On January 2, 2014 Brent crude sold for $107.94 per barrel, while the price for West Texas Intermediate (WTI) crude was $95.14 per barrel. The Brent price peaked at $115.19 on June 19th and the WTI a day later at $107.95. By October 14th the Brent price had sunk to $86.36 and the WTI fell to $81.72.
These price drops equal 25.0% from the year’s peak for Brent and 24.3% for WTI crude. In addition, the spread between the two prices contracted from $12.80 per barrel at the beginning of January to $4.64, or by $8.16 (63.8%). These price changes and their relationship have a number of implications for the U.S. economy.
The flow-through to gasoline prices for consumers means large savings for households. Since the week of June 23rd the price of regular gasoline has dropped from a national average of $3.64 per gallon to $3.07 per gallon (15.7%). Last year at this time the average price equaled $3.31 per gallon. With U.S. drivers consuming about 136 billion gallons of gasoline a year, this translates into a potential savings of about $33 billion per year. Since prices are expected to continue dropping, the savings will grow.
Similarly, businesses will benefit from a comparable drop in the price of diesel fuel. Since peaking at $4.02 per gallon during the week of March 10th the average price of diesel has fallen to $3.66 per gallon. Last year at this time the price equaled $3.95 per gallon. With about 38.5 billion gallons of diesel being consumed a year, the 29-cents per gallon drop over the last year means an annual savings of about $11.2 billion for the nation’s businesses.
One of the major reasons for the fall in crude oil and motor fuel prices is the large growth in the production of oil in the United States. Since 2010 U.S. oil production has increased from a rate of 5.5 million barrels per day to 7.4 million barrel per day in 2013. Output is expected to rise to 8.5 million barrels per day for all of 2014 and to 9.5 million barrels per day for 2015. Worldwide from June 2013 to June 2014 oil production has increased by only 820 thousand barrels per day (1.1%), while in the U.S. the increase has been 1.3 million barrel per day (17.9%). This has led to a large reduction in U.S. oil imports. Between 2012 and 2013 U.S. oil imports declined by 283.6 million barrels (9.2%). Accompanying the decline in oil imports has been a decrease in the cost of imported oil. After peaking at $331.6 billion during 2011 the cost of oil imports dropped to $272.8 billion during 2013, which is a 17.7% decrease in just two years. Through the first eight months of 2014 the value of oil imports is down $46.2 billion (21.2%). This leaves more money for spending and investment in the United States. Also, it provides support for a stronger dollar and a reduced concern over inflation.
Returning to the spread between Brent and WTI crude prices there is an interesting story behind what happened the past several years, why it happened, what will likely happen going forward, and what will be the impacts. Going back to as recently as 2010 Brent and WTI crude traded within a narrow range. But then in 2011 the spread exploded to as great as $29.59 per barrel, which meant Brent crude traded at 30% premium compared to WTI crude. At the center of this strange phenomenon was Cushing, OK, a town of only about 8,000 people. This town’s significance comes from its status as the largest storage area in the country for domestically produced oil and the official price point for WTI crude.
From the end of 2008 to the beginning of 2013 the amount of oil stored in Cushing rose from 28.1 million barrels to 51.9 million barrel. These inventories grew due to the rapid growth in the production of shale oil. This oil became trapped in Cushing because the pipeline system serving the tank farms located there had been designed to move oil into Cushing rather than away from city to refineries. Consequently, the surplus of oil at Cushing – the place where WTI crude is priced – caused the WTI price to drop relative to Brent crude. On December 31, 2008 the prices for Brent and WTI crude equaled $35.82 and $44.60, respectively. WTI crude actually sold at a $8.78 premium to Brent crude that day. The prices for both increased over the next four years, but on January 2, 2013 the Brent and WTI prices equaled $112.98 and $93.14, meaning that the Brent crude sold at a $19.84 premium to WTI crude.
Crude inventories at Cushing peaked on January 11, 2013. The repurposing of one pipeline to flow south rather than north and the construction of several other outbound pipelines resolved the bottleneck. These developments have resulted in crude inventories at Cushing dropping to 19.6 million barrel on October 10th. Also, on October 10th the Brent-to-WTI price spread settled at $4.64 per barrel. This is important because under normal circumstances at about this price differential optimum markets shift for oil produced in the Bakken area of North Dakota. A price differential over $5 per barrel favors railroad served markets on the East and West Coasts. Below this amount pipeline and railroad served markets on the Gulf Coast become more attractive.
Over the past several years shale oil production using hydraulic fracking has developed in several areas of the country. However, the most rapid growth in production of this type of oil has occurred in North Dakota. From the end of 2008 to July 2014 daily average output in North Dakota has risen from 202,000 barrel to 1,111,000 barrels. Over this period railroad carloads of oil shipped from the state increased from 8,100 barrels per month to about 760,000 barrels per month. With the lower Brent-to-WTI price spread that now exists under normal circumstances oil shipments from North Dakota would shift geographically from the East and West Coasts to the Gulf Coast and from railroad to pipeline, which has a $1 to $3 per barrel advantage for Gulf Coast shipments. However, currently North Dakota has inadequate pipeline capacity to handle the additional traffic. At the end of 2013 pipelines could only handle about 580,000 barrel per day.
It will likely be 2017 before significant new pipeline capacity becomes available. This means railroads have at least two more years in which to earn significant profits transporting North Dakota oil. What may cut into this income stream is the continued decline in the price of Brent crude. This is because East Coast refineries may again turn to imported oil. New safety requirements that require railroads to retrofit older tank cars and buy new more structurally sound equipment could further cut into railroad profits. There is also the possibility that the production of Bakken shale oil may slowdown. For some of the less productive areas of the Bakken formation a delivered price of much below $80 per barrel makes the oil unprofitable. Thus, North Dakota may become a less attractive place to move over the next couple of years, unless global warming dramatically accelerates, that is!