Bloomberg had a revealing article yesterday exposing the basic economics driving the Keystone Pipeline and how it affects Canadian and American oil producers, while exposing consumers in the upper Midwest to higher prices. The differential impact is not a surprise to anyone who understands the basics of “congestion pricing,” which has been a fact of market life in gas and oil markets for decades and is now the rule in most of the nation’s electricity markets.
But first, credit to Matthew Yglesias for his explanation and chart, (above) which shows a perfect example of how prices at different locations can diverge when there is congestion in the pipelines that move oil or gas product from one location to another. The assumption that oil is sold and priced on a world market doesn’t hold when there are local or regional transmission bottlenecks.
Put simply, if you have a surplus of supply in a region but limited ability to move the product outside that region, the prices inside the region will tend to be lower than they are in regions outside the high-supply region. A bottleneck in moving the product outside the supply region will depress prices there until more pipeline capacity (for oil/gas) or transmission (for electricity) is built to move the product to larger markets.
As Yglesias notes, limited fuel pipeline capacity from Cushing, Oklahoma to refineries along the Gulf Coast — and hence to world markets — has created supply surpluses in the upper Midwest, which depressed crude oil and gasoline prices there. As a result, as Bloomberg points out, crude oil and gasoline prices above the bottleneck, from Denver to Chicago, remained significantly below what the same product could command on world markets, if they could only get the product to the world markets.
Now that Keystone’s sponsor, TransCanada, plans (with the Administration’s relieved blessing) to relieve this bottleneck by building more pipeline capacity from Cushing down to the Gulf Coast, that oil glut that arose in the Midwest can get to the Gulf and, voila!, prices will rise in the Midwest to levels closer to world market prices. Who knew? Well, anyone paying attention.
Economists and industry/market analysts have known about this for ages, but state and federal regulators sometimes prevented prices from reflecting these realities. In another life I helped explain the effects of “congestion pricing” to state electric utility regulators and worked with a consulting team on rules that now recognize locationally different prices caused by transmission bottlenecks on America’s electricity transmission grids. (You can see these locational price differences in real time, as they change throughout the day, in color-coded pricing maps for regional grid operators at the Midwest ISO.)
Locational price differences are neither good nor bad; they just tell us how transmission (or pipeline) capacity limits affect prices. If the differences are big enough, it may make sense to expand transmission, which means that someone can make (or lose) money if the congestion is relieved by building more transmission (or pipelines) to remove the bottleneck.
So the question is always: who wins and who loses by relieving the bottlenecks? The value of the Bloomberg article is that it explains very clearly that the original and now revised (lower half) Keystone XL pipeline was never designed to benefit consumers, let alone the land owners along the pipeline route. It was always meant to allow bottled up oil producers in the US and Canada raise prices in much of the US, allow the oil producers to escape the Midwest’s lower price region and reach the world markets where prices are higher. All that stuff about helping the US become “independent” or helping to lower gasoline prices to America was just bunk. From Bloomberg:
The line would create a new way to carry Canadian imports outside the Midwest and reduce an oil surplus that’s depressing prices in the central U.S. Spot gasoline was 55 cents cheaper in Chicago than in New York on June 1, the second-highest ever. Nationwide, retail gasoline set its highest February average at $3.55 a gallon, data compiled by Bloomberg show.
The purpose of the $7.6 billion Keystone is to move 830,000 barrels of oil a day from landlocked Alberta to the Texas Gulf Coast, obtaining new customers and a higher price for heavy Canadian crude, Canadian regulators said in a 2010 report. The oil sold for $23.38 less per barrel in 2011 compared with heavy grades of Mexican crude, according to data compiled by Bloomberg.
“The Canadian plan was to use their market power to raise prices in the United States (UNG) and get more money from consumers,” Philip Verleger, founder of Colorado-based energy consulting firm PK Verleger LLC, said in an interview. Prices may gain 10 to 20 cents in central states, he said.
Spitting the project between the lower pipeline from Cushing, Oklahoma to the Gulf Coast and the upper part for moving even more Canadian Tarsands oil across the US border makes this underlying purpose much clearer. Before, Midwest politicians could fool themselves and voters into thinking that more crude oil from Canada would help them by supplying refineries in the Midwest. What they never realized, or didn’t tell you, was that the lower half pipeline to the Gulf Coast would collapse the nice low pricing bubble some US consumers have been enjoying, thus allowing every US and Canadian oil producer in the entire region to raise its prices in a dozen states and major cities, from Denver, Colorado to Chicago, Illinois.
But don’t worry, the people who have to bear the risks of this all going wrong, aside from the earth’s climate, are farmers in Nebraska and Texas.