International Trade, an Enhanced Petroleum Transportation Network, and Gasoline Prices

Don’t expect a big impact on gasoline prices from opening up an oil pipeline to the coast.

I am a little late to this debate [0] [1] [2], but I wanted to highlight something that is clear from basic international trade theory. Opening up to international trade changes relative prices, and in fact raises some prices. If a pipeline were to be built which could transport oil currently produced in the Midwestern US to the Gulf Coast, then to the extent that oil in the Midwest is lower priced than on the coasts, then average US oil prices may actually rise with completion of the pipeline.

The difference in oil prices in the interior US (West Texas Intermediate) and on the coasts (Brent) is shown in Figure 1.

Figure 1: Price per barrel ($/bbl) of West Texas Intermediate (blue), and Brent (red). NBER defined recession dates shaded gray. Source: St. Louis Fed FRED and NBER.

The analytics of the current situation is shown in Figure 2, which shows the Midwest US market, the US coasts, and the Rest-of-World. The world price (Brent) is at P0, and is above the autarky price for the Midwest at PAut. I’m assuming that in this case, oil cannot be shipped out to the US coasts and to the rest-of-world until the requisite pipelines are in place. (See this NYT article for discussion.)

Figure 2: World oil markets, for US Midwest/interior, US Coasts, and Rest-of-World. Dotted lines denote pre-pipeline prices, quantities. Dashed lines denote post-pipeline prices, quantities.

Once oil can be transported from the interior of the US to the US coasts, then by arbitrage, the US Midwest/interior price (WTI) should rise to world levels, denoted as Pworld. Notice that average US oil prices might very well rise, depending on interior oil production, and the gap between the autarky price and the new world price. (Pre-pipeline imports and exports given by gray arrows, where the US Midwest is in initial balance; post-pipeline trade balances given by black arrows.)

What would happen to gasoline prices? This is hard to say, but to the extent that gasoline is relatively easy to transport (compared to oil), then if average US oil prices rise, US gasoline prices may very well rise. Of course, depending on the parameters, it might fall. The point that gasoline is fairly easy to transport, so law of one price applies with greater force (after accounting for quality differences and restrictions on formulations [3]) is shown by inspecting the oil price differentials and the gasoline price differentials, in Figure 3.

Figure 3: Log East Coast-Midwest price differential for all formulations of gasoline (blue), and log Brent-West Texas Intermediate (WTI) price differential (red). NBER defined recession dates shaded gray. Source: St. Louis Fed FRED, NBER, and author’s calculations.

Notice that despite the widening of the Brent-WTI differential, the East Coast/Midwest gasoline price differential has barely budged.

In fact, the transportability of gasoline and other petroleum products relative to oil explains why the US is now a net exporter of petroleum products. Figure 4 shows petroleum product exports.

Figure 4: Exports of petroleum products, Census basis, bn$ SAAR. NBER defined recession dates shaded gray. Source: BEA, NBER, and author’s calculations.

This analysis suggests that as the price for WTI rises, that for Brent declines (probably slightly, considering relative production levels). Given relative tradability of gasoline, then the crack margins for Midwest refiners should decline, and margins for East coast refiners should increase. That might mitigate the profitability problems of those firms .

The bottom line: One should not expect that increasing the ability to ship oil from the Midwest to the coasts to noticeably decrease oil prices in the US. On the other hand, it is true that welfare (measured as the sum of consumer and producer surplus) should increase, assuming away externalities associated with oil production and transportation.

In any case, the main effects would likely be distributional (between refiners and oil producers, in particular; between refiners in the Midwest and coasts; between consumers and producers; the US and the rest-of-the-world). Gasoline prices will be much more determined by shifts in the Rest-of-world supply and demand curves, as Jim has explained. [4] [5] [6]

This post originally appeared at Econbrowser and is posted with permission.

One Response to "International Trade, an Enhanced Petroleum Transportation Network, and Gasoline Prices"

  1. barf   March 31, 2012 at 7:25 am

    why shouldn't profitability simply rise at the refineries in the Midwest irregardless of what the price of the "gasoline thingy" does?