Crude Economics

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There has been a significant downward move in oil prices – North Sea Brent is around $36. It got up to about $115 in 2014. That’s old hat but there is something else significant happening.

To start in the 1980s, crude oil prices in the US were, give or take a bit, determined by the price of West African and North Sea crude plus the trans-Atlantic freight to US refineries on the US Gulf Coast. This meant that they usually traded about $2.50 above Brent, the North Sea marker crude. Then there was a structural shift. West coast Canadian crude that had been pipelined to refineries on the Canadian east coast was allowed to be exported down into the mid-west of the US. (The Canadian refiners didn’t mind as they could buy North Sea crude more cheaply.)

Hitherto the US refineries in the mid-west had sourced some crude from domestic production in Oklahoma but a lot came up pipelines from the Gulf Coast. When Canadian imported crude flooded in, not only did they not need to bring crude up the pipelines anymore but they had too much and needed to reverse the pipelines to pump crude in the other direction. This is a money and time consuming exercise.

While this was going on it was happy days for the mid-west refiners who were buying crude at around $8 less than the Gulf Coast price. Before the pipeline flows were reversed something else happened to put the market into further upheaval. Fracking started to produce significant amounts of oil that added to the surplus already in the mid-west. This at its most extreme drove mid-west prices $25 below North Sea prices.

So, where are we now? US domestic production will contract in 2016 as low prices discourage fracking. The pipeline network has been expanded and rationalised to allow crude to move from the mid-west to the Gulf Coast. Last, but not least, the prohibition on exporting US domestic crude has been lifted. These factors have finally re-integrated US domestic crude prices with the world market and we are back close to where we were in the 1980s. Prices for crude in the mid-west are now at a small premium to those in the North Sea.

Interesting isn’t it? Like most markets it is cyclical, although it has taken thirty years. What next? I think we will grow accustomed to seeing WTI, the US marker crude in the mid-west, trade at premiums of around $3 to the North Sea marker, Brent. A trader willing to keep an eye on freight rates and pipeline tariffs should be able to make a bit on the arbitrage.

For more generalist investors, this change in the structure of the US oil market seems to me a portent that international crude oil prices may have finally found a bottom, having fallen for about eighteen months. (I thought they were bumping along the bottom when they were at $50 in the autumn but that turned out to be premature.)

 

2 comments

  1. Christopher, just wanted to drop you a short note to say I have thoroughly enjoyed reading your blog over the past six months. In particular, I have found you’re more recent Posts on London (ie Eating en Famille, How About a Bacon Butty? And the rule of Seven) the most interesting of all. I love hearing about some of your “old school London” experiences and how they are still relevant today…whether it’s eating a bacon & black pudding sandwich in a cabman’s shelter (I always wondered what those little huts were!) or having a drink in the Mandarin Oriental or Lanesborough Hotel (Heather’s favourite)).

    I agree with you for the most part on “Crude Economics”. I am still waiting for the day one of the major newspapers does an articles on something like “Central London Property Values driven by Oil Price”. Let me explain. Yesterday I was reading that the Saudi’s are running a $100bn budget deficit (largely blamed on the world’s lower oil price). Funnily enough, central London real estate prices have been slipping in recent times. One realizes that prices can’t go up, up and up forever; however why are values coming off? For the most part, who are the buyers of the £10-20m + houses in places like Mayfair? Very wealthy foreigners for the most part. The way I see it is there are fewer and fewer ultra-rich people (many have been Russian and Middle Eastern descent) who have in recent times built wealth on the back of their (countries) oil natural resource interest. It would appear that with oil prices set to stay low for a considerable amount of time, London house prices should cool off or at least not rise like they had been up to now….Says the man (reassuring himself?) who sold his London terrace recently.
    Keep up the blog – I look forward to next years.

    All the best for 2016.

    Ladd
    PS Thanks for the tip with the Glycerin…Heather has been on my case to clean up the moss on our car so I’ll be paying a visit to Boots tomorrow to pick up a jar!

    1. Thank you for your contribution. I think there is a blogger in you, trying to get out.
      Your observations on the central London property market are most interesting. The uber-rich class inevitably will grow and the unknown factor is if they will choose London. Earlier this year I was driven around St George’s Hill and shown high spec new-build properties that were, and probably still are, unsold, backing up your opinion. It is unfortunate that overseas buyers have made most of Knightsbridge, Mayfair and Belgravia a ghost town so far as residential property goes. However, it’s still a great city to live in and I will be walking to Piccadilly today for lunch.
      Happy new year, and I hope you are wrong about oil prices. I have too many BP and Shell shares!
      Christopher

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