dump diesel into the global market at prices lower than those prevailing in key markets at the time of dumping. Spot diesel prices will continue to fall, for example, should Russia keep offering diesel to Brazilian consumers at a 30¢/gallon ($12.50/bbl) discount to US Gulf Coast prices. The decline in spot diesel prices will be reflected in falling crude prices.

The LOP is holding and will continue to hold for oil.

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.