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. My view is that such attempts are futile absent an understanding of the linkage between environmental regulations, the mix of global crude production, and the state of world refining capacity.
1. The Model
The simple, stylized model is characterized by two simple components that describe product demand and crude oil qualities. I postulate simple log-linear product demand curves for clean and dirty products:
[D.sub.C] = [A.sub.C][P.sub.C.sup.b1]
[D.sub.D] = [A.sub.D][P.sub.D.sup.b2](1)
where demand is characterized by the letter D price by the letter P, and the subscripts "C" and "D" denote clean and dirty. Price elasticities are represented by "b" with the subscript "1" referring to clean product price elasticity and "2" referring to the dirty product price elasticity.
The model also postulates two crude oils, denoted as L for light sweet crude and H for heavy sour crude oil. I assume that each crude produces a percentage of clean product C and dirty product D. The percentage of clean product produced by light sweet crude is denoted by aL and the percentage of clean product produced by heavy sour crude by aH.
The percentage of dirty product produced is given by (1-[a.sub.L]) and (1-[a.sub.H]).
The model is based on the following assumptions:
* [a.sub.L] > [a.sub.H]
* The supply of each type of crude is fixed at any moment in time, and the supply of light sweet crude is determined in a competitive market for a sufficiently long period. This comports with the actual market's observed behavior, where the time required to boost production is seen as long and where the prevailing price is well above the level where producers would curtail output.
* Producers set the heavy sour crude supply one month ahead by establishing a fixed differential to the light sweet crude price. This differential is adjusted over time to maintain the desired output level. This assumption is discussed further below.
* Product prices are determined in a competitive market. This assumption comports with the Federal Trade Commission's findings in various merger investigations, which have found that refining is generally competitive. It also comports with observed industry behavior, where integrated companies-having seen the profits previously earned through their control over crude supply vanish-chose to exit refining in many world regions.
* Buyers for competitive refiners bid for a crude based on the values they can obtain for the products produced from the crude. The product prices arc derived by solving equation (1) for price under the assumption that crude supply is fixed and known in advance for any period.
Letting [S.sub.LS]and [S.sub.HS] represent the supply of light sweet and heavy sour crude, the supply and demand of clean and dirty products are given by
[D.sub.C] = [a.sub.L][S.sub.LS] + [a.sub.H][S.sub.HS]
[D.sub.D] = (l-[a.sub.L])[S.sub.LS] + (1-[a.sub.H])[S.sub.HS] (2)
Equations (1) and (2) provide a complete description of the market under the assumption that product prices are set competitively, supply is fixed for the period, no part of crude or product production is removed from the market to be stored n stocks, and no crude or product is withdrawn Tom stocks. These equations also provide a neans of characterizing the market response to changes in environmental regulations, changes in producer actions, and changes in refining char icteristics.
The product prices predicted from the model ire used to establish crude prices. Given the assumption that refining markets are competitive, the Slice paid for light sweet crude, PLs, is given by
[P.sub.LS] = [a.sub.L][P.sub.C] + (1-[a.sub.L])[P.sub.D] (3)
while the price paid for heavy sour crude, PHS, is given by
[P.sub.HS] = [a.sub.H][P.sub.C] + (1 -[a.sub.H])[P.sub.D] (4)
Here we assume that the sweet crude oil market is competitive while the heavy sour market is dominated by OPEC, a group that attempts to operate as a cartel. Like any cartel, OPEC might limit production or engage in more sophisticated management approaches. Below, I explain that OPEC does the latter. Below, I also defend the assumption that the light sweet crude market is competitive or almost competitive.
This description of the crude market is at variance with many studies. Smith, for example, has published several articles on how OPEC countries seek to maximize their income. More recently, Fattouh  and his colleagues at the Oxford Institute of Energy wrote a long (and, in my view, irrelevant) article on oil pricing that by definition assumes oil price determination starts at the crudemarket and works down to products. (1) Neither Smith nor Fattouh nor other academics writing on the subject ever seem to contemplate the economic process by which oil is bought or sold. The one exception may be my own work [Verleger1982].
As noted above, the assumption here is that refining is a highly competitive business in most regions, an assumption affirmed by various FTC studies and by the actions of the multinational companies that have sold or closed refineries in many regions. (Table 1 presents a partial list of refinery sales and closures by large multinationals over the last decade.) For refineries to survive today, their traders must refrain from bidding more for crude oil than they can get from the products they sell in the competitive product market. The aggregate bids of all traders in the competitive refining business establish the prices paid and reported for crude oils.
Table 1. Refineries Sold and Closed in KEYOECD Countries by Major Integrated Oil Companies Country Company Location apacity (housand Barrels per Day) Refineries Closed Australia ExxonMobil Adelaide 80 Australia Shell Clyde 85 Canada Shell Montreal 130 France Total Grandpuits 95 France Total Flanders 155 United Shell Haven 92 Kingdom 637 Total Refineries Sold Australia Shell Geelong 110 France Shell Berg Letang 82 France BP Lavera 210 France Shell Petit Couronne 141 Germany Shell Harburg 102 Germany Exxon Ingolstadt 105 United BP Grangemouth 212 Kingdom United Shell Stanlow 260 Kingdom United ExxonMobil Coryton 180 Kingdom U.S Shell Wood River 275 U.S BP Yorktown (VA) 62 U.S BP Belle 255 Chasse (LA) U.S Shell Bakersfield (CA) 61 U.S Chevron El Paso (TX) 92 U.S Motiva Delaware City 157 (DE) U.S Motiva Norco (LA) 225 U.S. Shell Los Angeles (CA) 91 Total 2,620 Source: Petroguide (2000 issue); PKVerleger LLC.
Oil-exporting countries influence oil prices by adjusting volumes of the various crude oil types put on the market. For more than 20 years, they have accomplished this by setting price differentials for their crudes against market-specific benchmark crudes. For example, Saudi Aramco, the marketing arm for Saudi Arabia, will announce the differential to be paid by buyers of each type of Saudi crude delivered to a specific market. The differential can be represented abstractly as
Diff= [P.sub.LS]-[P.sub.HS] (5)
Refiners, operating in a competitive market, indicate the amount of oil they wish to purchase each month from Saudi Arabia and other oilexporting countries after the differentials are made public. Producing countries then tailor their output to meet the resulting nominations.
On April 5, 2011, for example, Saudi Aramco informed European buyers they would pay $9.75 per barrel less than Brent "B-Wave" (the volume eighted average price of Brent futures traded on the Intercontinental Exchange or ICE) for 45 to 54 days after a heavy crude cargo purchased from the Saudis was loaded on ship. Brent is a light sweet crude traded in a competitive market. In this instance, traders at refineries would use the expected prices of products to predict the anticipated price of light sweet crude and, using a variant of equations (4) and (5), calculate the value they expected for the differential between light sweet crude and Arab Heavy. They would then base their nominations for the amount of heavy sour crude on this assessment.
The hypothesis seems to be confirmed when OPEC output levels are compared with price spreads announced by Saudi Arabia. Figure 1 shows the price spreads announced for Arab Heavy sold to Western European buyers from 2002 through 2011. These discounts have ranged from $1.88 to $13.80 per barrel.
Figure 2 presents the discount as a percentage of the outright price. Figure 2 reveals that, over the last year, the Arab Heavy discount has ranged between 5 and 7 percent, suggesting a Saudi policy to hold a specific line regarding price. Looking back, one can observe that Saudi Arabia aggressively raised the discount in 2008 in an attempt to cool the market and support the global economy after the Lehman Brothers bankruptcy. They boosted discounts first to 10 percent and then 22 percent in December 2008.
2. Initial Conditions
The model presented here is a "stylized" version of the oil market. To avoid any misunderstanding, the term "stylized" means "to conform or represent according to the rules of style [i.e., normalize] rather than according to nature" [Webster 1968J. The alternative to this approach would be building a descriptive model that attempts to capture all of the world oil market's details and nuances. The Energy Information Agency, the International Energy Agency, and many consultants produce such descriptive models.
In my stylized model, I describe the market for two types of products and two types of crudes. I set initial conditions that roughly characterize the state of the world as of August 2007. In particular, the model is calibrated to the following assumptions:
* Global demand for petroleum products is 86 million barrels per day.
* The mix of global supply is initially 44 million barrels per day of light sweet crude oil and 41 million barrels per day of heavy sour crude oil. This assumption may be extreme. In May 2008, we categorized 71 million days of global pro-duction by sulfur content. (2) Based on that analysis, our assumption of 44 million barrels per day of light sweet crude would cover crudes with sulfur content up to roughly 1.5 percent. Figure 3 shows our calculation of crude production by sulfur content at the time.
* Refinery yields in the model are fixed at 80 percent light products and 20 percent heavy for sweet crude and 50 percent light products and 50 percent heavy products for sour crude.
* Price elasticities of demand for heavy and light products are assumed to be a negative 0.05. This estimate is in line with those published elsewhere [International Monetary Fund 2011, p. 97].
* The model was benchmarked to product prices prevailing in Europe in August 2007. These prices were $91 per barrel for low-sulfur distillate and $55 per barrel for heavy fuel oil, according to Argus Global Media .
Under these base assumptions, the crude prices predicted by the model were $82 per barrel for sweet crude and $70 per barrel for heavy sour crude. These estimates were close to the prices reported for Nigerian crude at the time ($80 per barrel) and Middle East sour crude ($69 per barrel), according to Petroleum Intelligence Weekly .
3. Simulating the Impact of the 2008 Events
Between August 2007 and June 2008, light sweet crude oil prices rose from $70 to $147 per barrel. Observers writing at the time attributed the increase to a surge in demand. Hamilton provided a slightly more persuasive explanation, noting that global supply stagnated from 2005 to 2007 while demand from China rose. Hamilton [2009, p. 229] stated:
With global oil production flat, China's increased consumption meant that consumption in other regions had to decline. U.S. consumption in 2007 was 122,000 barrels a day below its level in 2005; mean while Europe's daily consumption dropped by 346,000 barrels and Japan's by 318,000 barrels. What persuaded residents of these countries to reduce oil consumption in the face of rising incomes? The answer is a rising price of oil.
This explanation has appealed to macroeconomists. However, it ignores three other essential events. These are first, the introduction of ultra-low-sulfur diesel (ULSD) fuel in Europe in 2008; second, the decline in Nigerian sweet crude production; and third, the fall in the dollar's exchange rate against the euro. My stylized model captures the first two of these effects.
Start with the decrease in sweet crude oil pro-duction. Nigeria experienced a low-level civil war that disrupted crude production through the period. Figure 4 shows that output declined from 2.2 million barrels per day to 1.8 during this time. At the same time, the U.S. government started taking oil from the market for storage in its strategic petroleum reserve. This action may have removed as much as 100 thousand barrels per day of sweet crude.
Hamilton dismissed the Nigerian situation and failed to note the U.S. action as he summed up the supply situation: "Despite occasional dramatic news, such as hurricanes in the Gulf of Mexico in September 2005, turmoil in Nigeria in 2006-2008, and ongoing strife in Iraq, global production in the 2000s has been remarkably stable" [Hamilton 2009, p. 225].
This remark ignores the nature of the world oil market, a characteristic shared by other macro-economists, such as Lutz Killian , who comment on the market. These economists view crude oil as a homogeneous commodity, which is naive
Table 2 captures the facts that belie such assumptions. This table compares products that can be produced from one of the world's best sweet crude oils, Nigerian Bonny Light, with product yields for Arab Heavy, one of the most widely available heavy crudes. The graphic reveals two key facts. First, Bonny Light produces a higher yield of distillates (kerosene and gasoil) than Arab Heavy. Second, refiners processing Bonny Light Nigerian crude only have to remove 0.2 kilos of sulfur per barrel, while refiners processing Arab Heavy crude must take out four kilos per barrel.
Table 2. Comparison of Distillation Yields and Other Characteristics for Two Crude Oils: Nigerian Bonny Light and Saudi Arabian Arab Heavy Bonny Arab Light Heavy LPR (%) 0.9 2.8 Light 4.3 -- Gasoline (%) Light Naphtha 13.4 6.7 (%) Intermediate -- 8 7 Naphtha (%) Heavy Naphtha 10,1 -- (%) Kerosene (%) 13.3 7.0 Gasoil (%) 22.7 12.5 Intermediate -- 9.7 Gasoil (%) Residual Fuel 39.1 52.6 Oil (%) Sulfur 0.3 4.1 Content of Resid (%) Sulfur (Kilos 0.2 4.1 per Barrel) Total Gasoil 36.0 29.2 Potential (%) Source: EIG, International Crude Oil Handbook, 2010.
Hamilton's comment regarding the loss of Nigerian supply would be correct only if refiners could produce the same amount of distillate fuel oil that meets environmental specifications from Arab Heavy as they can from Bonny Light. To do so, they would need to process residual fuel oil into distillates while removing two million kilos of extra sulfur from the crude. There is strong evidence that refiners at the time could do neither. In its June 2009 Medium Term Outlook, the International Energy Agency (IEA) succinctly described the economic and operational reasons behind the refiners' attraction to light sweet crude [International Energy Agency 2009, p. 103]:
Refinery yields are a function of refinery complexity and crude input. Thus, a surge in demand for middle distillates, or any other refined products can only be met by changing configuration of refinery [sic] or the type of feedstock or some combination of both. Making changes to refinery configuration or upgrading refining capacity entails capital investment with long lead times, while change of feedstock is an operational, short-term decision. It is not surprising, therefore, that refiners turned to sweet crude to boost middle distillate yields. Frequent claims by OPEC (in 2008) that there were adequate oil supplies rested upon the fact that some OPEC heavy crudes were struggling to find a market even when benchmark prices kept breaking record highs.
The IEA report also noted that consumption of light products (gasoline, kerosene, and diesel) increased from 2006 to 2008, while demand for heavier products declined. While the agency observed that "there was no evidence of shortage of crude during the period," it also pointed out that "changes in required product specifications affected the type and amount of crude that refiners could process, effectively tightening fundamentals for these grades'" (emphasis added) [International Energy Agency 2009, p. 104].
The 2008 simulation using my stylized model comprises three steps. First, I examine the impact of the loss of sweet crude. Second, I add the impact of environmental regulations that boosted light product demand and cut use of heavier products. Finally, I examine the impact of producer actions to cut heavy crude supply. Figure 5 tracks the 2007/ 2008 price increases that resulted from the "perfect storm" of these factors.
In the simulation, the loss of Nigerian and U.S. sweet crude supply raised crude from $48.84 per barrel at the end of August 2007 for Brent to $94 by December 2007. This is the increase that occurs because substitution of heavier crude causes a modest loss in diesel supply.
The price increase becomes larger if one uses a different yield structure for heavy sour crude. Here I assumed refiners could extract a 50 percent yield of low-sulfur products from the heavy crude, which the evidence suggests may be somewhat optimistic.
The mandated snitt in product mix causes a further jump in crude oil value in the model as specified. In the simulation, the increase in light product demand, put at one million barrels per day, lifts crude prices 33 percent from $94 to $121. Note that this is not the change in consumption postulated by Hamilton, who asserted increased Chinese demand required consumers in the United States, Europe, and Japan to pay higher prices. While such a shift may have happened, the more important change was the imposition of environmental regulations that forced consumers to move from dirty to clean products. This required significant operational changes by refiners and, as shown here, prompted them to bid up sweet crude prices.
Finally, oil-exporting countries contributed to the problem by cutting production to preserve income and prop up the heavy sour crude price. As noted above, Middle Eastern producers administratively establish differentials to sweet crude prices. The resulting prices bear no relationship to what would prevail in a free market. My stylized model suggests this practice added $25 per barrel to the sweet crude price in 2008 by limiting the amount of heavy crude oil purchased and hence the total supply of crude available to the world market.
For this reason, Hamilton's comment on the stability of production strikes us as extraordinarily naive. Indeed, through this period, OPEC nations had considerable surplus capacity, as can be seen from Figure 6. In fact, in June 2008, OPEC could have boosted production three million barrels per day but chose not to do so. Our stylized model offers a clear explanation for the organization's decision. According to the simulation, prices for dirty products would have had to decline to $20 per barrel and the heavy crude price would have been no higher than $50. The light crude price would have also been lower at $70 per barrel. However, the lesson is that oil-exporting countries would have had their income reduced on the order of 50 percent from the levels actually recorded. In short, oil-exporting countries earned a significant financial benefit from limiting production after environmental regulations tilted the market toward light sweet crude.
Odviousiy me resuiis presenieu nere uepenu on the assumptions noted earlier. Modest variations in these, such as changes in price elasticities or product yields from crude oil, will produce very different results. The point of the effort is to demonstrate that the determination of oil prices depends not only on the demand level but also on the mix of crudes, the industry's capacity to process the crudes, and decisions by oil-exporting nations on the volume of sour crude produced. In our view, the analyses of Hamilton and Killian are useless because they mistakenly give policymakers and others the impression that markets can be char acterized by a single factor: demand. Our analyses reveal that demand may, in fact, be the least important contributor to price fluctuations.
4. Simulating the Loss of Libyan Crude Oil and Reduction in Japanese Use
The stylized modeling framework also provides the means to simulate the effects of the Libyan civil war and the Japanese earthquake and tsunami. The results are striking. The loss of Libyan production alone could take sweet crude prices to almost $200 per barrel absent compensating output increases from Saudi Arabia or other OPEC countries. This upward pressure could be moderated, though, by lower Japanese consumption in the initial months after the earthquake. If Japanese demand returns, as some predict, this might take prices well above $200 per barrel unless consuming countries draw down strategic stocks.
My simulation of the Libyan war and Japanese earthquake effects begins with benchmarking the model to conditions just prior to the two events, that is, the market circumstances prevailing in mid-February 2011.
* I set the price of light sweet crude (Dated Brent) at $103 per barrel, the actual price at the time.
* I put the heavy crude price at $95 per barrel, the price quoted by the petroleum press for various heavy crude grades at the time.
* I set the price of ultra-low-sulfur gasoil (diesel) at $115 per barrel based on quotes for the fuel at around $880 per metric ton in Rotterdam.
* I set the price of heavy fuel oil at $75 per barrel, again based on Rotterdam quotes.
I initially simulated the Libyan disruption by assuming that light sweet crude supply was reduced 1.2 million barrels per day. This calculation is based on the IEA estimate of Libyan production in February, which was 1.4 million barrels per day [International Energy Agency 2011a, p. 19]. The IEA also put sustainable Libyan production capacity at 1.8 million barrels per day, as shown in Table 3.
Table 3. OPEC Crude Production and Productive Capacity (Million Barrels per Day) February March 2011 2011 Sustainable Supply Supply Capacity Algeria 1.28 1.32 1.32 Angola 1.60 1.68 1.84 Ecuador 0.50 0.51 0.51 Iran 3.68 3.68 3.70 Iraq 2.73 2.69 2.75 Kuwait 2.35 2.42 2.55 (1) Libya 1.39 0.45 1,80 Nigeria 2.16 2.05 2.50 Qatar 0.82 0.82 1.00 Saudi 8.90 8.90 12.10 Arabia (1) UAE 2 48 2.52 2.70 Venezuela 2.20 2.20 2.35 (2) Total 30.09 29.20 35.12 (1.) Includes half of Neutral Zone. (2.) Includes extra heavy Orinoco of 400 thousand barrels per day in March. Source: IEA.
The net loss of Libyan production to the world is put at only 1.2 million barrels per day, not 1.4 million barrels, because we assume Libya consumes roughly 200 thousand barrels per day. I did not assume that the disruption of Libyan output would result in Libya importing products.
The model predicts sweet crude prices to jump initially from $103 to $180 per barrel should sweet crude supplies be reduced by 1.2 million barrels per day. Sour crude prices are predicted to rise to $155. The increases occur because consumers bid up light product prices from $115 to $196 per barrel (implying a rise in gasoline and diesel prices of $1.90 per gallon).
Of course, prices did not rise to such levels. Instead, as of this writing, sweet crude prices remained between $120 and $130 per barrel, while light product prices were holding around $140 per barrel. I offer four reasons for this muted market response.
* First, the results presented here are simulated with a stylized market model that captures price impacts in only the sketchiest terms.
* Second, many European refineries were in turnaround in February and March. Thus demand for sweet crude was artificially depressed.
* Saudi Arabia compensated for the lost Libyan crude by blending a sweet crude substitute. This reduced the supply disruption by 300 thousand barrels per day.
* Finally, the disastrous March 11 earthquake in Japan seems to have reduced Japanese petroleum consumption significantly in March and April. Japanese use declined as much as 800 thousand barrels per day immediately after the catastrophe. According to the IEA, consumption levels for light products remained depressed though the end of the summer [International Energy Agency 2011b]. Here I assume Japanese consumption has been cut 500 thousand barrels per day from expected levels due to the earthquake.
The model predicts a sweet crude price of $125 per barrel when the inputs are adjusted for the lost Japanese consumption and the increased Saudi supply of sweet crude oil. This is close to the Brent price level that prevailed from March 2011 through August 2011.
5. Market Implications of an Increase in Japanese Consumption
After a careful examination of the earthquake's impact on Japanese oil consumption, the IEA's forecasters concluded that use would increase from baseline levels as much as 200 thousand barrels per day [International Energy Agency 2011a, pp. 11-12]. This would represent a reversal from the 500-thousand-barrel-per-day reduction noted in the calculation above.
I simulated the IEA's projected increase with the model, assuming Saudi Arabia maintained output of 300 thousand barrels per day of the Libyan sweet crude substitute and that Libyan crude exports do not resume. Under this scenario, the model sees light sweet crude prices rising to $170 per barrel absent any other actions.
A crude price increase to $170 per barrel would have clear and important implications for the U.S. economy. In particular, retail gasoline prices would probably rise to around $6 per gallon, a level that would no doubt create significant political issues. Prices would also rise in Europe, probably topping [euro]1.70 per liter.
Such increases could, of course, be moderated through the use of strategic reserves. A release of 900 thousand barrels per day of sweet crude, for example, would bring crude prices down to $110 per barrel. Such a release could presumably continue for several years, given the current strategic stock levels held by consuming nations.
Figure 7 presents the impact of the various scenarios for the 2011 disruptions.
6. The May 2011 Strategic Stock Release
Crude oil prices did surge as a result of the civil war in Libya and the recovery from the Japanese earthquake. The Brent price rose from $100 per barrel to almost $130 between late February and May 2011. In response, the IEA members agreed to release strategic reserves. The release was announced on June 23 [Broder and Krauss 2011].
The release of strategic stocks was, however, far smaller and much later than required to fully offset the effect of the Libyan disruption. Only 60 million barrels of crude were released to cover the loss. This replaced approximately 300 thousand barrels per day of the lost supply. Furthermore, most of the extra crude was not delivered until August 2011. Nevertheless, the release did arrest the price increase and, for a time, brought crude down temporarily as much as 10 percent.
7. New Challenges in 2012 and Beyond
Product markets will see new challenges in 2012. In the United States, a number of eastern states will require heating oil with less sulfur. In China, the Beijing area will adopt regulations mandating sulfur reductions in diesel and gasoline to the levels required today in the United States and Europe. At the same time, European countries will push to reduce sulfur in heating oil.
These new rules will exert an upward bias on product prices through 2013 if the global economy continues to expand as predicted. This pressure may be moderated, however, as new refining capacity capable of converting heavier sour crudes into the light products sought by the market comes on line. In particular, the completion of Motiva's Port Arthur refinery late in 2011 will introduce a new source of clean products. This refinery, jointly owned by Shell and Saudi Aramco, will boost the global supply of clean products perhaps 1 or 2 percent. This addition could exert significant downward pressure on prices.
In this paper, I have sought to demonstrate that oil price movements cannot be explained solely by movements in aggregate supply or demand. To the contrary, the mix of crude production and the actions taken by environmental regulators and policymakers in oil-exporting countries have a greater impact on oil price determination than the basic forces that determine demand and supply.
A Key finding is that environmental rules mat have boosted demand for clean products such as ULSD can cause very large changes in crude oil prices. This linkage has been ignored in the past by environmental regulators, who have focused solely on the increased cost of manufacturing individual products. Going forward, I hope regulators will consider the market impact of their actions and improve their coordination with refiners and oil exporting countries. Absent such cooperation, expect tighter environmental rules to cause significant crude price increases and, possibly, economic dislocations.
(1) The problems with this theory, which in ways hark back to the Catholic Church's fifteenth-century geocentric view of the universe, are discussed below.
(2) Petroleum Economics Monthly, May 2008, p. 10.
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* Philip K. Verleger, Jr. is the Owner and President of PKVerleger LLC and is the David E. Mitchell/EnCana Professor of Management at the University of Calgary's Haskayne School of Business. He writes and publishes The Petroleum Economics Monthly. He began his work on energy as a consultant to the Ford Foundation Energy Policy Project in 1972. He then served as a Senior Staff Economist on President Ford's Council of Economic Advisers and Director of the Office of Energy Policy at the U.S. Treasury in President Carter's administration. He has been a Senior Research Scholar and Lecturer at the School of Organization and Management at Yale University, a Vice President in the Commodities Division at Drexel Burnham Lambert, and a Senior Fellow at the Institute for International Economics. Verleger earned his Ph.D. in Economics from MIT in 1971.
PHILIP K. VERLEGER Jr *…
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Publication information: Article title: Rising Crude Oil Prices: The Link to Environmental Regulations. Contributors: Verleger, Philip K., Jr. - Author. Journal title: Business Economics. Volume: 46. Issue: 4 Publication date: October 2011. Page number: 239+. © 1999 The National Association of Business Economists. COPYRIGHT 2011 Gale Group.
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