Rising Crude Oil Prices: The Link to Environmental Regulations

By Verleger, Philip K., Jr. | Business Economics, October 2011 | Go to article overview

Rising Crude Oil Prices: The Link to Environmental Regulations


Verleger, Philip K., Jr., Business Economics


Crude oil is not a homogenous commodity. Light sweet crude oils produce a high percentage of products desired by consumers after distillation. Other crude oils (heavy, sour, or high-sulfur crude) must be heavily processed to obtain needed products. The failure to understand the differences between desirable light crudes and heavy sour crude oils can lead to bad forecasts of market behavior. Using a stylized model of the market, I show that tightening environmental regulations in the absence of adequate refining capacity to process heavy sour crude puts upward pressure on crude prices and explains the 2008 price increase. The upward pressure is exacerbated by the monopolist practices of heavy sour crude producers, who set price differentials to maximize income. This model also can be used to analyze the impact of the supplies lost from Libya in 2011.

Business Economics (2011) 46, 239-248.

Keywords: crude oil, environmental regulation, oil prices, model, refining capacity

Crude oil prices are rising again. Brent, the one crude oil today freely traded in global markets, rose from $75.67 to $116.11 per barrel between September 30, 2010, and August 31, 2011. The increasing crude prices have again led to calls for limiting the market activity of passive investors and speculators in crude oil markets. However, as I demonstrate here, the price change can be fully explained by new, tighter environmental regulations combined with certain members of the Organization of Petroleum Exporting Countries (OPEC) refusing to allow high-sulfur crudes to trade at very large discounts to Brent. The latter action has retarded needed expansion in refining infrastructure.

Tne enect 01 environmental regulations on crude oil prices can be illustrated with a simple stylized model. This model incorporates the product market's competitive nature, the link between crude product prices and crude prices, and the world crude market's bifurcated structure. In it, I postulate a very simple world where two products exist--one "clean" and one "dirty"--and two crude oils--"light sweet" and "heavy sour." In this model, I see environmental regulations shifting demand from "dirty" to "clean" products. I also see the petroleum product market as competitive and crude prices being set by refiner bidding, which in turn is based on product prices. The model assumes that light sweet crude supply is fixed and that heavy sour crude producers adjust output to maintain a stable differential to light sweet crude.

In this model, I view the imposition of regulations that prompt consumers to buy less "dirty" product and more "clean" product as causing light sweet crude prices to rise in absolute value absent a crude supply increase. In other words, if producers do nothing, changes in environmental standards raise the price differential between light sweet and heavy sour crude. All crude prices rise if heavy crude oil producers reduce production to maintain a constant differential between light sweet crude and heavy sour crude prices. In some circumstances, the latter action can have as large an impact on outright prices as regulations.

The price increases brought on by producers seeking to sustain income levels can be offset. though, if world refiners build more capacity to convert heavier crude oils to clean products. This suggests that world consumers and the world economy would be better off if environmental regulators and refinery owners acted in concert. The incentive to invest in refining capacity to convert heavy sour crude into clean products is reduced or negated, however, when heavy crude producers cut output to maintain a fixed differential.

I his description or the world oil market comports with the behavior of various players in oil for the last decade. However, I make no attempt here to find an optimal price level or suggest that any major party is acting to optimize long-term income. Others have developed such models.

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