Oil! Price Discovery and Regulation

There is a growing disconnect between the price of oil and the price and supply of retail fuels 

by JACOB BORDEN

Market signals about the relative value of available materials are paramount for widely dispersed people to make rational decisions. Such was the solution to the “knowledge problem” elaborated by F. A. Hayek. A topical example of Hayek’s theory in practice is the decade-long adjustment in the prices of oil and products refined from petroleum. Oil is generally considered to be a fungible global commodity, and one frequently hears reference to global oil prices as reflecting global supply and demand. But a combination of factors over the past decade has substantively reduced the fungibility of this once-standard product. 

Increasingly, oil is a design-specific product and the price you pay at the pump for a gallon of fuel more often reflects local design characteristics than the underlying price of a global commodity. These local design characteristics are exacerbated by regulations that disrupt the market’s price-discovery process. 

As recently as December 2001, oil was still trading at the 20-year average of $20 per barrel, even despite the September 11 attacks and the ongoing recession. Over the next seven years, a series of disruptions drove the price up. It became more expensive to do business with the countries that held most of the world’s proven reserves, which two oil-intensive wars did nothing to help. Moreover, oil politics in Venezuela and surging demand from China and other developing nations helped push prices to record highs—over $130 per barrel—by 2008.

By the time the economic crash brought prices back down to $39 per barrel, major oil companies had already invested billions in research and development projects to bring new supplies online. These spanned unconventional tar sands, tight shale oil, unconventional natural gas, and even biofuels. As recovery slowly crept along in the United States, oil prices peaked again at $110 in April 2011. Since then prices have stabilized between $90 and $100 per barrel. At that level for light, sweet Texas Tea, it is profitable to fill the marginal barrel with a combination of cheaper and vastly available shale oil, tar sands, and Brazilian sugarcane ethanol. 

Regulatory Barriers

But even as global price discovery for oil appears to be reaching equilibrium, in the United States today there is a growing knowledge problem in what actually drives the retail supply of gasoline and diesel. As the global oil slate has gotten heavier, regulatory burdens have only increased already-daunting costs and have kept the American refinery fleet largely inflexible. 

Keep in mind that no two refineries are of identical design, capacity, or location, and no new U.S. refinery has been built since 1976. The result is that some refineries today are limited by the amount of asphalt they can accept in their crude, while others are limited more by the capacity to remove sulfur. Only a handful of refiners have elected for the extensive upgrades and regulatory approvals needed to process large amounts of oil shale or tar sands.

Increasingly stringent specifications simply cannot be met with the available refineries and crude mix, and regulatory bottlenecks keep other sources from picking up the slack. A recent example: Last October, one refinery in Southern California was idle for maintenance when a second refinery had to shut down briefly after a power failure. The second outage was enough to send California prices up $0.53 per gallon above the national average. And since gasoline from outside the state doesn't meet California specifications, gasoline from the remaining California refineries had to be rationed. The United States is thus a patchwork quilt of discrete regulated markets, rather than a single market. This fact, of course, makes fuel prices higher than they would be in a single market.

Then there’s ethanol. Since 2007, legislation has mandated increases in the amount of ethanol blended into gasoline. This year 14 billion gallons of ethanol will displace about 10 percent of a fast-shrinking U.S. gasoline market. 

But the ethanol mandates confound a separate effort at smog prevention. Most major cities across the country are still considered non-attainment areas for ozone, a contributor to urban smog. Quite a bit of urban smog today is from the small amount of gasoline leaking out of your gas tank. Especially in the summer, small amounts of evaporated gasoline from each of millions of cars add up to a lot of fugitive emissions. 

Ethanol makes evaporation even worse. As refiners have been required to blend in more ethanol, they have had to compromise already-constrained operating conditions and crude slate in order to meet EPA specifications. The result is an even lower yield of gasoline from each barrel, and even higher prices for summer-grade gasoline. The EPA evaporation standard also exacerbates wasteful incentives from artificial price barriers: Gasoline sold across state and county lines may not be subject to regulation and may therefore be cheaper, making it worthwhile to drive 20 to 30 miles just to buy gasoline. 

Diesel

A similar set of regulatory constraints is affecting the supply of diesel. In 2007, the EPA lowered the sulfur limit for on-road diesel to 15 parts per million (ppm), and for the first time it applied the previous specification of 500 ppm to off-road diesel, such as railroad and marine fuels. Last year, the 15 ppm ultra-low-sulfur diesel (ULSD) specification was applied to off-road diesel as well. Having to meet new specifications has left refiners with three options: use only the lightest and sweetest crudes, operate existing equipment harder and sacrifice yields, or invest the necessary capital to maintain capacity.

The cumulative effect of all these regulations is to make oil less of an economic "commodity" and more and more a specialty product produced (and priced) based on a combination of source, local production, and refining constraints; regional and state-based environmental regulations; political mandates affecting blending; transportation and pipeline availability; and other factors.

After a decade of price discovery, the growing knowledge base about supplying unconventional fuels has converged on a price point of $90 to $100 per barrel of conventional crude. Eventually there will be a benchmark price for tar sands and shale oil, traded at some discount to West Texas Intermediate, the benchmark grade. But despite financial-market transparency for “standard” petroleum benchmarks, there is a growing disconnect between the price of oil and the price and supply of retail fuels in any specific market.