Why are WTI and Brent Oil Prices Out of Whack?

As regular readers may recall, I am intrigued when prices deviate from normal relationships (see, e.g., previous posts on oil vs. natural gas prices and the pricing of Citigroup securities).

Over the past couple of months, a new anomaly has emerged: crude oil quoted at Brent has become much more expensive than WTI, the usual price benchmark quoted in the United States.

Over at the Oil Drum, Gail the Actuary illustrates the price disparity:

And explains it:

We have all heard at least a partial explanation as to why West Texas Intermediate (WTI) and Brent prices are so far apart. We have been told that the Midwest is oversupplied because of all of the Canadian imports, and the crude oil cannot get down as far as the Gulf Coast, because while there is pipeline capacity to the Midwest, there isn’t adequate pipeline capacity to the Gulf Coast. I have done a little research and tried to add some more context and details. For example, the opening of two pipelines from Canada (one on April 1, 2010 and one on February 8, 2011) seems to be contributing to the problem, as is rising North Dakota oil production.

There are two pipelines (Seaway – 430,000 barrels a day capacity and Capline – 1.2 million barrels a day capacity) bringing oil up from the Gulf to the Midwest. It is really the conflict between the oil coming up from the Gulf and the oil from the North that is leading to excessive crude oil supply for Midwest refineries and the resulting lower price for WTI crude oil at Cushing. Demand for output from the refineries remains high though, so prices for refined products remains high, even as prices for crude oil are low. This mismatch provides an opportunity for refiners to make high profits.

Her whole post is well worth reading if you are into such things.

Can Natural Gas Replace Oil for Diesel?

In a series of posts (most recent here), I’ve noted that oil and natural gas prices have become unhinged from each other. Oil (denominated in $ per barrel) used to trade at 6 to 12 times the price of natural gas (denominated in $ per MMBtu). But lately that ratio has been north of 20, thanks to a surfeit of new gas in the United States (and elsewhere) and, recently, growing global demand for oil.

The wide spread between oil and natural gas prices provides a tempting incentive for any innovators who can figure out how to use natural gas, rather than oil, to make transportation fuels.

Over at the New York Times, Matthew Wald identifies one possibility, using natural gas to produce diesel:

Diesel and jet fuel are usually made from crude oil. But with oil prices rising even as a glut of natural gas keeps prices for that fuel extraordinarily cheap, a bit of expensive alchemy is suddenly starting to look financially appealing: turning natural gas into liquid fuels.

A South African firm, Sasol, announced Monday that it would spend just over 1 billion Canadian dollars to buy a half-interest in a Canadian shale gas field, so it can explore turning natural gas into diesel and other liquids. Sasol’s proprietary conversion technology was developed decades ago to help the apartheid government of South Africa survive an international oil embargo, and it is a refinement of the ones used by the Germans to make fuel for the Wehrmacht during World War II.

The technology takes “a lot of money and a lot of effort,” said Michael E. Webber, associate director of the Center for International Energy Environmental Policy at the University of Texas, Austin. “You wouldn’t do this if you could find easy oil,” he said.

But with the huge spread between oil and gas prices, and predictions of oil topping $100 a barrel next year, the conversion technology could be a “a money-maker for whoever is a first mover in that space.”

Will Budget Concerns Ever Influence Carbon Policy?

Climate change legislation died an ignominious death in the Senate earlier this year. If you’d like to understand why, check out Ryan Lizza’s autopsy of the effort in the latest New Yorker. Lizza documents how the “tripartisan” trio of John Kerry, Joe Lieberman, and Lindsey Graham came up short in their effort to craft a 60-vote coalition in the Senate. Among the bumps along the way:

  • On March 31, President Obama announced a dramatic expansion in offshore waters open for oil and natural gas drilling. In so doing, he gave away one of the sweeteners that the trio was hoping to use to attract pro-drilling senators.
  • On April 15, Fox News reported that, according to “senior administration officials”, the White House was opposing efforts by Senator Graham to increase gasoline taxes. That claim was perverse–the bill didn’t include higher gasoline taxes and Graham certainly wasn’t pushing them–but not surprisingly it created problems for Graham back home.

Lizza’s article is rich with such anecdotes, but it’s the larger picture I’d like to emphasize. Kerry, Lieberman, and Graham adopted a traditional approach to building a Senate coalition. They identified their main goal–comprehensive climate change limits–and then started negotiating with individual Senators and special interests to see how they could get to 60 votes. Nuclear power, electric utilities, oil refiners, home heating oil, even cod fisherman all make an appearance at the bargaining table. But it’s not clear that such horse-trading could ever yield 60 votes.

This failure makes me wonder whether the traditional approach will ever generate a substantive climate bill. I suppose that’s still possible, particularly if the EPA begins to implement a burdensome regulatory approach to limiting carbon emissions. That might bring affected industries running back to the table.

But I would like to suggest another strategy: Perhaps the environmental community should make common cause with the budget worrywarts. In principle, a carbon tax is a powerful two-birds-with-one-stone policy: it cuts carbon emissions and raises money to finance the government. (This is equally true of a cap-and-trade approach in which the government auctions allowances and keeps the proceeds.) Perhaps there’s a future 60-vote coalition that would favor those outcomes even if various energy interests would be opposed?

Such a coalition is unthinkable today. Opposition to energy taxes runs deep, as Senator Graham experienced. But fiscal concerns will continue to grow in coming years, and spending reductions may not be enough to get rising debts under control. If so, maybe we’ll see a day in which a partnership of the greens and the green eyeshades will take a stab at a carbon tax.

The New Normal in Oil and Natural Gas Prices

In previous posts (most recent here), I noted that oil and natural gas prices have disconnected from their usual historical relationship. For many years, oil prices (as measured in $ per barrel) tended to be 6 to 12 times natural gas prices (as measured in $ per MMBtu). That ratio blew out to more than 20 in late 2009, briefly receded toward more traditional levels, and then expanded again. At Tuesday’s close, the ratio stood at 19.4, far above its historical range:

(Note: A barrel of oil has roughly 6 times the energy content of a MMBtu of natural gas. If the fuels were perfect substitutes, oil prices would thus tend to be about 6 times natural gas prices. In practice, however, the ease of using oil for making gasoline makes oil more valuable. As a result, oil has usually traded higher.)

The unusual pricing of the last two years reflects two factors. First, there has been a dramatic–and welcome–expansion in domestic natural gas supplies. That’s driven natural gas prices down to less than $4 per MMBtu at yesterday’s close. Second, there is limited opportunity for energy users–utilities, businesses, and homeowners–to switch from oil to natural gas. Years ago, such switching linked oil and natural gas prices relatively closely. But today those prices appear largely decoupled.

All of which poses an important question for investors, forecasters, and industry planners: Will historical relationships eventually reassert themselves, perhaps by longer-term fuel switching by utilities and transportation fleets to natural gas? Or is this time really different, with old pricing relationships no longer relevant?

One way to answer that question–or, at least, to get some insight into how others are answering it–is to look at futures prices. As illustrated in dark blue above, those prices imply that the ratio of oil to natural gas prices will remain well above historical levels for at least the next eight years. The new normal, according to futures markets, will be for oil prices to average about 15 times natural gas prices.

The End of Cap and Trade?

No, not for carbon. For sulfur dioxide.

As noted by Mark Peters at the Wall Street Journal:

The original U.S. cap-and-trade market, which succeeded in slashing the power-plant emissions that cause acid rain, is in disarray following the issuance of new federal pollution rules.

The collapse in the pioneering market where power producers trade permits that allow them to emit sulfur dioxide and other pollutants that cause acid rain comes as policy makers seek to establish a similar market to curb the emissions of carbon, a cause of climate change.

The SO2 market has been one of the great successes of economic engineering, using market forces to drive down the cost of cleaning the environment. After almost twenty years of trading, however, the market ran into what may be an insurmountable hurdle: increased regulatory concern about the location of SO2 emissions.

The SO2 marketplace is national in scope, which has been great for establishing liquid trading and allowing emitters to find the cheapest way of reducing emissions. But it also meant that some SO2 emissions would end up in particularly unwelcome spots, e.g., upwind of cities, states, or entire regions that are having trouble meeting air quality standards.

Over the past couple of years, court rulings and new regulatory efforts by the Environmental Protection Agency have increased the emphasis of the location of emissions. And that means that the national market may be coming to an end.

That’s certainly what it looks like in the allowance marketplace, where prices have fallen from more than $600 per ton in mid-2007 to $5 or less today:

The price decline has been particularly sharp because utilities had been polluting less than allowed in recent years. That allowed them to build up an inventory of allowances to use in the future. With prices so low today, however, utilities have essentially no incentive to avoid sulfur emissions and no incentive to hold allowance inventories. As Gabriel Nelson puts it over at the New York Times:

With SO2 allowances trading at about $5 per ton, and little prospect of carrying over the permits into the new program, utilities have little incentive to bank allowances or add emissions controls for the time being, traders say. Because those controls have upkeep costs beyond the original investment, some plants might even find it more cost-effective to use allowances than to turn on scrubbers that have already been installed, traders said.

Afghanistan and the Resource Curse

Yesterday, the New York Times reported that the United States has identified “vast mineral riches in Afghanistan“:

The United States has discovered nearly $1 trillion in untapped mineral deposits in Afghanistan, far beyond any previously known reserves and enough to fundamentally alter the Afghan economy and perhaps the Afghan war itself, according to senior American government officials.

The previously unknown deposits — including huge veins of iron, copper, cobalt, gold and critical industrial metals like lithium — are so big and include so many minerals that are essential to modern industry that Afghanistan could eventually be transformed into one of the most important mining centers in the world, the United States officials believe.

An internal Pentagon memo, for example, states that Afghanistan could become the “Saudi Arabia of lithium,” a key raw material in the manufacture of batteries for laptops and BlackBerrys.

This report has generated some healthy skepticism (e.g., here). So let me add my own.

First, it appears that the $1 trillion figure reflects the gross value of the resources at current market prices. But it doesn’t reflect the cost of extracting and transporting them. When you factor those in, the net resource wealth of Afghanistan will be much lower than the $1 trillion headline figure.

Second, if these resources are real, Afghanistan may well fall prey to the resource curse that has hit so many other resource-rich nations. Last September, I quoted a Financial Times article on oil that described the problem very nicely:

Poor countries dream of finding oil like poor people fantasise about winning the lottery. But the dream often turns into a nightmare as new oil exporters realise that their treasure brings more trouble than help. Juan Pablo Pérez Alfonso, one time Venezuelan oil minister, likened oil to “the devil’s excrement”. Sheikh Ahmed Yamani, his Saudi Arabian counterpart, reportedly said: “I wish we had found water.”

Such resignation reflects bitter experience of the way that dependency on natural resources can poison a country’s economic and political system. Inflows of hard currency push up prices, squeezing the competitiveness of non-oil businesses and starving them of capital. As a result, productivity growth withers (a phenomenon known as “Dutch disease” after the negative effects of North Sea gas production on the Netherlands). Meanwhile, the state institutions in charge of oil often become corrupt and evade democratic control. And oil-rich states almost invariably waste the income it brings, many ending their oil booms deeper in debt than when they started.

As the FT notes, some countries, most notably Norway, have managed to elude the resource curse. But it’s hard to believe that Afghanistan will be able to follow Norway’s lead.

Rethinking Oil and Natural Gas Prices

My recent post about oil and natural gas prices elicited some very constructive responses from readers (thanks in particular to PJ, MF, and FW, in addition to public commenters on the post). As a result, I’ve rethought my discussion of the relationship between oil and natural gas prices.

I was also inspired to look at the futures markets to see what they are signaling about the relationship between oil and natural gas prices. Here’s my usual chart of the ratio of oil prices to natural gas prices, now showing both history (lighter blue) and futures markets (darker blue):

As noted in my earlier posts, oil and natural prices appear to have disconnected from their historical relationship. For many years, oil prices (as measured in $ per barrel) tended to be 6 to 12 times natural gas prices (as measured in $ per MMBtu). That ratio blew out to more than 20 in late 2009, then receded to more traditional levels, and then blew out again in recent months. At yesterday’s close, the ratio stood at 21.8, far above its historical range.

In my previous posts, I argued that this unusual pricing reflects the sudden (and welcome) increase in natural gas supplies and that we should expect oil and natural gas prices to eventually move back toward their historical relationship as markets absorb the new gas. Of course, I was careful not to say when this would happen.

As shown in the graph, the futures markets are indeed signaling some normalization in the price ratio in coming years, but not a rapid one. Moreover, even after eight years, the ratio would return only to the upper end (12) of its historical range. (Caveat: Futures markets are quite thin that far out, so we shouldn’t place too much weight on those distant prices.)

Let me offer a revised interpretation of the pricing relationship that’s consistent both with the futures data and the comments I received. This interpretation (consider it a theory, really) distinguishes four time periods:

  • Good Old Days: For many years, the electric utility industry had generating plants that ran on oil, natural gas, or both. The ability to fuel switch (either by changing the dispatch order of oil and gas plants or changing fuels at plants that could use either) limited how much oil and natural gas prices could deviate. If oil prices fell too low, utilities would move from natural gas to oil, and vice-versa. Similar fuel arbitrage occurred, to varying degrees, among other uses as well (e.g., home heating and some industrial uses).
  • More Recent Days: In recent decades, electric utilities have embraced natural gas and moved away from oil. As a result, there is much less opportunity for arbitrage between the fuels. The same has happened among other fuel consumers as well. Oil and natural gas prices nonetheless remained within their usual historical relationship. For example, oil and natural gas prices rose and fell in tandem during 2008. This suggests that the markets encountered similar shocks during those years (e.g., strong demand or, some would argue, speculation), not that they were linked via arbitrage.
  • Today: With the decline of traditional fuel arbitrage possibilities, oil and natural gas prices can now move separately if they experience distinct shocks. That appears to have happened with the increase in natural gas supply, for example.
  • Future: Looking further ahead, however, one would expect some new arbitrage relationships to develop. If we have persistently cheap natural gas and persistently expensive oil, that creates an incentive for ingenious folks to find ways to use natural gas to serve what have traditionally been oil demands. That should eventually limit the degree to which the prices can deviate (although not necessarily in the 6 to 12 ratio range). Two leading candidates for this linkage are using natural gas as a transportation fuel (directly as a fuel and perhaps indirectly as electricity) and increased international trade in liquified natural gas.

Note: The chart uses the spot price for West Texas Intermediate at Cushing and the spot price for natural gas at Henry Hub on a monthly basis through March 2010. For April 2010, I use the closing prices on April 8. The monthly futures are from the CME Group.

Oil and Natural Gas Prices Disconnect Again

Update (4/9/10): Please see my follow-up post as well.

Last summer I noted that oil and natural gas prices had diverged to an unprecedented degree. I bravely predicted that this divergence would reverse (unbravely, I didn’t predict when).

As the chart below shows, I was right: the price relationship did move sharply toward normal levels. In the last two months, however, it’s blown out again:

The chart shows the ratio of the price of oil (measured in $ per barrel) to the price of natural gas (in $ per MMBtu). Under normal circumstances, that ratio fluctuates between 6 and 12. A barrel of oil has roughly 6 times the energy content of a MMBtu of natural gas. If the fuels were perfect substitutes, oil prices would thus tend to be about 6 times natural gas prices. In practice, however, the ease of using oil for making gasoline makes oil more valuable. As a result, oil has usually traded higher.

Natural gas closed today at $4.11 per MMBtu. Under normal circumstances, that would imply an oil price of around $25 to $50. But oil actually closed above $85. As a result, the ratio of oil prices to natural gas prices is up at 20.7, well above the usual range and closing in on the peaks of last summer (on the day before I wrote my earlier piece, the ratio reached 24.5).

Where do prices go from here?

Well, history still suggests that the price gap will eventually narrow, through some combination of oil prices falling and natural gas prices rising. But there’s no guarantee that will happen in the short-run. Over the longer-term, however, I feel confident that demand for natural gas will rise to meet the new supply (the prime reason why natural gas prices have been so low recently) and that the oil vs. natural gas price relationship will eventually move back to normal. Natural gas is cleaner than coal and is available in large quantities in the U.S. and Canada. As a result, natural gas is on the short-list of potential responses to climate change and oil dependence, two concerns that aren’t going away anytime soon.

Note: The chart uses the spot price for West Texas Intermediate at Cushing and the spot price for natural gas at Henry Hub. Both series are monthly, except for the prices for today, 4/01/10.

P.S. Note that I have again obeyed the first law of forecasting: I have given a prediction (the relationship between oil and natural gas prices will normalize), but I haven’t given a date.

The President Caves on Climate Policy

At a time of unsustainable deficits, deficit neutrality is a remarkably lame vision for climate policy.

Last year, President Obama proposed to raise $500 billion over ten years through a cap-and-trade system that would limit carbon emissions. This year his climate policy raises nothing.

The president still backs cap-and-trade, but he has caved into congressional pressure to give away or spend all that potential revenue rather than use it to help taxpayers. Cap-and-trade has thus become cap-and-spend.

The new policy is described as follows in a footnote to Table S-2 of the budget:

A comprehensive market-based climate change policy will be deficit neutral because proceeds from emissions allowances will be used to compensate vulnerable families, communities, and businesses during the transition to a clean energy economy. Receipts will also be reserved for investments to reduce greenhouse gas emissions, including support of clean energy technologies, and in adapting to the impacts of climate change, both domestically and in developing countries.

I am sympathetic to the idea that the value of some emission allowances should be used to compensate some families, communities, and businesses as the system ramps up. But studies have repeatedly found that such compensation would require only a fraction of the overall value of the allowances. There should still be plenty of room for allowances that are ear-marked for deficit reduction.

Proponents of the bills currently pending in Congress counter by pointing out that allowance giveaways would get smaller in later decades, helping cut future deficits.

I wouldn’t bet on it. In my experience, these dessert-now-spinach-later policies usually get renegotiated just as the spinach course is about to begin. The alternative minimum tax is about to hit more taxpayers? Let’s patch it for a year. Doctors are about to get their Medicare payments cut? Let’s put that off for another year. Terrorism risk insurance is about to phase out of existence? Let’s extend it for a few more years until we are ready. And on and on.

If we are serious about using some allowances for deficit reduction, we are better off doing it immediately, not creating beneficiary groups who will lobby for extensions when their free dessert is coming to an end.

And faced with $10 trillion or more in deficits over the next decade, we could really use the money.

Note: In his 2010 budget, the president proposed to raise $624 billion in revenues from a cap-and-trade program. $120 billion was earmarked for investing in clean energy technologies, so I netted it out in calculating the $500 billion figure above. The president proposed using those funds to pay for a permanent extension of the making work pay tax program, but they could also have been used to reduce the deficit. (See Table  S-2 from last year’s budget)