OXFORD Ns-nrn E N E R G Y STUDIES

= FOR-

A Study of the Relationship Between Spot Product

Prices and Spot Crude Prices

Robert Bacon

Oxford Institute for Energy Studies

WPM 5

1984

The c o n t e n t s o f t h i s paper a r e f o r t h e purposes of s t u d y and d i s c u s s i o n and d o not represent the v iews of the Oxford I n s t i t u t e for Energy Studies or any of its members.

Copyright 0 1984 Oxford I n s t i t u t e for Energy S t u d i e s

ISBN 0 948061 05 7

TABLES

Table I R e l a t i o n s h i p s Between Spot P r i c e Measures f o r Arab Light

I1 R e l a t i o n s h i p s Between Spot P r i c e Measures f o r Nigerian Light

111 Months wi th Extreme Disagreements Between S e r i e s

I V R e l a t i o n s h i p s Between Netbacks f o r Arab Light

V R e l a t i o n s h i p s Between Netbacks f o r N i g e r i a n L i g h t

V I C o r r e l a t i o n s f o r Saudi Netbacks (1981.01-1983.06)

V I 1 C o r r e l a t i o n s f o r Nigerian Netbacks (1981.01-1983.06)

V I 1 1 The Normal Margin Model (1976 .01-1983.06)

IX Estimated Normal Margins f o r Various Sub-Per iods

X Estimated Normal Margins a t D i f f e r e n t Refinery Centres

XI Regression of Arab Light Margin on Nigerian Light Margin

XI1 R e l a t i o n s Between Netbacks and Spot Crude P r i c e s for Arab Light

XI11 R e l a t i o n s Between Netbacks and Spot P r i c e s f o r Nigeria

XIV The Impact of Spot and O f f i c i a l P r i c e s o n Metbacks for Arab Light

XV The Impact of Spot and O f f i c i a l P r i c e s on t h e Netback f o r Nigerian Light

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27

28

34

35

36

36

41

45

48

49

78

80

82

83

TABLE OF CORTEldS

B . l

B.2

B.2.1

B.2.2

8.3

B.3.1

B . 3 . 2

B.4

B.5

B . 5 . 1

B.5.2

B.5.3

B . 5 . 4

INTRODUCTION

PART A: PRINCIPAL FINDINGS OF THE STUDY

PART B: DETAILED ANALYSIS

The R e l a t i o n Between Spot Crude P r i c e s and Spo t Product Values

The Data

Spot Crude P r i c e s

Netback Data

A Simple Model R e l a t i n g Spot Product Values and Spot Crude Prices

The Model

The Goodness of F i t of t h e Normal Margin Model

Economic F a c t o r s Determining t h e Netback t o Crude Margin

Further S t a t i s t i c a l Tests on t h e R e l a t i o n s h i p s Between Product and Crude P r i c e s

An Unconstrained Re la t ionsh ip

O f f i c i a l P r i c e s as Explanatory Var i ab le s

Dynamic Equation6

V a r i a t i o n s B e tween Ref i n e r ies

DATA APPENDIX: KEY TO ABBREVIATIONS

1 7

23

30

3 7

40

51

76

81

85

90

94

NOTES 96

XVI Lags Between Spot Prices and Netbacks of Arab Light

XVII Lags Between Spot Prices and Netbacks for Nigerian Light

XVIII Relat ion Between Netback and Spot Price for Various R e f iner ies fo r Arab Light f o r the Third Episode

X I X Relat ion Between Netback and Spot and O f f i c i a l Prices f o r Arab Light for Various Ref iner ies for the Fourth Episode.

86

87

92

92

I ATBODU CT I OH

T h i s p a p e r i s an i n v e s t i g a t i o n i n t o t h e r e l a t i o n

between crude o i l p r i c e s and t h e p r i c e s of the products made from

r e f i n i n g crude o i l . Commentators on t h e o i l market o f t e n focus

o n a measure of t h e d i f f e r e n c e be tween t h e " v a l u e " of t h e o i l

once c o n v e r t e d i n t o p r o d u c t s and t h e c o s t of t h e c r u d e o i l

i t s e l f . There has been very l i t t l e pub l i shed work on the n a t u r e

and b e h a v i o u r of t h i s m a r g i n and t h e f i r s t p a r t of t h e s t u d y i s

a d d r e s s e d t o t h e p r o b l e m of m e a s u r i n g and summar i s ing its

behaviour.

Once some p a t t e r n s f o r t h e margin between t h e two s i d e s

of t h e o i l market - crude and products - have been e s t a b l i s h e d ,

t h e p a p e r i s t h e n a b l e t o t u r n to t h e q u e s t i o n of model l i n g t h e

r e l a t i o n s h i p be tween t h e t w o se r i e s , and t h i s r e q u i r e s some

a n a l y s i s of t h e markets concerned.

The p a p e r c o n c e n t r a t e s on two c r u d e o i l s (and t h e i r

a s s o c i a t e d p r o d u c t values), A r a b i a n L i g h t (33.9 'API) and

N i g e r i a n L i g h t (37.7 OAPI). The r e a s o n f o r c h o o s i n g t h e s e two

p a r t i c u l a r crudes i s t h a t d a t a i s a v a i l a b l e for long per iods and

t h a t t h e i r p r i c e behaviour is n o t t o o s imilar (as would be Arab

and I r a n i a n Light f o r example).

A p a r t i c u l a r p r o b l e m w i t h s t u d y i n g t h e s e c o n c e p t s i s

t h a t t h e r e is n o " o f f i c i a l " s o u r c e of d a t a f o r t h e c r i t i c a l

c o n c e p t s . I n s t e a d t h e r e a r e s e p a r a t e e s t i m a t e s p roduced by

1

v a r i o u s p r i v a t e agencies and t h i s l e a d s t o t h e unusual s i t u a t i o n

of having mu1 t i p l e o b s e r v a t i o n s ( e s t ima tes ) f o r t h e same concept.

An important p a r t of t h e paper is t h e r e f o r e devoted t o comparison

of t hese v a r i o u s d a t a sources.

The p a p e r i s d i v i d e d into two s e c t i o n s . Part A

d e s c r i b e s t h e main r e s u l t s , both a n a l y t i c a l and s t a t i s t i c a l , of

t h e study. This s e c t i o n i s se l f - con ta ined but does n o t i nc lude

any d i s c u s s i o n of how t h e r e s u l t s were der ived. For r e a d e r s who

are i n t e r e s t e d i n t h e d e r i v a t i o n of t h e r e s u l t s and t h e d e t a i l s

of t h e i n v e s t i g a t i o n Part B cove r s t h e same m a t e r i a l but a t much

g r e a t e r l e n g t h . The a r r a n g e m e n t of p a r t B i s a s follows.

S e c t i o n B.l p r e s e n t s t h e b a s i c c o n c e p t s t o be u s e d i n t h e

a n a l y s i s and t h e f u n d a m e n t a l h y p o t h e s i s of t h e "normal margin"

(between s p o t crude p r i c e s and s p o t product p r i ces ) . Sec t ion B.2

is concerned wi th t h e d a t a used, w i th t h e va r ious sou rce of d a t a

and w i t h a c o m p a r i s o n be tween d i f f e r e n t s o u r c e s f o r t h e same

concep t . S e c t i o n B.3 p r e s e n t s t h e s t a t i s t i c a l a n a l y s i s of t h e

b a s i c h y p o t h e s i s which i s t h a t t h e 'netback' ( t h e v a l u e of t h e

p r o d u c t s o b t a i n e d from a b a r r e l of c r u d e l e s s t r a n s p o r t and

product ion c o s t s ) moves i n a d o l l a r f o r d o l l a r r e l a t i o n s h i p with

t h e s p o t c r u d e p r i c e a t t h e p o i n t o f s a l e . T h i s s i m p l e

h y p o t h e s i s is n o t s u p p o r t e d by t h e d a t a . S e c t i o n B.4 t h e n

o u t l i n e s some new h y p o t h e s e s , a s a r e a c t i o n t o t h e r e s u l t s of

s e c t i o n B.3, which a n a l y s e t h e e x t e n t t o which concen t r a t ion on a

s imple market i n e q u i l i b r i u m (as assumed i n B.3) does c o r r e c t l y

inco rpora t e prob 1 e m s r a i s e d by c e r t a i n impor t a n t i n s t i t u t i o n a 1

f e a t u r e s eg geograph ica l s e p a r a t i o n of markets, t h e e x i s t e n c e of

2

a two t i e r c r u d e p r i c e s y s t e m , and t h e e x i s t e n c e of r e f i n e r i e s

wi th d i f f e r e n t cos t s t r u c t u r e s . Some of t hese new hypotheses a r e

t h e m s e l v e s t e s t e d and t h e r e s u l t s p r e s e n t e d i n B.5. The

conclus ion t o s e c t i o n B is i n e f f e c t p a r t A of t h e paper so t h a t

no s e p a r a t e conclusion i s r e q u i r e d . The unifying d e v i c e f o r

hand1 i n g a v e r y complex marke t is t h a t of a s k i n g how t h e two

s i d e s (crude and products) would be r e l a t e d i f the market were i n

e q u i l i b r i u m and u s i n g t h e s i m p 1 i c a t i o n s t h a t t h i s p e r m i t s t o

carry out a s e r i e s of tests on t h e o p e r a t i o n of t h e market.

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PART A : PRIBCIPAL FIRDIIVGS OF THE STUDY

The b a s i c h y p o t h e s i s t h a t r u n s t h r o u g h a l l s t u d i e s

r e l a t i n g product p r i c e s t o crude p r i c e s i s t h a t t h e v a l u e of t h e

p r o d u c t s , n e t t e d back t o t h e p o i n t of s a l e of t h e c r u d e , should

be s y s t e m a t i c a l l y r e l a t e d t o t h e p r i c e of t h e c rude . The

d i f f e r e n c e between t h e two c o n c e p t s , which w e s h a l l c a l l t h e

" n e t b a c k margin", or s i m p l y t h e "margin", h a s been used a s a

measu re o f p r o f i t o r loss f o r r e f i n e r i e s o r as a tool t o d e c i d e

w h e t h e r t h e marke t i s s u b s t a n t i a l l y out of equi l ibr ium. There

has been an i m p l i c i t assumption t h a t t h e r e i s a ''normal" margin

between t h e two s e r i e s and t h a t t h e a c t u a l v a l u e of t h e margin i s

n o t expected t o move away from t h i s v a l u e by s u b s t a n t i a l amounts

or f o r l o n g p e r i o d s . We show t h a t , i n d e e d , i f t h e r e i s

e q u i l i b r i u m in t h e markets w i t h a p e r f e c t l y compe t i t i ve s t r u c t u r e

t h e n t h e n e t b a c k c o r r e c t l y c a l c u l a t e d f o r a m a r g i n a l r e f i n e r y

would b e e x p e c t e d t o b e s l i g h t l y a b o v e t h e c r u d e p r i c e b u t t o

move with it.

To t e s t t h i s hypothes is of t h e "normal" margin d a t a on

both ne tbacks and spot c rude is required. There i s no " o f f i c i a l "

d a t a on e i t h e r concept but t h e r e a r e s e v e r a l u n o f f i c i a l series of

d a t a . Comparing t h e d a t a o n i d e n t i c a l c o n c e p t s on a m o n t h l y

b a s i s over t h e p e r i o d 1 9 7 6 t o 1983 r e v e a l s two g e n e r a l and

important f ind ings . Sources d o d i f f e r s y s t e m a t i c a l l y o v e r t h e

w h o l e p e r i o d and t h e r e a r e s u b - p e r i o d s of g r e a t d i s a g r e e m e n t .

4

For crude d a t a fou r sources were used:

( i > OPEC B u l l e t i n

( i i ) Petroleum I n t e l l i g e n c e Weekly

( i i i ) Middle East Petroleum and Economic Pub l i ca t ions

( i v ) An indus t ry es t imate .

The main s p e c i f i c f i n d i n g s were t h a t t h e OPEC B u l l e t i n f i g u r e is

s i g n i f i c a n t l y g r e a t e r on average than t h e o t h e r sou rces over t h e

p e r i o d (by be tween one and two p e r c e n t ) . On a v e r a g e t h e o t h e r

t h r e e sources a r e c l o s e but vary between each o ther by an amount

e q u a l t o abou t 65 c e n t s . I n t h e f i r s t e i g h t months of 1 9 7 9 t h e

d i f f e r e n c e between sources i s o f t e n very g r e a t - f o r Arab Light

the maximum d i f f e r e n c e reaches $6 w h i l e for Nigerian t h e maximum

d i f f e r e n c e i s $3. This "measurement e r r o r " i n t h e spo t p r i c e i s

s o l a r g e t h a t no s t a t i s t i c a l work shou ld i n c l u d e t h i s period.

For netback d a t a t h r e e sou rces were u t i l i s e d :

(i) Petroleum I n t e l l i g e n c e Weekly

( i i ) OPAL

(iii) An i ndus t ry e s t ima te .

Netback d a t a d i s t i n g u i s h e s not on ly t h e crude used but a l s o t h e

l o c a t i o n of t h e r e f i n e r y and t h e t y p e of r e f i n e r y assumed.

Comparisons between t h e sources f o r i d e n t i c a l concepts r e v e a l e d a

c l o s e agreement between a l l t h r e e b u t w i th OPAL below b o t h o t h e r

sources f o r both crudes. Again t h e d i f f e r e n c e s between sources

a r e a t t h e i r g r e a t e s t i n 1979. Rather s u r p r i s i n g l y t h e agreement

between sources i s c l o s e r f o r netbacks than f o r crudes. However,

c l o s e n e s s of s e r i e s i s n e i t h e r a n e c e s s a r y n o r a s u f f i c i e n t

5

c o n d i t i o n f o r t h e s e r i e s to be a c c u r a t e , e v e n though i t d o e s

i n c r e a s e c o n f i d e n c e in t h o s e s e r i e s w h i c h a r e a r r i v e d a t

independent ly . Hence a l l t h e subsequent s t a t i s t i c a l work, which

i s b a s e d on u s i n g a s e r i e s which i s n o t an " o u t l i e r " , must b e a r

t h e q u a l i f i c a t i o n t h a t measurement e r r o r is p o s s i b l e . However it

is an i m p o r t a n t f i n d i n g t h a t n o n - i n d u s t r y p u b l i s h e d d a t a on

n e t b a c k s a r e v e r y c l o s e to t h o s e a c t u a l l y u s e d by an an a c t u a l

a g e n t . The d e t a i l e d knowledge of t h e m a r k e t d o e s n o t p roduce

n o t i c e a b l y d i f f e r e n t f i gu res .

Given the amount of measurement e r r o r t h a t t hese ser ies

r e v e a l i t i s q u i t e l i k e l y t h a t t h e o r e t i c a l models, based on i d e a l

d a t a , w i l l n o t be a b l e t o be f i t t e d e x a c t l y t o t h e d a t a . T h e r e

w i l l b e a n e r r o r t e r m of a n i r r e d u c i b l e minimum however t he

a n a l y s i s is conducted.

The d e t a i l e d e x a m i n a t i o n of d a t a on p r o d u c t n e t b a c k s

and spo t crude p r i c e s ove r t h e lengthy per iod 1976 t o 1983 makes

it c l e a r t h a t t h e r e is a very c l o s e t i e between t h e two s i d e s of

t h e o i l m a r k e t , i e be tween p r o d u c t s and c r u d e . However, t h e

exac t n a t u r e of t h e r e l a t i o n s h i p raises some i n t e r e s t i n g a s p e c t s

t h a t a r e u n l i k e l y t o h a v e b e e n a p p a r e n t s o l e l y f rom a p r i o r i

t h e o r i s i n g or from empi r i ca l a n a l y s i s of s h o r t runs of da ta .

The two major f i n d i n g s a r e t h a t :

(i) The r e l a t i o n s h i p between spot product netbacks and s p o t crude pr ices a p p e a r s t o b e e p i s o d i c (however t h e r e l a t i o n s h i p i s f o r m u l a t e d ) . The s h i f t i n g i n the r e l a t i o n s h i p d o e s n o t a p p e a r t o b e c o n t i n u o u s , i n d i c a t i n g the o m i s s i o n of some c o n t i n u a l l y v a r i a b l e factor, but is rather discontinuous, indicating the e f f e c t of a factor vhich changes at d iscrete in terva l s .

( i i ) The r e l a t i o n s h i p between the two series c o u l d only be c o n s i s t e n t v i t h a prof i t maximising o p e r a t i o n of t h e

6

market i f the period of adjustment to change i s slow and/or there are large fixed cost elerents involved in adjustment to large shifts in the market situation. The persistence of the netback a t a l e v e l below the spot p r i c e ( r a t h e r than above i t ) i s an important characteristic of the market which requires explanation. In particular the persistence of th i s phenomenon even when the data are analysed separately for each episode i d e n t i f i e d i n (i) c l e a r l y r e q u i r e s f u r t h e r inve s t i g a t ion.

The v i e w i m p l i c i t in t h e " t r a d e j o u r n a l s " a p p e a r s t o b e

t h a t t h e d i f f e r e n c e between t h e netback and t h e s p o t crude p r i c e s

- t h e netback margin - f l u c t u a t e s around a normal v a l u e (which is

by i m p l i c a t i o n c o n s t a n t ) . D e v i a t i o n s f rom t h e m a r g i n c a n be

t a k e n a s i n d i c a t i n g changes i n t h e s t a t e of t h e m a r k e t and a l s o

t h e f i n a n c i a l ( p r o f i t o r l o s s ) p o s i t i o n o f f i r m s . The "normal

margin" hypothesis has t o be d i sca rded for two s e p a r a t e reasons.

F i r s t l y , o v e r l o n g p e r i o d s , t h e a v e r a g e o r t y p i c a l m a r g i n

changes. F igu res I and I1 make i t c l e a r how sharp t h e s e changes

a r e . The second r e a s o n f o r a b a n d o n i n g t h e "normal marg in"

c o n c e p t , e v e n for i d e n t i f i e d e p i s o d e s , i s t h a t the d o l l a r € o r

d o l l a r response i t imposes can be b e t t e r e d by a r e l a t i o n s h i p w i t h

a m a r g i n t h a t v a r i e s c o n t i n u o u s l y w i t h t h e g e n e r a l o i l p r i c e

l e v e l . The e x i s t e n c e o f a p e r c e n t a g e r a t h e r t h a n a n a b s o l u t e

mark-up (or mark-down) r e c e i v e s s t r o n g s u p p o r t f rom t h e d a t a .

However, i t i s i m p o r t a n t t o n o t i c e t h a t t h i s p e r c e n t a g e m a r g i n

changes be tween e p i s o d e s and t h a t no f i n a l e x p l a n a t i o n for why

t h i s should be i s a r r i v e d a t .

The e p i s o d e s t h a t a r e i d e n t i f i e d f o r b o t h Arab L i g h t

and N i g e r i a n L i g h t a r e : ( a ) f rom J a n u a r y 1 9 7 6 t o l a t e i n 1978;

( b ) from l a t e 1978 t o l a t e summer 1 9 7 9 ; ( c > from l a t e summer

7

1979 t o sp r ing 1981; (d) from sp r ing 1981 t o t h e end of 1983.

In t h e first episode ( Jan 1976- l a t e 1978) spo t p r i c e s

and t h e netback a r e a lmost i n a d o l l a r f o r d o l l a r r e l a t i o n s h i p

( w i t h a s t a n d a r d e r r o r of e s t i m a t e of 30 c e n t s f o r Arab and 50

c e n t s f o r N i g e r i a n ) . T h i s seems t o f i t t h e e x p e c t e d p a t t e r n ,

p a r t i c u l a r l y f o r t h e indus t ry d a t a - t h e two s i d e s of t h e market

are very c l o s e l y r e l a t e d and t h e netback is s l i g h t l y h igher than

t h e s p o t p r i c e . T h i s wou ld be q u i t e c o n s i s t e n t w i t h a n M C = M R

cond i t ion f o r p r o f i t maximisation, wi th a f a 1 l i n g demand cu rve

h a v i n g a l o w e r MR t h a n t h e c o s t of p r o d u c t s and a r i s i n g c o s t

c u r v e wi th a higher MC than t h e cos t of r e f i n i n g average b a r r e l .

Both e f f e c t s would be expected t o be very s l i g h t ; hence t h e s m a l l

p o s i t i v e margin of t h e netback over spot i s not su rp r i s ing . The

very t i g h t f i t f o r t h i s per iod sugges t s t h a t i t is u n l i k e l y t h a t

o t h e r v a r i a b l e s w o u l d h a v e a s i g n i f i c a n t r o l e t o p l a y

( p a r t i c u l a r l y t h e o f f i c i a l p r i c e which was almost i d e n t i c a l t o

t h e s p o t p r i c e ) . T h i s p e r i o d , f o r R o t t e r d a m p r o d u c t p r i c e s , i s

c o n s i s t e n t w i th t h e "normal margin" hypothes is where t h e margin

is v e r y s l i g h t l y p o s i t i v e o r n e g a t i v e d e p e n d i n g on t h e d a t a

source. One s t r ange f i n d i n g (common t o a l l per iods) i s t h a t the

margin f o r Arab Light is c o r r e l a t e d wi th t h e margin f o r Nigerian

Light. I n equ i l ib r ium t h e r e would be no such c o r r e l a t i o n and so

t h i s suggests t h a t t h e r e are demand s i d e shocks (hence common t o

a l l c r u d e s ) which a r e f e l t on a l l p r o d u c t p r i c e s b u t which a r e

t r a n s l a t e d back to d i f f e r e n t d e g r e e s t o t h e v a r i o u s c r u d e s .

S ince t h e "normal margin" model is t h e b e s t f i t t i n g found f o r t h e

f i r s t e p i s o d e , t h e f i n d i n g c a n n o t be s i m p l y a t t r i b u t e d t o

8

s p e c i f i c a t i o n e r r o r .

The second episode, f rom l a t e 1 9 7 8 t o mid 1979, saw a

l a r g e number of unexpected e v e n t s and e x t e r n a l p r ice movements

a p p e a r in a v e r y s h o r t p e r i o d . I t can s c a r c e l y be t r e a t e d a s a

s i n g l e homogeneous p e r i o d ( e v e n t h e d a t a i s more t h a n u s u a l l y

suspect) and a l l a t tempts t o do so produced r e l a t i o n s h i p s of t o o

poor a s t a t i s t i c a l f i t f o r u s e f u l a n a l y s i s . The one s t r i k i n g

f e a t u r e of t h i s p e r i o d ( o f t e n t h o u g h t of as b e i n g domina ted by

t h e s u p p l y d i s r u p t i o n of t h e I r a n i a n r e v o l u t i o n ) i s t h a t

on averaRe netbacks were some 5 % higher than s p o t f o r Arab Light

and 12% higher f o r Nigerian Light. This f i n d i n g is a l l t h e more

remarkable because i n a l l o t h e r episodes netbacks have been on

average below s p o t pr ices . Rowever, the v a r i a t i o n s w i t h i n t h e

p e r i o d a r e so g r e a t t h a t o n l y a m o n t h by month a n a l y s i s of t h e

f i g u r e s b a s e d on i n s t i t u t i o n a l and f a c t u a l m a t e r i a l c o u l d

e s t a b l i s h any f i rm conclusion.

The t h i r d episode, s t r e t c h i n g f rom l a t e i n 1979 t o

e a r l y in 1981, corresponds to a period i n which t h e s p o t p r i c e of

t h e crude i n q u e s t i o n was above t h e o f f i c i a l p r i ce . This can be

i n t e r p r e t e d as a per iod of excess demand ( a t the g i v e n o f f i c i a l

p r i c e s ) where l i m i t e d s u p p l i e s meant t h a t b u y e r s of m a r g i n a l

c a r g o s w e r e w i l l i n g t o pay more t h a n t h e o f f i c i a l p r i c e . Fo r

t h i s p e r i o d t h e "normal margin" was v e r y s t r o n g l y n e g a t i v e -

(around $3 f o r Arab Light and $2 f o r Nigerian). There has been a

temptat ion t o suggest t h a t t h i s i n d i c a t e s producers ope ra t ing a t

a loss, b u t t h i s i g n o r e s t h e d i f f e r e n c e be tween m a r g i n a l and

a v e r a g e c o n c e p t s . S i n c e most c r u d e was bough t a t o f f i c i a l

9

p r i c e s , below t h e spo t p r i c e , t h e t o t a l c o s t s of r e f i n i n g cou ld

w e l l have been below t h e t o t a l revenue even though t h e marginal

c o s t f o r t h e r e f i n e r y chosen was above marginal revenue according

t o t h e d a t a .

For t h i s p e r i o d t h e p e r c e n t a g e m a r g i n model e x p l a i n s

t h e d a t a b e t t e r t han t h e a b s o l u t e margin model, and g i v e s a Saudi

netback a t 90% of s p o t p r i c e and a Nigerian netback of 95% of t h e

spo t p r i ce . The accuracy of t h e equa t ions i s s u b s t a n t i a l l y l e s s

than those f o r t h e f i r s t per iod f o r Arab L igh t , suggest ing t h a t

some o t h e r v a r i a b l e may be invo lved . The low v a l u e of t h e Durbin

Watson s t a t i s t i c confirms t h i s f inding. There a r e two cand ida te s

f o r i n c l u s i o n i n t h e equations. F i r s t l y , t h e o f f i c i a l p r i c e must

be t e s t e d s i n c e , i n a p e r i o d when t h e s p o t i s h i g h e r t h a n t h e

o f f i c i a l p r i c e i t m i g h t b e e x p e c t e d t h a t t h e l o w e r p r i c e wou ld

d e t e r m i n e p r o d u c t p r i c e s , a t l e a s t i n p a r t . When b o t h s p o t and

o f f i c i a l p r i c e s were included a s exp lana to ry v a r i a b l e s f o r t h e

n e t b a c k t h e n t h e s p o t v a r i a b l e c o n t i n u e d t o be s t r o n g l y

s i g n i f i c a n t , but t h e o f f i c i a l p r i c e was comple t e ly i n s i g n i f i c a n t

and added n o t h i n g t o t h e d e g r e e of e x p l a n a t i o n . T h i s i s s t r o n g

c o n f i r m a t i o n of t h e h y p o t h e s i s t h a t p r i c i n g was c a r r i e d o u t o n

m a r g i n a l i s t l i n e s and n o t on an average c o s t basis . T e s t s were

a l s o c a r r i e d o u t f o r t h e p r e s e n c e of l a g s by a n a l y s i n g spot

p r i c e s l e a d i n g n e t b a c k s and n e t b a c k s l e a d i n g s p o t p r i c e s . No

e v i d e n c e f o r l a g g e d r e l a t i o n s h i p s ( w i t h o r w i t h o u t o f f i c i a l

p r i c e s ) cou ld be found f o r t h i s episode.

Hence f o r t h e per iod of excess demand t h e d a t a s u p p o r t s

a h y p o t h e s i s of m a r g i n a l i s t p r i c i n g w i t h r a p i d a d j u s t m e n t t o

10

s h o c k s a r i s i n g f rom e i t h e r side of t h e marke t . The one f e a t u r e

wh ich c a n n o t b e s o s i m p l y e x p l a i n e d is t h e d e g r e e t o wh ich t h e

netback i s p e r s i s t e n t l y below t h e spo t pr ice . If it was p u l l e d

down by t h e o f f i c i a l p r i c e we migh t h a v e e x p e c t e d t o f i n d t h e

o f f i c i a l p r i c e s i g n i f i c a n t . The d a t a from a l l sources confirms

t h i s n e g a t i v e margin and f o r a genuinely marginal r e f i n e r y t h e

n e t b a c k would h a v e been l o w e r s t i l l . I n o r d e r t o a r g u e t h a t

marginal revenue was s y s t e m a t i c a l l y underestimated by t h e netback

c o n c e p t i t would be n e c e s s a r y t o show t h a t t h e s p o t p r o d u c t

p r i c e s were n o t t h e a p p r o p r i a t e marginal concepts and were lower

than t h e t r u e marginal revenues from products , o r t h a t t h e c o s t s

n e t t e d o u t ( t r a n s p o r t , r e f i n e r y e t c . ) were t o o l a r g e . S i n c e

t h e s e cos t elements were probably less than a d o l l a r i n t o t a l t h e

margin of e r r o r on t h e c o s t s i d e cou ld not p o s s i b l y e x p l a i n t h e

n e g a t i v e netback margin.

The o b s e r v a t i o n t h a t n e t b a c k s were b e l o w s p o t c r u d e

p r i c e s t h e n p r e s e n t s a p r o b l e m of i n t e r p r e t a t i o n . I t i s w e l l

known t h a t some r e f i n e r s r a n a t a loss and o u r d a t a m e r e l y

a p p e a r s t o c o n f i r m it . Even t h e p e r s i s t e n c e of t h e l o s s o v e r a

year and a h a l f is eas i ly exp la ined i f t h e r e a r e l a r g e e x i t and

r e - e n t r y c o s t s ( m o t h b a l l i n g c o s t s ) . C l e a r l y i t c a n o f t e n be

b e t t e r t o run a t a s m a l l l o s s t han t o incur t h e s e l a r g e shutdown

c o s t s . However t h e p e r s i s t e n c e of mara ina l l o s s e s cannot be so

e a s i l y explained. Sec t ion B4 of t h e paper a n a l y s e s a series of

a s p e c t s of t h e m a r k e t i n o r d e r t o s e e w h e t h e r i n s t i t u t i o n a l

f a c t o r s c o u l d e x p l a i n t h i s f i n d i n g . I t i s a r g u e d t h a t u n l e s s

t h e r e i s g e n e r a l n o n - p r o f i t making b e h a v i o u r w e do n o t h a v e a n

11

adequate exp lana t ion f o r t h i s phenomenon. Thus w e must conclude

t h a t t h e t h i r d e p i s o d e p r e s e n t s a p u z z l e - p r i c e s were s e t o n a

m a r g i n a l i s t b a s i s but t h e r e was a p e r s i s t e n t margina l l o s s on t h e

d a t a a s c a l c u l a t e d .

The final episode, which r u n s f r o m e a r l y 1 9 8 1 t o end

1983, a l s o p re sen t s a complex p i c tu re . The percentage margin and

a b s o l u t e margin hypotheses work e q u a l l y w e l l and both show t h e

netback below t h e spo t p r i c e f o r Arab Light , w i t h Nigerian Light

showing a lmost a d o l l a r f o r d o l l a r r e l a t i o n s h i p . The goodness of

f i t is b e t t e r t h a n i n t h e p r e v i o u s e p i s o d e and as good a s t h e

f i r s t episode f o r Nigerian (but no t f o r Arab Light) . The period

of t h e f i n a l e p i s o d e w a s one i n which t h e s p o t p r i c e was l ower

than t h e o f f i c i a l pr ice . S ince t h i s phenomenon is d i f f i c u l t t o

e x p l a i n i n a t w o - t i e r marke t s y s t e m u n l e s s b u y e r s t a k e a

p o r t f o l i o t y p e choice even a t t h e margin ( i e buy some o f f i c i a l

even though i t is more expens ive than spot ) , t e s t s were c a r r i e d

o u t t o s e e w h e t h e r t h e o f f i c i a l p r i c e a s we1 1 as the s p o t p r i c e

a f f e c t e d t h e netback. There was confirmation of t h i s hypothesis

for Arab Light but not f o r Niger ian Light. Such a f ind ing could

be e x p l a i n e d i f b u y e r s f e l t i t l e s s i m p o r t a n t t o pay t h e

i n s u r a n c e of p u r c h a s i n g N i g e r i a n a t o f f i c i a l p r i c e s t h a n

purchasing Saudi a t o f f i c i a l p r i ces .

A second, unusua l , f e a t u r e of t h e l a s t episode i s t h a t

f o r t h e f i r s t time ev idence of lagged r e a c t i o n s was found. The

spo t p r i c e was r e l a t e d t o both t h e cu r ren t and one month lagged

netback f o r bo th Arab and Niger ian crudes. It i s n o t obvious why

t h e r e s h o u l d be a l a g t o demand s i d e i n f l u e n c e s only when t h e

12

s p o t is below t h e o f f i c i a l pr ice . The e f f e c t was small ( w i t h an

ave rage l a g of one week) and o n l y w i t h d a t a based on s h o r t e r time

pe r iods could a proper dynamic a n a l y s i s be undertaken.

Even f o r t h e f i n a l episode when netbacks a r e r e l a t e d t o

s p o t and o f f i c i a l p r i c e s (and o f f i c i a l p r i c e s a r e h i g h e r t h a n

s p o t ) t h e sum of t h e c o e f f i c i e n t s i s less than un i ty , i n d i c a t i n g

a l o s s a t t h e margin. Since the netback i s c a l c u l a t e d t o be l e s s

t h a n t h e s p o t p r i c e t h e n e v e n on a n a v e r a g e c o s t i n g b a s i s a

r e f i n e r y would show a loss according t o these f igu res . Hence t h e

f i n a l p e r i o d p r o v i d e s d a t a which s u g g e s t s t h a t t h e p e r i o d of

a d j u s t m e n t t o a new marke t s t r u c t u r e i s v e r y l e n g t h y ( o v e r 4

y e a r s ) o r t h a t o n a c o n v e n t i o n a l c o s t i n g b a s i s most r e f i n e r i e s

a r e prepared not t o prof it maximise because continued product ion

s e r v e s o t h e r ends. These f i n d i n g s mus t be l o o k e d a t i n t h e

con tex t of t h e wider range of d a t a on r e f in ing . The s t a t i s t i c a l

a n a l y s i s has concent ra ted l a r g e l y on b a s i c r e f i n i n g a t Rotterdam.

T h i s c h o i c e took i n t o a c c o u n t s e v e r a l f a c t o r s . F i r s t l y , i t

a l l o w e d t h e l o n g e s t r u n o f d a t a . S e c o n d l y , i f m a r k e t s a r e i n

e q u i l i b r ium then t h e netback should be t h e same everywhere except

f o r random f l u c t u a t i o n s . Th i rd ly , on a m a r g i n a l i s t argument i t

wou ld be t h e h i g h e s t c o s t p l a n t s u r v i v i n g i n a n i n d u s t r y t h a t

w o u l d j u s t b r e a k e v e n and which s h o u l d t h e r e f o r e be u s e d f o r

t e s t s concerning market behaviour. Data on complex r e f i n i n g show

t h e n e t b a c k h i g h e r t h a n t h e s p o t p r i c e f o r most o f t h e f i n a l

pe r iod under study. This of course i s n o t a proof t h a t e v e n such

a r e f i n e r y o p e r a t e d a t a p ro f i t ( b e c a u s e o f f i c i a l p r i c e s were

somet imes h i g h e r s t i l l ) b u t d o e s warn a g a i n s t t h e u s e of

13

gene ra l i s a t i o n s on prof i t s or l o s s e s .

A n a l y s i s of t h e m o d e l s when a p p l i e d t o n e t b a c k s as

d i f f e r e n t i a t e d by l o c a t i o n ( and by t e c h n o l o g y ) shows t h a t as

be tween c e n t r e s t h e r e s u l t s a r e v e r y s i m i l a r . Ne tbacks a r e

r e l a t e d to s p o t p r i c e s when t h e r e is " e x c e s s demand'' d u r i n g t h e

t h i r d episode, and a r e r e l a t e d t o both spo t and o f f i c i a l p r i c e s

d u r i n g t h e f o u r t h e p i s o d e when t h e r e i s " e x c e s s supply." The

weakest l i n k between netbacks and crude p r i c e s appears t o be f o r

t h e US case. In g e n e r a l , t h e r e l a t i o n between Rotterdam netbacks

and c r u d e p r i c e s f o r Arab L i g h t i s as c l o s e a s f o r any o t h e r

c e n t r e .

The a n a l y s i s of t h e r e l a t i o n s be tween t h e p r o d u c t

p r i c e s , as summarised by t h e netback, and crude p r i c e s shows t h a t

t h e two s i d e s of t h e market a r e very c l o s e l y I inked on a month by

month bas i s . The n a t u r e of t h e l i n k has changed, n o t always i n a

p r e d i c t a b l e f a s h i o n (eg between t h e f i r s t and t h i r d episodes) ,

b u t t h e r e l a t i o n s h i p s seem f a i r l y s t a b l e o v e r t h e medium r u n .

There is, however, a r e s i d u a l d i f f e r e n c e between t h e s e r i e s which

a p p e a r s t o b e u n p r e d i c t a b l e . The a v e r a g e m a g n i t u d e of t h i s

u n e x p l a i n e d component i s a t l e a s t a b o u t 50 c e n t s . T h i s means

t h a t ( u s i n g t h e u s u a l 9 5 % c o n f i d e n c e i n t e r v a l ) g i v e n t h e s p o t

p r i c e t h e n e t b a c k c a n be p r e d i c t e d w i t h i n p l u s o r minus $1 ( and

v i c e v e r s a ) . It d o e s n o t a p p e a r l i k e l y , g i v e n t h e p r e s e n c e of

measurement e r r o r s i n t h e d a t a , t h a t any s u b s t a n t i a l improvement

can e a s i l y be made i n t h e e x p l a n a t i o n of t h e r e l a t i o n s h i p between

t h e two s i d e s of t h e marke t . I t i s p o s s i b l e t h a t v e r y complex

dynamic m o d e l s m a y improve t h e f i t of t h e model and i n d e e d t h e

14

s h i f t i n g m a r g i n h a s i t s e l f to be e x p l a i n e d . However t h e

t e c h n i q u e s r e q u i r e d would p r o b a b l y be of a n o r d e r o f magn i tude

more d i f f i c u l t t o u s e and t h e p o t e n t i a l g a i n f rom any a p r i o r i

model r a t h e r u n c e r t a i n and p o s s i b l y s m a l l . The marg in of

accuracy of e x p l a n a t i o n is c r u c i a l when we t u r n t o t h e o t h e r use

of netbacks - t h a t of judging whether o f f i c i a l d i f f e r e n t i a l s a r e

o u t of l i n e . The t e c h n i q u e , a s e x p l a i n e d by PIW, is t o compare

t h e n e t b a c k / o f f i c i a l d i f f e r e n t i a l f o r v a r i o u s c r u d e s . Those

which a r e h i g h ( o r low) r e l a t i v e t o t h e d i f f e r e n t i a l f o r t h e

"marker" (Arab L i g h t ) i n d i c a t e w h e t h e r an o f f i c i a l p r i c e i s

r e l a t i v e l y t o o low ( o r h igh) . S y m b o l i c a l l y w e c a l c u l a t e f o r

example :

(MN - NO) - ( S A - SO> (1)

where :

NN = Nigerian netback NO = O f f i c i a l p r i c e of Nigerian Light SN = Saudi netback SO = O f f i c i a l p r i c e of Arab Light .

If this i s z e r o the o f f i c i a l p r i c e s a r e s a i d t o be i n

l i n e wi th market r e a l i t i e s - i f i t i s p o s i t i v e t h e o f f i c i a l p r i c e

of N i g e r i a n i s r e l a t i v e l y t o o low, w h i l e i f i t i s n e g a t i v e t h e

o f f i c i a l p r i c e of N i g e r i a n is r e l a t i v e l y t o o h igh . T h i s

c a l c u l a t i o n assumes t h a t t h e n e t b a c k s d o a c t u a l l y measu re t h e

v a l u e of t h e c r u d e a t t h a t t i m e and t h a t t h e m a r g i n i s a b s o l u t e

and not r e l a t i v e . The measurement e r r o r s i n t h e netback toge ther

w i t h t h e e v i d e n c e t h a t n e t b a c k s d o n o t measu re t h e e q u i l i b r i u m

v a l u e of t h e c r u d e a t t h e m a r g i n i m p l i e s t h a t t h e r e w i l l b e a

15

random term or even a systematic term missing from (1). Hence a

systematic study of d i f f e r e n t i a l s would be needed t o investigate

t h e i r behaviour and i n p a r t i c u l a r t h e r e l a t i v e s i z e of spot

d i f f erent ia 1 s t o ne tback d i f f e r e n t i a l 6.

16

PART B : DETAILED ABULYSIS

B. 1 THE BELBTIOB BETWEEH SPOT CRUDE PRICES ARD SPOT PRODUCT VALUES

The b a s i c hypothes is i s t h a t crude p r i c e s and t h e v a l u e

of t h e p r o d u c t s o b t a i n e d f rom t h e c r u d e a r e s y s t e m a t i c a l l y

r e l a t e d . S p e c i f i c a l l y we c a n c o n s i d e r t h e % y i e l d of p r o d u c t s

(naphtha, g a s o l i n e , f u e l o i l e t c ) from crude o i l f o r a " typ ica l "

r e f i n e r y . The sum of t h e s h a r e s times t h e p e r u n i t p r i c e f o r

each product i s known as t h e "gross product va lue" (worth) and i s

t h e revenue f o r t h a t r e f i n e r y r e s u l t i n g from the r e f i n i n g of one

e x t r a b a r r e l o f o i l . I n o r d e r t o compare t h i s w i t h t h e c o s t of

i n p u t s w e must look a t t h e c o s t o f t h e c r u d e o i l c i f , and t h e

o the r r e f i n i n g costs. I f we concen t r a t e on a shor t - run marginal

a n a l y s i s t h e n t h e r e i s no e x t r a c a p i t a l c o s t i n v o l v e d i n

r e f i n i n g another b a r r e l of o i l (below f u l l capac i ty ) but t h e r e

a r e r u n n i n g c o s t s of o p e r a t i n g t h e r e f i n e r y . I t wou ld t h u s be

p o s s i b l e t o b u i l d up t h e e x t r a s h o r t - r u n c o s t s by t a k i n g t h e

crude o i l p r i c e ( a p p r o p r i a t e l y def ined) fob, adding on t r a n s p o r t

and insurance c o s t s t o o b t a i n t h e c i f o i l p r ice and then adding

on t h e r e f i n i n g c o s t . The r e s u l t i n g c o s t could b e compared t o

t h e r e v e n u e f i g u r e . However , i n d u s t r y p r a c t i c e h a s been t o

"Netback" t h e revenue by s u b t r a c t i n g r e f i n i n g c o s t s and t r a n s p o r t

c o s t s t o o b t a i n t h e "value" of the o i l i n t h e p r o d u c e r c o u n t r y .

T h i s c o n c e p t i s known by s e v e r a l names: o f t e n c a l l e d t h e " fob

1 7

n e t b a c k " o r t h e " i m p l i e d f o b c r u d e o i l n e t b a c k v a l u e ' ' (OPAL) or

t he ''spo t product e q u i v a 1 e n t v a 1 uel' ( i ndus t ry t e r m ino 1 ogy).

The d i f f e r e n c e between what w e s h a l l from now on c a l l

t h e "netback" and t h e c r u d e p r i c e , w e s h a l l c a l l t h e "ne tback

margin". The r e s u l t i n g f i g u r e is f r e q u e n t l y used in t w o ways :

( i ) "General ly , t h e spo t v a l u e of t h e r e f i n e d b a r r e l a t t h e

producer ' s l o a d i n g p o r t i s compared w i t h .... c r u d e p r i c e s t o

determine p r o f i t o r l o s s " (PIW(supp) 7 March 83 p4).

( i i ) Dif fe rences between spo t product v a l u e s of the major

c rude o i l s are r e l a t e d t o d i f f e r e n c e s i n o f f i c i a l crude ( f o r t h e

same p a i r s of c r u d e s ) t o show w h e t h e r " t h e v a r i a t i o n s o r

" d i f f e r e n t i a l s " among the o f f i c i a l crude p r i c e s a r e a l i g n e d w i t h

s p o t product market r e a l it ies" (PIW, ib id) .

I n a l l s u c h a p p l i c a t i o n s t h e d i f f e r e n c e be tween t h e

r e l a t e d s e r i e s have been c a l c u l a t e d which i m p l i e s t h e e x i s t e n c e

of a 'normal' a b s o l u t e margin between the series. I n f a c t , t h e r e

are f o u r d i s t i n c t t ypes of netback margin t h a t can be c a l c u l a t e d

and t h i s i s o n e s o u r c e of v a r i a t i o n t h a t mus t be a l l o w e d f o r .

The p l u r a l i t y arises because crude o i l is s o l d e i t h e r on t h e s p o t

m a r k e t ( a t s p o t p r i c e s ) o r a t o f f i c i a l p r i c e s , and p r o d u c t s a r e

s o l d e i t h e r on t h e s p o t p r o d u c t m a r k e t ( a t t h e f a c t o r y g a t e ) o r

a t c o n t r a c t p r i ces . Furthermore, it i s p o s s i b l e (OPAL) t o extend

t h e l e n g t h of t h e c h a i n of n e t t i n g back by s t a r t i n g w i t h t h e

i n l a n d ' ' m a r k e t p r i c e s of p r o d u c t s and s u b t r a c t i n g d u t i e s and I'

marketing c o s t s ( t o give composite proceeds ex-ref inery).

18

I n f a c t s t a n d a r d a n a l y s i s of t h e c r u d e o i l m a r k e t

( r a t h e r than t h e product market) concen t r a t e s on using t h e s p o t

product concept and combining t h i s e i t h e r w i t h spo t crude p r i c e s

o r w i t h o f f i c i a l crude p r i ces .

B e f o r e w e t u r n t o t h e q u e s t i o n of which of t h e s e two

, m a r g i n s t o examine we must f i r s t look in more d e t a i l a t t h e

c a l c u l a t i o n of t h e netback i t s e l f . The netback is r e f e r r e d t o by

t h r e e c r i t i c a l parameters:

(i) t h e t y p e of crude being used;

(ii)

( i i i )

t h e type of r e f i n i n g process being used;

t h e l o c a t i o n of t h e r e f i n e r y .

The f i r s t two c a t e g o r i e s must be t aken into account because t h e r e

i s no u n i v e r s a l l y t y p i c a l r e f i n e r y - t h e y i e l d s v a r y b e t w e e n

c r u d e s , t h e y a l s o depend on t h e t y p e and l o c a t i o n of t h e

r e f i n e r y . The c r u d e s w e c o n s i d e r a r e j u s t Arab L i g h t and

N i g e r i a n L i g h t , b u t t h e s e h a v e d i s t i n c t l y d i f f e r e n t y i e l d

percentages a s the PIW annual supplement r e v e a l s . Furthermore,

e v e n f o r a g i v e n t y p e of r e f i n i n g t h e t y p i c a l o r a v e r a g e y i e l d

f o r a p a r t i c u l a r c r u d e w i l l v a r y b e t w e e n l o c a t i o n s , b e c a u s e

r e f iaeries a r e s p e c i f i c a l l y designed w i t h l o c a l demand c o n d i t i o n s

i n mind. Hence PIW u s e s y i e l d p e r c e n t a g e s w h i c h a r e c r u d e and

l o c a t i o n s p e c i f i c f o r t h e same t y p e o f r e f i n i n g . T h e r e a r e s i x

19

l o c a t i o n s f o r r e f i n e r i e s used by PIW:

( i ) Rotterdam

( i i ) US Gulf Coast

( i i i ) Caribbean

( i v ) P e r s i a n Gulf

( v ) Singapore

( v i ) I t a l y .

Other sources concen t r a t e on Rotterdam and/or t h e US Gulf .

The techniques of r e f i n i n g assumed by t h e v a r i o u s d a t a

sources a r e d i f f e r e n t , eg PIW assumed t h a t non-US r e f i n e r i e s a r e

of a s imple toppinglreforming type w h i l e its f i g u r e f o r t h e US is

for a c o n v e r s i o n t y p e r e f i n e r y . OPAL u s e s f o r R o t t e r d a m b o t h

b a s i c hydro-skimming (p r imary d i s t i l l a t i o n and r e f i n i n g ) and

c o n v e r s i o n ( c a t a l y t i c c r a c k i n g and a l k y l a t i o n ) t y p e r e f i n e r i e s .

These two t y p e s of r e f i n e r y w e s h a l l r e f e r t o a s b a s i c and

complex ( a l though the l a t t e r is something of a h o l d a l l term).

G i v e n t h a t we d e c i d e wh ich r e f i n e r y we w i s h t o u s e w e

must t h e n v a l u e i t s p r o d u c t s by l o c a l s p o t p r o d u c t v a l u e s and

s u b t r a c t m a r g i n a l r u n n i n g c o s t s , i n s u r a n c e c o s t s and f r e i g h t

c o s t s . This l a s t i s c a l c u l a t e d on a m a r g i n a l b a s i s u s i n g

Wor ldsca le f r e i g h t r a t e s from t h e producer country t o t h e country

i n which t h e r e f i n i n g i s being eva lua ted .

From d e f i n i t i o n s w e n e x t t u r n t o t h e b a s i c h y p o t h e s i s

which is t h a t , f o r a g iven crude, t h e netback and crude p r i c e a r e

r e l a t e d . G i v e n t h a t w e h a v e d e c i d e d t o u s e s p o t p r o d u c t

v a l u a t i o n s w e must d e c i d e which c r u d e p r i c e t o use . The

c a l c u l a t i o n s a re e x p l i c i t l y on a margina l b a s i s , as t h e exc lus ion

20

of c a p i t a l c o s t e lements makes c l e a r . Hence t h e c o r r e c t p r i c e i s

t h a t which i s m a r g i n a l t o t h e buyer . Here i t m i g h t be t h o u g h t

t h a t t h e lower of t h e o f f i c i a l and s p o t p r i c e s would be marg ina l ,

but t h i s ignores how a t w o - t i e r p r i c e s y s t e m o p e r a t e s . We must

a s k why t h e two p r i c e s a r e n o t e q u a l i s e d by p u r c h a s e s s h i f t i n g

demand t o t h e l o w e r (and d r i v i n g i t u p u n t i l t h e two meet). I f

t h e s p o t p r i c e i s a b o v e t h e o f f i c i a l , i t i s h e l d t h e r e by t h e

r a t i o n i n g of s u p p l i e s on t h e o f f i c i a l m a r k e t - i n s u c h a

s i t u a t i o n t h e s p o t p r i c e is g e n u i n e l y m a r g i n a l . The more

d i f f i c u l t c a s e i s t h a t where t h e s p o t is ( p e r s i s t e n t l y ) b e l o w

o f f i c i a l . Given t h a t n o t a l l crude is being bought on s p o t t h i s

w i l l only happen i f t h e r e is some reason f o r p r e f e r r i n g o f f i c i a l

o i l d e s p i t e t h e f a c t t h a t it is more expensive. We w i l l r e t u r n

t o this po in t later and assume f o r t h e p r e s e n t t h a t spot crude is

t h e m a r g i n a l s o u r c e of s u p p l y where s p o t p r i c e s a r e a b o v e o r

below o f f i c i a l p r i c e s .

Thus t h e b a s i c h y p o t h e s i s i s t h a t t h e n e t b a c k (NI i s

r e l a t e d t o t h e s p o t crude ('3) pr i ce :

N = f (SI (2 )

T r a d i t i o n a l l y a n a l y s i s has centred on t h e margin between those

two magnitudes so t h a t w e cou ld s p e c i a l i s e t h e f u n c t i o n t o

N = a + S (3 )

Since t h e r e l a t i o n s h i p i s n o t thought t o h o l d i d e n t i c a l l y a t a l l

t i m e s we can make i t s t o c h a s t i c by adding a t e r m U, which s t a n d s

for t h e sum of a l l o t h e r i n f l u e n c e s on t h e r e l a t i o n :

Nt = a + S, + ut (4)

where t h e s u b s c r i p t d e n o t e s t h e t i m e p e r i o d . The t e r m U s h o u l d

21

e x h i b i t no s y s t e m a t i c b e h a v i o u r - i f i t d o e s t h e n t h e

r e l a t i o n s h i p between t h e netback and t h e spot c rude p r i c e would

n o t be just on a v e r a g e a c o n s t a n t . Hence it would n o t b e

p o s s i b l e t o dec ide whether a p a r t i c u l a r v a l u e of t h e margin was

high or low - t h i s would have t o be decided r e l a t i v e t o t h e o the r

f a c t o r s determining t h e margin. Another way t o look a t t h e same

p o i n t i s t h a t i n d e c i d i n g w h e t h e r a p a r t i c u l a r v a l u e of t h e

marg in was u n u s u a l l y h i g h o r low t h e v a r i a n c e of t h e random

f l u c t u a t i o n (U> i s a c r i t i c a l component. I f we were a b l e t o

e x p l a i n p a r t of U b y i n c l u d i n g e x t r a f a c t o r s t h e n t h e r a n g e o f

randomness for t h e margin would decrease and we should be a b l e t o

spo t more e a s i l y when an i n d i v i d u a l v a l u e was abnormal.

E q u a t i o n ( 4 ) p r o v i d e s a p u r e l y mechanis t ic hypothes is

t o tes t . Although w e have i m p l i c i t l y suggested t h a t t h e concepts

used a r e margina l revenues and c o s t s w e have not y e t s p e l l e d ou t

t h e economic a s s u m p t i o n s which would j u s t i f y s u c h c l a i m s , and

w i t h o u t which a h y p o t h e s i s of how t hey a r e l i n k e d c a n n o t be

constructed. This deeper ques t ion is taken up i n s e c t i o n B.3.

22

B.2 THE DATA

B . 2 . 1 SPOT CRUDE PRICES

The d i s t i n g u i s h i n g f e a t u r e of spot p r i c e d a t a for crude

o i l is t h a t t h e r e i s no o f f i c i a l s e r i e s . I n s t e a d i n t e r e s t e d

p a r t i e s , s u c h as p r o d u c e r s , r e f i n e r s and c o n s u l t a n c i e s t e n d t o

produce t h e i r own f i g u r e s , This has r e s u l t e d i n a m u l t i p l i c i t y

of e s t ima tes f o r t h e same concept, caused i n p a r t by t h e l a c k of

an agreed methodology and i n p a r t by c e r t a i n f e a t u r e s of t h e o i l

market.

Crude o i l i s no t t raded on a p a r t i c u l a r market “ f l o o r ”

- t h e r e is no l o c a t i o n a t which a l l t h e d e a l s a r e made and a t

which t h e d a t a might be c e n t r a l l y r e g i s t e r e d . In s t ead d e a l s are

i n d i v i d u a l l y r e g i s t e r e d between agen t s who a r e spread worldwide.

Hence d a t a must b e c o l l e c t e d by some form of s u r v e y approach .

T h i s l e a d s t o a f i r s t s o u r c e of v a r i a t i o n - an a g e n t a t a

p a r t i c u l a r t i m e may b e a b l e t o p r o v i d e a p r i c e “done” (ie

a c t u a l l y t r ansac ted ) or m e r e l y a pr ice I’offered”. Pub1 i c a t i o n s

which sometimes r e p o r t both f o r t h e same time per iod sugges t t h a t

a t p re sen t ( i n a r a t h e r t r a n q u i l environment) t h e s e two concepts

a r e v e r y c l o s e . Hence t h e r e i s a s o u r c e of a m b i g u i t y i n t h i s

a s p e c t of t h e d a t a . T h i s sho r t - coming is l i k e l y t o be more

s e r i o u s i n t h e f i r s t p a r t of our per iod , when t h e spo t market was

v e r y “ t h i n “ and few t r a n s a c t i o n s a c t u a l l y t o o k p l a c e e v e n € o r

major crudes.

23

A second p r o b l e m f o r s p o t p r i c e d a t a i s t h e d a t i n g of

t h e c o n t r a c t . I f w e a r e c o n s i d e r i n g , s a y , December p r i c e s w e

c o u l d e i t h e r f o c u s on p r i c e s " in t h e month" o r p r i c e s " f o r t h e

month". The fo rmer r e f e r s t o c o n t r a c t s made i n December wh ich

w i l l a c t u a l l y be implemented some l i t t l e t i m e ( u p t o 2 o r 3

months) ahead , w h i l e t h e l a t t e r r e f e r s t o p r i c e s s e t on o r

be fo re December t h a t w i l l be payable on o i l r e c e i v e d i n December.

C l e a r l y t h e l a t t e r w i l l be much more l a b o r i o u s t o b u i l d up on a

t i m e s e r i e s b a s i s . These two c o n c e p t s a l s o s u g g e s t t h a t

d i f f e r e n t a g e n c i e s may h a n d l e t h e d a t i n g p r o b l e m in d i f f e r e n t

ways. I n f a c t , s i n c e t h e r e i s no c l e a r s t a t e m e n t of t h e

p r i n c i p l e s on which any series i s c a l c u l a t e d , i t i s not p o s s i b l e

t o come t o any d e c i s i o n as t o which s e r i e s i s t h e b e s t for

e m p i r i c a l work. We need t o l o o k a t a l l t h e s o u r c e s and compare

t h e i r performance.

For t h e purposes of this study w e ob ta ined monthly d a t a

from four d i f f e r e n t sources.

(1) OPEC B u l l e t i n

We c a l l t h e s p o t p r i c e s f rom t h i s s o u r c e SSO and NSO.

This s o u r c e , which is a v a i l a b l e on a w e e k l y b a s i s , b e g i n s i n

J a n u a r y 1 9 7 9 and r u n s c o n t i n u o u s l y u n t i l t h e end of our p e r i o d

(December 1983). It is a n a v e r a g e of 4 w e e k l y f i g u r e s and i s a

mid-month f igu re .

( 2 ) Middle Eas t Petroleum and Economic P u b l i c a t i o n s (MEPEP)

T h i s d a t a s o u r c e p r o v i d e s w e e k l y d a t a f r o m t h e

b e g i n n i n g of our p e r i o d (which s t a r t s at J a n u a r y 1976) . The

week ly a v e r a g e s a g a i n p r o d u c e a mid-month f i g u r e . W e d e n o t e

24

t h e s e by SSM and NSM.

( 3 ) Indus t ry Sources

Many l a r g e r e f i n i n g and producing companies c o n s t r u c t

t h e i r own " b e s t e s t i m a t e s " of t h e p r i c e by combining a l l t h e

knowledge a v a i l a b l e t o them. We h a v e one such s o u r c e ( S S I and

N S I ) f rom t h e b e g i n n i n g of o u r p e r i o d ( J a n u a r y 76) t o t h e end o n

a monthly bas i s .

( 4 ) Petroleum I n t e l l i g e n c e Weekly (PIW)

This aga in is a mid-month average.

This p u b l i s h e s d a t a on spot p r i c e s from January 1978 t o

t h e p re sen t f o r t h e two crudes i n ques t ion (denoted S S P and NSP).

We can summarise t h e r e l a t i o n s h i p s between t h e v a r i o u s

s p o t p r i c e s i n terms of r e g r e s s i o n models. The model r e g r e s s e s

one se r ies on a n o t h e r ( o v e r t h e maximum d a t a p e r i o d common t o

b o t h ) w i t h o u t i n t r o d u c i n g a c o n s t a n t . I f t h e s e r i e s were

i d e n t i c a l t h e r e g r e s s i o n c o e f f i c i e n t would b e u n i t y , t h e

c o r r e l a t i o n u n i t y and t h e s t a n d a r d e r r o r o f e s t i m a t e ( a v e r a g e

r e s i d u a l ) zero. The r e s u l t s a r e shown i n Tab le s I and I1 ( ~ 2 7 ) .

The t a b l e s show two important f e a t u r e s .

(i> For b o t h c r u d e s t h e OPEC B u l l e t i n f i g u r e is

s i g n i f i c a n t l y g r e a t e r t h a n a l l t h e o t h e r f i g u r e s (by a f a c t o r

r a n g i n g f r o m 1 t o 2 p e r c e n t ) . T h i s i m p l i e s t h a t a t a p r i c e of

$30 p e r b a r r e l t h e OPEC b u l l e t i n p r i c e would be about 30-60 cen t s

a b a r r e l higher t han o t h e r series.

(ii) The o the r t h r e e s e r i e s a r e a l l very c l o s e t o each

o t h e r and i n g e n e r a l do not d i f f e r s i g n i f i c a n t l y . However, t h e

s tandard e r r o r of estimate f o r a l l s i x cases , exc lud ing t h e OPEC

B u l l e t i n , i s between 50 c e n t s and 80 cents. Hence a l though t h e

25

c o r r e l a t i o n i s very h igh t h e average e r r o r i s t h e same o rde r of

m a g n i t u d e a s t h e d i f f e r e n c e be tween t h e s e s e r i e s and the OPEC

B u l l e t i n s e r i e s when t h e p r i c e i s around $30. I n v e s t i g a t i o n of

t h e r e s i d u a l s r e v e a l s a few months when t h e r e s i d u a l s a r e many

t i m e s the s tandard e r r o r of es t imate . S ince t h e r e s i d u a l s f o l l o w

a "t" d i s t r i b u t i o n i t would be expected t h a t approximately one i n

a hundred would be more than t h r e e times as l a r g e as t h e s tandard

e r r o r of es t imate . Table I11 ( ~ 2 8 ) l i s t s t h e months and t h e s i z e

o f t h e m u l t i p l e when t h i s c r i t e r i o n is exceeded . It i s n o t

s u r p r i s i n g t h a t t h e only per iod of s u b s t a n t i a l d i s a g r e e m e n t i s

t h e f i r s t e i g h t months of 1979, when t h e s p o t p r i c e w a s moving

with g r e a t r a p i d i t y and t h e r e was a g r e a t d e a l of u n c e r t a i n t y i n

t h e marke t . F o r t h e c a s e of Arab L i g h t t h e s p o t p r i c e f o r May

1979 r a n g e s f rom $28.35 f o r SSI, t o $28.95 f o r SSO, t o $30.67 f o r

SSM and up t o $34.25 for SSP. The extreme d ive rgence i s f o r SSP

w h i c h is usually v e r y c l o s e t o SSI and SSM. With 8 r a n g e of $6

in $30 t h e r e i s c l e a r l y a very s u b s t a n t i a l measurement e r r o r f o r

t h i s month, and i t s h o u l d n o t b e i n c l u d e d i n any s p e c i f i c t e s t s

o f h y p o t h e s e s s i n c e such a n ex t r eme " o u t l i e r " c o u l d a f f e c t t h e

t o t a l p i c t u r e t o a g r e a t e x t e n t . By compar i son t h e r a n g e o f

p r i c e s for Nigerian Light i n t h e same month i s SSO a t $31.13, SSI

a t $33.35, S S P a t $34.25 and SSM a t $ 3 4 . 5 . T h i s r a n g e o f $3 is

l a r g e , but only h a l f t h a t of Arab Light. The per iod of extreme

disagreement f o r Arab Light i s s h o r t e r being j u s t May, June and

J u l y of 1979, w h i l e for N i g e r i a n L i g h t t h e p e r i o d e x t e n d s from

J a n u a r y t o August 1979 w i t h t h e a d d i t i o n of J u n e 1981. As a

check an agreement between t h e s e r i e s which are a v a i l a b l e for t h e

26

TABLE I: RELATIOIM€IPS BETWEEB SPOT PRICE MEASURES FOB ARAB LIGHT

Regress ion Dependent Independent Per iod C o e f f i c i e n t Sqd. SEE DWS Equat ion va r i a b l e var iab 1 e (SE) c o r r e l - No. a t ion

(R1) S S I S SM 76.01- 0.997 0.997 0.51 1.59

(R2) s SP SSI 78.01- 1.000 0.991 0.81 2.21

(R3) s SP S SM 78.01- 0.997 0.992 0.71 2.72

(R4) s SP sso 79.01- 0.985 0.954 1.01 2.01

(R5) sso SSI 79.01- 1.015 0.989 0.51 1.19

(R6) sso S SM 79.01- 1.011 0.984 0.61 1.61

( R I 3 ) SSI S SM 76.01- 1.00 0.999 0.22 0.79

........................................................................

83.12 (0.002)

83.12 (0.003)

83.12 (0.003)

83.12 (0.004)

83.12 (0.002)

83.12 (0.002)

78.12 (0.001) 81.01- 83.12

TABLE 11: BELBTIOASHIPS BETWEEB SPOT PRICE LIRASWES FOR HIGEEFA% LIGHT

(R7) NSI NSM 76.01- 83.12

(R8) NSP NSM 78.01- 83.12

(R9) NSP NSI 78.01- 83.12

(R10) NSP NSO 79.01- 83.12

(R11) NSO MSI 79.01- 83.12

(R12) NSO NSM 79.01- 83.12

(R14) NSI NSM 76.01- 78.12 81.01- 83.12

1.004 0.996 0.63 1.90

0.998 0.993 0.70 1.97

0.994 0.995 0 . 5 9 1.56

0.981 0.972 0.81 1.16

1.012 0.973 0.79 1.81

1.017 0.960 0.96 1.76

1.0037 0,999 0.30 1.37

(0.002)

(0.003)

(0.002)

(0.003)

(0 .003>

(0.004)

(0.0013)

27

TABLE 111: MOHTHS WITH EXTBEHE DISBC;BKEMENTS* BETWEEH SERIES

( a ) Arab Light

SSI s SP s SP SSP sso sso +SSM SSI S SM sso S S I SSM

79.05 4.3 79.05 7 . 3 79 .05 5.2 7 9 . 0 5 5 .7 7 9 . 0 5 3 . 4

79.07 5.0 79.06 3 . 4 79 .07 3.7

( b ) Nigerian Light

NSI NSP NSP NSP NSO NSO NSM NSI NSM NS 0 NSI NSM

79.01 81.06 79.06 79.02 79.05 7 9 . 0 5 3 . 8 3 . 5 3 . 2 3 . 2 3 . 3 4.1

7 9 . 0 8 3.7

* An extreme d ive rgence i s a r e s i d u a l g r e a t e r t han t h r e e times

t h e s tandard e r r o r of estimate. It is measured i n m u l t i p l e s of the SEE.

l o n g e s t per iod, we re-ran the r e g r e s s i o n s omi t t i ng t h e two y e a r s

1979 and 1980. The r e s u l t s a r e shown i n T a b l e s 1 and I1 and as

e q u a t i o n s (R13) and (R14). Over t h e n o n - t u r b u l e n t p e r i o d t h e

s e r i e s are extremely c l o s e with s t a n d a r d e r r o r s of estimate t h a t

a r e a b o u t h a l f t h o s e of when 1979 and 1 9 8 0 d a t a a r e i n c l u d e d .

The measurement e r r o r problem f o r t h i s abbrev ia t ed pe r iod i s n o t

non-existent but is very small and shou ld not b i a s t h e r e s u l t s t o

1 any g r e a t ex ten t .

I n c o n c l u s i o n we c a n f e e l f a i r l y s a f e t h a t t h e PIW,

28

MEPEP and industry based s e r i e s w i l l g i v e s i m i l a r r e s u l t s ,

part icular ly i f some months during 1979 are de leted from whatever

s t a t i s t i c a l t e s t s are t o be run. The OPEC B u l l e t i n s e r i e s i s

s ign i f i cant ly greater than the other ser i e s and its use could be

expected t o lead t o d i f ferent r e s u l t s from the others.

29

B.2.2 HETBBCK DATA

The cons t ruc t ion of netback series r e q u i r e s information

on f o u r elements:

( i ) t h e spot product p r i c e s i n a p a r t i c u l a r market;

(ii) t h e r e f i n e r y y i e l d s i n t h a t market ;

( i i i ) t h e running c o s t s per b a r r e l f o r t h e r e f i n e r y ;

( i v ) t h e t r a n s p o r t and insurance c o s t s between t h e r e f i n e r y and the expor t po in t of t h e crude under cons idera t ion .

Given these requirements and t h e absence of any o f f i c i a l

agency i t i s n o t s u r p r i s i n g t h a t t h e r e a r e a m u l t i p l i c i t y of

e s t i m a t e s of t h e n e t b a c k e v e n f o r a g i v e n c r u d e a t a g i v e n

r e f i n e r y l o c a t i o n . G i v e n t h e c o m p l e x i t y o f t h e c a l c u l a t i o n s

r equ i r ed it is not s u r p r i s i n g t h a t t he re should be susp ic ion of

f i g u r e s produced by agencies no t i nvo lved i n r e f i n i n g . However,

pub l i shed f i g u r e s are an important source of common information

which must be inves t iga t ed .

We have used t h r e e sources of d a t a bu t f o r each source

t h e r e i s more than one ne tback s o t h a t t h e t o t a l number of series

a v a i l a b l e i s r a t h e r l a rge . Each source i d e n t i f i e s e i t h e r more

t h a n one l o c a t i o n of t h e r e f i n e r y or more t h a n one t y p e of

r e f i n e r y (or both).

30

( i > Petroleum I n t e l l i g e n c e Weekly (PIW)

This major source p u b l i s h e s d a t a on Saudi netbacks from

R o t t e r d a m on a m o n t h l y b a s i s f rom t h e b e g i n n i n g of o u r p e r i o d

(SNPIWR). Four o t h e r c e n t r e s , t h e C a r i b b e a n (SNPIWC), t h e

P e r s i a n Gulf (SNPIWP), Singapore ( S N P r W S ) and I t a l y (SNPIWI) were

added i n September 1976 and a s i x t h c e n t r e , t h e U S Gulf (SNPIWU)

i n J a n u a r y 1977. The a v e r a g e of t h e s e s e r i e s (SNPIW6) h a s a l s o

been cont inuously publ ished from t h e beginning of 1977. S i m i l a r

s e r i e s h a v e b e e n p u b l i s h e d f o r N i g e r i a n s i n c e 1979 f o r f i v e

c e n t r e s ( N N P I 8 5 ) i n c l u d i n g R o t t e r d a m (NMPIWR), w i t h 4 c e n t r e s

back to January 1979 and j u s t Rotterdam back t o January 1976.

A l l t h e PIW d a t a , w i t h t h e e x c e p t i o n o f US n e t b a c k s ,

assume t h e r e f i n i n g t o be of t h e b a s i c t o p p i n g / r e f o r m i n g t y p e .

The y i e l d p a t t e r n s a r e v a r i e d be tween summer and w i n t e r months

b u t a p a r t f rom t h i s were unchanged u n t i l J u l y 1983. From t h a t

month on the y i e l d s were a l t e r e d and t h i s i n c r e a s e d t h e Gross

Product Value by approximately Z X , g i v i n g a sharp d i s c o n t i n u i t y

a t t h a t d a t e . F o r t h e U S a r e f i n e r y w i t h c o n v e r s i o n

p o s s i b i l i t i e s ( u p g r a d i n g h e a v i e r p r o d u c t s i n t o l i g h t e r ) i s

assumed throughout t h e period.

PTW assumed i n 1982 t h a t t h e r e f i n i n g c o s t w a s about 20

c e n t s a b a r r e l ( t h i s f i g u r e is a l t e r e d y e a r l y ) and t r a n s p o r t

c o s t s ( c a l c u l a t e d on a m o n t h l y b a s i s ) were 8 5 c e n t s a b a r r e l .

E r r o r s i n t h e s e e l e m e n t s a r e n o t l i k e l y t o a f f e c t t h e n e t b a c k

very g r e a t l y .

I t i s c l e a r t h a t t h e PIW d a t a o f f e r s a v e r y wide

geograph ica l coverage and t h a t f o r b a s i c r e f i n i n g t h e long r u n s

31

of d a t a on a cons t an t b a s i s a r e very v a l u a b l e .

( i i > OPAL

A second source of pub l i shed d a t a is provided by OPAL.

They g i v e d a t a s t a r t i n g i n J a n u a r y 1980 f o r n e t b a c k s f rom

R o t t e r d a m for b o t h b a s i c hydroskimming and a c o n v e r s i o n t y p e

r e f i n e r y (SNOPAB, SNOPAC, NNOPAB and NNOPAC). I n 1983 t h e y

assumed r e f i n i n g c o s t s of 30 cen t s and 45 c e n t s f o r t h e two types

of r e f i n e r ies .

( i i i ) Indus t ry Data

As wi th spo t crude p r i c e s it i s important f o r companies

i n t h e o i l i ndus t ry t o c a l c u l a t e t h e v a l u e of netbacks based on

t h e i r own e x p e r i e n c e r a t h e r t h a n on t h a t o f some h y p o t h e t i c a l

t y p i c a l r e f i n e r y . We h a v e s u c h d a t a , c a l c u l a t e d f o r a s i m p l e

( b a s i c ) r e f i n e r y from J a n u a r y 1 9 7 6 for R o t t e r d a m ( S N R B I , N N R B I )

and f o r complex r e f i n i n g from January 1981 f o r both Rotterdam and

t h e US Gulf (SNRCI, SNUCI, NNRCI and NNUCI) .

There a r e v a r i o u s t y p e s of comparisions t h a t might be

made between t h e netback ser ies (between l o c a t i o n s , between types

of r e f i n e r y and be tween d a t a s o u r c e ) . For r e a s o n s t h a t w i l l

become apparent , it i s s e n s i b l e t o concen t r a t e on t hose f i g u r e s

wh ich a r e f o r t h e same l o c a t i o n and t h e same t y p e of r e f i n i n g

process. W e begin w i t h b a s i c r e f i n i n g a t Rotterdam €or which a l l

t h r e e s o u r c e s g i v e d a t a . ( p p s 34 and 35) g i v e

t h e r e s u l t s for r e g r e s s i o n s between t h e ser ies (without i n t e r c e p t

terms) r u n o v e r t h e l o n g e s t pe r iods a v a i l a b l e .

T a b l e s I V and V

We can s e e from t h e t a b l e s

t h e l o n g e s t per iod (PIW and indus t ry

t h a t t h e d a t a a v a i l a b l e f o r

bas i c r e f i n e r y a t Rotterdam)

32

a r e i n c l o s e agreement ( E q u a t i o n s (Et151 and (R20)). The OPAL

d a t a , f o r b a s i c r e f i n i n g , h a s a v e r y c l o s e f i t t o PIW, a s

measured by t h e s tandard e r r o r of es t imate , for both Arabian and

N i g e r i a n . For A r a b i a n i t i s s i g n i f i c a n t l y l e s s t h a n t h e o t h e r

two s o u r c e s (by 1.5 t o 2 p e r c e n t ) . For N i g e r i a n t h e OPAL f i g u r e

i s j u s t s i g n i f i c a n t l y l e s s t h a n t h e PIW f i g u r e bu t i t is

s u b s t a n t i a l l y l e s s t h a n t h e i n d u s t r y d a t a . Hence f o r b a s i c

r e f i n i n g at Rotterdam t h e r e i s a very l a r g e measure of agreement

between t h e series, w i th s tandard e r r o r s much less than those f o r

equat ions l i n k i n g t h e va r ious spo t p r i c e measures.

For complex r e f i n i n g i n Rotterdam t h e OPAL s e r i e s f o r

Arabian and Nigerian a r e s i g n i f i c a n t l y l o w e r t h a n t h e i n d u s t r y

d a t a (3 -4%) , w h i l e f o r US d a t a using complex r e f i n i n g t h e PIW and

indus t ry d a t a a r e a lmost i d e n t i c a l on average.

An e x a m i n a t i o n of t h e r e s i d u a l r e v e a l s o n l y two

obse rva t ions f o r which t h e r e s i d u a l is g r e a t e r than t h r e e times

t h e s tandard e r r o r of es t imate . One case is May 1 9 7 9 f o r S N P I W R

and SMRBI, and t h e o t h e r is January 1981 f o r SNPIWU and SNUCI ( i n

both cases t h e margin was o n l y j u s t ove r t h r e e s tandard e r ro r s ) .

The c a s e of May 1 9 7 9 is n o t s u r p r i s i n g - t h e t u r b u l e n c e i n t h e

c r u d e spot marke t a f f e c t e d t h e s p o t p r o d u c t m a r k e t , and s l i g h t

v a r i a t i o n s i n d a t a c o l l e c t i o n p r o c e d u r e s a t s u c h a t i m e c o u l d

e a s i l y change t h e sampled v a l u e by $1.5.

I n summary t h e netback series a r e i n c l o s e r agreement

than the p r i c e d a t a - t h e r e a r e g e n e r a l l y h ighe r c o r r e l a t i o n s and

fewer p o i n t s of extreme disagreement. The i n d u s t r y and PIW d a t a

correspond extremely c l o s e l y and a r e a t v i r t u a l l y t h e same l e v e l ,

33

TABLES IV: BELBTIOBSBIPS BETWEEN BETBACKS FOE ARAB LIGHT

( a ) Basic Refining a t Rotterdam

(RI51 SNIWR SNRBI 76.01- 1.001 0.997 0.47 1.04

(R16) SNPIWR SNOPAB 80.01- 1.016 0.985 0.30 1.39

(RI 7 ) SNRBI SNOPAB 80.01- 1.020 0.977 0.37 0.45

83.06 ( 0 . 0 0 2 )

83.06 (0.001)

83.12 (0.002)

(b) Complex Refining a t Rotterdam

SNOPAC SNRCI 81.01- 0 .954 0.985 0.32 0 . 3 5 (RI81 83.12 (0.002)

( c ) Complex Refining i n US

(R19) SNPIWU SNUCI 81.01- 0 . 9 9 5 0 .955 0 .53 1.50 83.06 (0.003)

34

TABLE V: RELBTIOHSEIPS BKTWIZElU HETBACKS FOR BIGERIBlP LIGHT

(a) Basic RefininE a t Rotterdam

(R20) NNPIWR NNRBI 76.01- 0.981 0 .998 0.43 1.12

(R21) NNPIWR NMOPAB 80.01- 1.003 0.985 0.34 0 .94

(R22) NNRB I NNOPAB 80.01- 1.020 0.986 0 . 3 6 0.74

83.06 (0.002)

83.06 (0.002)

83.12 (0.002)

(b) Complex Refining a t Rotterdam

(R23 1 NNRCI NNOPAC 81.01- 1.030 0.984 0.42 0.52 83.12 (0.002)

w h i l e t h e OPAL d a t a move l e s s c l o s e l y wi th t h e o t h e r two sources

and a r e below them on average. This is an important r e s u l t g i v e n

t h e n a t u r a l tendency t o t r u s t i ndus t ry d a t a more i n t h i s case.

F i n a l l y , t o r o u n d o f f t h e p i c t u r e , we g i v e t h e

( u n s q u a r e d ) c o r r e l a t i o n m a t r i x be tween a l l n e t b a c k s f o r t h e

common p e r i o d f o r which w e h a v e d a t a on a l l of them ( T a b l e s V I

and VII) . It i s c l e a r f rom t h o s e t a b l e s t h a t t h e h i g h e s t

c o r r e l a t i o n s occur be tween s e r i e s w i t h d i f f e r e n t s o u r c e s but

which have i d e n t i c a l d e f i n i t i o n s . Corr e 1 a t i o n s b e tween s e r i e s

f o r s imple and complex r e f i n i n g or between Rotterdam and t h e US

a r e apprec i ab ly lower even when t h e d a t a sou rce i s t h e same.

For both p r i c e and netback d a t a t h e r e a r e a l t e r n a t i v e

s o u r c e s o f d a t a which ma tch v e r y c l o s e l y and w h i c h e x t e n d o v e r

long per iods. It i s tempting t o assume t h a t t h e c l o s e n e s s of t h e

s e r i e s p roves t h a t they a r e c o r r e c t and o t h e r s e r i e s a r e wrong;

however , a l t h o u g h t h i s c l e a r l y s t r e n g t h e n s t h e i r c l a i m t o b e

35

correct it does not const i tute a proof, and we w i l l need to bear

t h i s i n mind when using t h e s e r i e s in t h e l a t t e r part of t h i s

paper .

TABLE VI: COBBELATIOBS PCR SAUDI EETBAmS (1981.01-1983.06)

SNPIWR SNRBI SNOPAB SNOPAC SNRCI SNPIWU SNUCI

SNPIWR 1.000

SNRBI 0.988 1.000

SNOPAB 0.992 0.993 1.000

SNOPAC 0.966 0.964 0.981 1.000

SNRCI 0.966 0.956 0.978 0.976 1.000

SNPIW 0.910 0.884 0.915 0.933 0.907 1.000

SNUCI 0.919 0.894 0.927 0.933 0.920 0.977 1.000

TABLE V I I : COBBELBTIORS FOB HIG'HtIAH HETBAmS (1981.01-1983.06)

NNPIWR NNRB I NNOPAB NNOPAC NNRCI

NNPIWR 1.000

NNRB I 0.989 1 .ooo

NNOPAB 0.993 0.993 1 .ooo

NNOPAC 0.983 0.976 0.990

NNRCI 0.976 0.973 0.980

1 .ooo

0.990 1 .ooo

36

B . 3 A SIHPLE MODEL BELBTIHG SPOT PRODUCT VBLWS Al9D SPOT CRUDE PRICES

B.3 .1 THE HODEL

I n t h e i n t r o d u c t o r y s e c t i o n o f t h i s pape r w e a r g u e d

t h a t t h e netback and spo t p r i c e for a g i v e n crude a r e t r e a t e d i n

t h e l i t e r a t u r e a s i f t h e y were r e l a t e d by a s i m p l e e q u a t i o n of

t h e type :

where ut i s a random term a t time t. I f t h i s term is random then

i t s v a l u e should on average be zero and success ive v a l u e s of t h e

random term should n o t be s y s t e m a t i c a l l y r e l a t e d . Such a model

has two imp 1 i c a t ions:

( i > If t h e s t a t i s t i c a l d i s t r i b u t i o n of t h e random t e r m were

known t h e n any p a r t i c u l a r v a l u e of t h e m a r g i n ( N t - S t ) could b e

c o m p a r e d w i t h t h e " n o r m a l m a r g i n " a n d a m e a s u r e m e n t of

abnormali ty der ived . Extreme d e v i a t i o n s would symbolise changes

i n t h e market.

( i i ) Once t h e no rma l d i f f e r e n t i a l s f o r s e v e r a l c r u d e s were

e s t a b l i s h e d (al , a2....) then we could compare a c t u a l margins t o

see whether one was unusua l ly l a r g e r e l a t i v e t o another. This

t y p e of c a l c u l a t i o n h a s been s u g g e s t e d a s a g u i d e t o r e l a t i v e

p r o f i t a b i l i t y and hence t o demand pressure . It is important t o

r e c o g n i s e t h a t i f ut i s i ndeed random t h e n t h i s month's v a l u e s

c a n p r e d i c t only t h a t f o r n e x t month t h e marg in w i l l b e a t i t s

37

"normal" v a l u e . O v e r s h o o t i n g i n one p e r i o d d o e s n o t make it

more, o r l e s s l i k e l y t h a t t h e r e w i l l be overshoot ing i n t h e next

p e r i o d . I f s u c h p a t t e r n s e x i s t e d w i t h h i s t o r i c d a t a t h e n

e q u a t i o n s s u c h as ( 4 ) would t e n d t o show s e r i a l c o r r e l a t i o n

between success ive v a l u e s of ut.

A d i f f e r e n t p o i n t t o emerge f rom t h i s s t a t i s t i c a l

a p p r o a c h is t h a t t h e c o e f f i c i e n t of t h e s p o t p r i c e s h o u l d b e

u n i t y and t h a t t h e r e s i d u a l s h o u l d n o t b e c o r r e l a t e d w i t h the

s p o t p r i c e ( i e t h a t a l l s y s t e m a t i c i n f o r m a t i o n on t h e c u r r e n t

l e v e l of t h e netback is contained i n t h e spo t pr ice) . I f e i t h e r

of t h e s e r e s t r i c t i o n s d i d n o t h o l d t h e n t h e b a s i c way of u s i n g

t h e e q u a t i o n would h a v e t o change. Suppose , f i r s t l y , t h a t t h e

c o e f f i c i e n t on t h e spot p r i c e i s not u n i t y ( i e t h a t t h e two

s e r i e s a r e n o t i n a d o l l a r f o r d o l l a r r e l a t i o n s h i p ) :

Nt = a + ( 1 + b ) St + U (5)

I n t h i s case t h e margin is a f u n c t i o n of t h e s p o t p r i c e :

(Nt - St) = a + b S, + ut ( 6 )

Depending on t h e s i g n of b t h e marg in wou ld t e n d t o na r row o r

widen a t h i g h p r i c e s . T h i s would mean f i r s t l y t h a t a t t e m p t s

m e r e l y t o focus on t h e s i z e of t h e c u r r e n t margin as an i nd ica to r

of whether t h e market was d i s tu rbed would be mis l ead ing - a h igh

v a l u e of t h e marg in c o u l d m e r e l y b e a r e s u l t of t h e h i g h s p o t

p r i c e and n o t because of any d i s e q u i l i b r i u m between t h e two s i d e s

of t h e market. Futhermore, a s w e s h a l l see l a t e r , a r e l a t i o n s h i p

such as ( 6 ) would r a i s e problems of economic i n t e r p r e t a t i o n a s t o

how such a s i t u a t i o n could come about.

38

The second case (of an o m i t t e d v a r i a b l e ) c o u l d be

w r i t t e n :

Nt = a + ( 1 + b) St + cZt + ut ( 7 )

I f t h e e q u a t i o n i s e s t i m a t e d o r u s e d ( i n t h e fo rm o f t h e c u r e n t

margin) without a l l o w i n g for t h e i n f l u e n c e of v a r i a b l e 2 (what

ever t h a t might be) t hen aga in t h e a c t u a l margin cou ld seem t o be

most u n u s u a l e v e n though it would be c o m p l e t e l y e x p l i c a b l e i n

terms of t h e l e v e l of v a r i a b l e Z.

To summar ise , t h e u s e of t h e a c t u a l m a r g i n (N-S) t o

i n d i c a t e any form of market tendency i m p l i e s t h a t such a margin

has a normal value. This hypothes is p l a c e s s t rong r e s t r i c t i o n s

of a t e s t a b l e n a t u r e on t h e r e l a t i o n between the two s e r i e s . If

t h e r e s t r i c t i o n s can be shown not t o have he ld , t o a s i g n i f i c a n t

d e g r e e , i n t h e p a s t t h i s wou ld s u g g e s t t h a t u s e of t h e a c t u a l

margin as a guide t o i n d i c a t i n g abnormal behaviour i n t h e market

would have been i n c o r r e c t , and would s imul t aneous ly sugges t t h a t

a b e t t e r p r e d i c t o r of t h e no rma l r e l a t i o n s h i p b e t w e e n t h e two

s i d e s of t h e market could be found.

The tests of t h e b a s i c model have two f e a t u r e s . F i r s t ,

w e s h a l l j u s t e s t ima te t h e model as it s t a n d s i n order t o s ee how

w e l l i t f i t s t h e d a t a a n d , i n p a r t i c u l a r , w h e t h e r t h e

r e l a t i o n s h i p is s t a b l e ove r time. Secondly we compare t h e model

w i th more g e n e r a l models t o see whether they add ev idence a g a i n s t

t h e ex i s t ence of t h e s imple r e l a t i o n s h i p .

39

B.3.2 TEE GOODNESS OF FIT OF TEE BORHAL MARGIB MODEL

Given t h e l a r g e numbers of s e r i e s a v a i l a b l e f o r e a c h

c o n c e p t ( f o u r s e r i e s f o r s p o t c r u d e p r i c e s and s e v e n for

netbacks) i t i s n o t f e a s i b l e t o i n v e s t i g a t e eve ry combination i n

d e t a i l f o r e a c h c r u d e . The r e s u l t s of t h e p r e v i o u s s e c t i o n ,

compar ing t h e d i f f e r e n t c r u d e p r i c e s and n e t b a c k v a l u e s ,

suggested t h a t p r i c e s S S I and SSM would be very s i m i l a r (and that

SSP would a l s o be s imilar except for 1979). Since both of t h e s e

s e r i e s a r e a v a i l a b l e f o r t h e full l e n g t h of o u r p e r i o d it i s

n a t u r a l t o begin wi th them. The choice of which netback t o work

wi th i s more d i f f i c u l t . As between sources it seems t h a t t h e two

sources covering t h e l o n g e s t per iod (PIW and t h e indus t ry d a t a )

a r e most s t r o n g l y c o r r e l a t e d . It i s t h e n n e c e s s a r y t o c h o o s e

whether t o look a t complex or bas i c r e f i n i n g , and a l s o t o choose

wh ich r e f i n e r y l o c a t i o n t o d e a l w i t h . Complex r e f i n i n g became

i m p o r t a n t only i n t h e l a t e r p a r t of t h e p e r i o d , s o i t seems

d e s i r a b l e t o look f i r s t a t b a s i c r e f i n i n g . As f o r t h e l o c a t i o n

o f t h e r e f i n e r i e s , t h e d e c i d i n g f a c t o r i s t h a t U S d a t a i s for

complex r e f i n i n g . We t h e r e f o r e s t a r t w i t h b a s i c r e f i n i n g a t

Ro t t er d am.

This g i v e s two d a t a sources (SNPIWR and SNRBI) f o r t h e

netbacks and hence fou r combinations of r e g r e s s i o n t o be t r i e d .

Since t h e PIX d a t a s t o p s i n 1983.06 w e c a r r y out a l l t h e s e t e s t s

f o r t h e common p e r i o d 1976.01 t o 1983.06.

40

TABLE VIII: THE RoBlIBL M R G I R LICfDEL (1976.01-1983.06)

SNPIWR - SSM -1.08 2.02 0.36 (0.21)

SNPIWR - SSI -1.01 1 . 9 2 0.32 (0.20)

SNRBI - SSM -1.08 2.03 0 . 3 3 (0.21)

S N R B I - SSI -1.01 1.88 0.23 (0.20)

NNPIWR - NSM -0.40 1.76 0.52 (0.19)

NIPTWR - NSI -0.52 1.77 0.58 (0.19)

NMRBI - NSM 0.14 1.80 0.52 (0.19)

N N R B I - NSI 0.02 1.77 0.62 (0.19)

T a b l e VI11 g i v e s t h e r e s u l t s , which show a v e r y c l e a r p i c t u r e .

A l l t h e A r a b i a n d a t a show t h e n e t b a c k on a v e r a g e a round one

d o l l a r l o w e r t h a n t h e spot p r i c e f o r t h e p r i o d as a whole . The

v a r i a t i o n a r o u n d t h i s n o r m a l m a r g i n h a s a s t a n d a r d e r r o r of

around $1.90. This impl ies t h a t us ing a 95% confidence i n t e r v a l

t h e a c t u a l margin could be expected to be i n t h e range of -$4.80

t o +$2.80 95% of t h e t ime (-$6.70 t o $4.70 99% of t h e t ime) .

Thus f o r t h e Arab L i g h t c a s e , i f t h e no rma l m a r g i n h y p o t h e s i s

were t o be accepted as a long-run t r u t h , t hen the range of a c t u a l

margins between netback and s p o t p r i c e t h a t would be c o n s i s t e n t

w i th h i s t o r i c v a r i a t i o n would be very la rge .

41

For t h e N i g e r i a n c a s e t h e no rma l marg in depends on

w h e t h e r t h e PIW o r i n d u s t r y d a t a i s b e i n g used f o r t h e n e t b a c k .

The former impl ies a margin some $0.50 lower on average than t h e

l a t t e r . The sampling v a r i a t i o n of t h e margin i s again very wide

( a r a n g e o f abou t $7.2 i f a 95% i n t e r v a l i s t o b e used) .

The range of v a r i a t i o n of t h e a c t u a l margin c o n s i s t e n t

w i th t h e normal margin on t h e b a s i s of h i s t o r i c a l experience, i f

t h i s model i s c o r r e c t , is c l e a r l y t o o w i d e t o b e of any u s e at

a l l . However, two factors s u g g e s t t h a t t h e model is s e v e r e l y

mis-specif ied. F i r s t l y , i n a 1 1 cases t h e Durbin-Watson s t a t i s t i c

i s e x t r e m e l y l o w , i n d i c a t i n g s e r i o u s m i s - s p e c i f i c a t i o n .

Secondly, a p l o t of t h e a c t u a l v a l u e s (cent red on the es t imated

normal margin) of t h e a c t u a l margin shows very s t rong ev idence of

s t r u c t u r a l b r e a k s . For example w i t h t h e p a i r of s e r i e s SNPIWR

and SSM t h e a c t u a l d i f f e r e n t i a l between 1976.01 and 1978.10 has a

r a n g e of $-0.88 t o +$0.65 w i t h a n e a r z e r o mean and a s t a n d a r d

d e v i a t i o n of l e s s t h a n h a l f a d o l l a r . The n e t b a c k and s p o t

pr ices c l e a r l y moved c l o s e l y toge ther and were on average n e a r l y

e q u a l . For a few months a t t h e end of 1 9 7 8 and e a r l y 1979 t h e

netback margin was s t r o n g l y p o s i t i v e , and then from June 1979 t o

J u n e 1981 i t was a l w a y s such t h a t t h e n e t b a c k was more t h a n $ 2

below t h e spo t p r i c e (and w a s u s u a l l y more than $3 below). From

mid-81 t o mid-83 t h e m a r g i n f l u c t u a t e d a t a v a l u e of a b o u t $1

below. S imi l a r f i n d i n g s e x i s t f o r a l l fou r combinations based on

Arab Light.

42

For N i g e r i a n L i g h t t h e p o s i t i o n i s i n g e n e r a l v e r y

s i m i l a r . P r i o r t o t h e end o f 1978 t h e r e was a s m a l l n e g a t i v e

m a r g i n of a r o u n d $0.4. For l a t e 1 9 7 8 and e a r l y 1979 t h e m a r g i n

was s t r o n g l y p o s i t i v e , w h i l e from August 1979 t o January 1981 t h e

margin w a s c o n s i s t e n t l y n e g a t i v e w i t h t h e netback around $2 below

t h e spo t pr ice . After t h a t d a t e t h e margin narrowed t o around 70

cents. Again a l l s e r i e s show a s imilar p i c tu re .

These l a r g e and r a t h e r sudden s h i f t s r e j e c t t h e

h y p o t h e s i s t h a t t h r o u g h o u t t h e p e r i o d t h e r e h a s b e e n a normal

m a r g i n be tween t h e two s i d e s o f t h e marke t . The m a r g i n h a s

changed, and by s u f f i c i e n t l y l a r g e amounts t o r e q u i r e s e p a r a t e

e s t i m a t i o n f o r e a c h sub-pe r iod . The f i r s t check w e mus t run i s

t o s e e w h e t h e r our o t h e r s e r i e s c o n f i r m t h e s e s h i f t s . The OPAL

s e r i e s of n e t b a c k s , b e g i n n i n g i n 1980, c o v e r o n l y h a l f of t h e

t h i r d e p i s o d e and t h e w h o l e of t h e f o u r t h e p i s o d e and hence

c a n n o t be used. S i m i l a r l y , i n d u s t r y d a t a f o r complex r e f i n i n g

s t a r t s i n 1981 and hence cove r s o n l y t h e l a s t episode. Thus t h e

o n l y v a r i a t i o n s a r e w i t h t h e o t h e r two s o u r c e s for s p o t c r u d e

p r i c e s (SSP and SSO). The f o r m e r s t a r t s i n 1978 and t h e l a t t e r

i n 1979. Both s e r i e s show t h e same p a t t e r n f o r b o t h of t h e

n e t b a c k s and f o r b o t h of t h e c r u d e s . Hence we can c o n f i r m t h a t

t h e r e a r e a p p a r e n t l y fou r s e p a r a t e ep i sodes du r ing t h e e i g h t year

p e r i o d . The e x a c t d a t i n g of t h e b r e a k s i s f a i r l y c l e a r . For

Arab L i g h t e i g h t c o m p a r i s o n s show November 1978 a s t h e f i r s t

month a t which the margin increased s u b s t a n t i a l l y over prev ious

experience. The next break i s assigned e q u a l l y o f t e n t o May and

J u n e 1979. J u n e or July 1981 a p p e a r t o b e t h e b e g i n n i n g o f an

43

u n i n t e r r u p t e d r e c o v e r y i n t h e l e v e l of t h e m a r g i n ( a l t h o u g h

F e b r u a r y 1981 i s a n i s o l a t e d p r e c u r s o r of t h i s v a l u e ) . For

Nigerian t h e f i r s t break i s aga in c l e a r l y a f t e r October 1978, t h e

second is a f t e r J u l y 1979, and t h e t h i r d i s a f t e r May 1981 (with

some series showing June o r J u l y 1981). The f a c t t h a t t h e breaks

occur a t e x a c t l y t h e same pe r iods , n o t only f o r a l l measures of

t h e margin but a l s o f o r d i f f e r e n t crudes p o i n t s t o t h e e x i s t e n c e

of some i m p o r t a n t and s y s t e m a t i c f a c t o r t h a t is i g n o r e d by t h e

norma 1 margin" mode 1. I 1

The f i r s t e x t e n s i o n of our h y p o t h e s i s o f t h e "normal

margin" i s that a g i v e n m a r g i n is n o r m a l f o r a p e r i o d and t h e n

f o r some u n i d e n t i f i a b l e r e a s o n c h a n g e s t o a d i f f e r e n t l e v e l .

T h i s i s t e s t e d f o r adequacy of s t a t i s t i c a l e x p l a n a t i o n by

e s t i m a t i n g t h e margin f o r each ep i sode s e p a r a t e l y . The e x e r c i s e

i s c a r r i e d o u t s o l e l y f o r t h e PIW n e t b a c k and t h e MEPEP p r i c e

s e r i e s and t h e r e s u l t s a r e shown i n T a b l e I X . These r e s u l t s

confirm our p rev ious r e s u l t s - t h e margins s h i f t from near zero

p r i o r t o 1979, t o s t r o n g l y p o s i t i v e i n e a r l y 1979 and t h e n t o

s t r o n g l y n e g a t i v e u n t i l e a r l y 1981. F i n a l l y , t h e margin becomes

moderately n e g a t i v e for t h e rest of t h e period. The v a r i a b i l i t y

44

TABLE IX: ESTIMATED B W ZIBBGIBS FOB VARICHJS SUB-PKRImS

Depend en t v a r i a b l e s

SNPIWR - SSM

SNPIWR - SSM

SNPIWR - SSM S N P I W R - SSM

NWIWR - NSM

NNPIWR - NSM

NAPIWR - NSM

MNPIWR - NSM

Period

76.01 - 78.10

78.11 - 79.05

79.06 - 81.06

81.07 - 83.06 76.01 - 78.10 78.11 - 79.07 79.08 - 81.02 81.03 - 83.06

of t h e a c t u a l margin around

Const a n t S.E.E. D.W.S. ( S . E . )

-0.05 (0.06) 2.89 (0.76) -3.37 (0.27) -1.30 (0.15) -0 27 (0.09) 3.60 (0.72) -2.07

-0.70 (0.14)

(0.21)

0.32

2 .oo

1.36

0.73

0.53

2.16

0.93

0.73

1.15

1.71

1.21

1.36

0.39

2.13

1.24

1.45

t h e "normal margin" i s much g r e a t e r

during t h e very s h o r t per iod from November 1978 t o May 1979, and

i t seems l i k e l y t h a t t h i s p e r i o d c a n n o t b e r e p r e s e n t e d by a

s t a b l e "normal margin". A l l t h a t may be s a i d is t h a t , p e r h a p s

s u r p r i s i n g l y , a t t h e time when s p o t crude p r i c e s were undergoing

t h e v e r y s h a r p r i s e of t h e second o i l shock , t h e s p o t p r o d u c t

p r i c e s were r i s i n g even f a s t e r and hence i n c r e a s i n q t h e margin of

t h e n e t b a c k o v e r t h e c r u d e p r i c e by some t h r e e d o l l a r s . T h i s

e f f e c t p e r s i s t e d (on average) from November 1978 u n t i l May 1979

(by wh ich t i m e t h e s p o t c r u d e p r i c e r i s e was c o m p l e t e ) . A t a

t i m e when t h e p o t e n t i a l d i s r u p t i o n t o supply w a s occuring it i s

i n t e r e s t i n g t h a t f o r a s u b s t a n t i a l per iod product p r i c e s (having

r i s e n much f a s t e r than crude p r i c e s between October and November

1978, t h u s d r a m a t i c a l l y i n c r e a s i n g t h e margin) were then a b l e t o

keep pace w i t h crude p r i c e s d u r i n g t h e i r b ig r i s e (December 1978

t o February 1979) and on ly s t a r t e d t o f a l l behind i n May and June

45

1979. C l e a r l y t h e r e was i n i t i a l l y a f u l l pas s -on of t h e

a n t i c i p a t e d crude p r i c e rises. However, once t h e p r i c e s e t t l e d

a t t h e new h i g h e r l e v e l t h e m a r g i n c o l l a p s e d and was some $6

l o w e r t h a n in e a r l y 1979. A f t e r t h e b e g i n n i n g o f 1981 t h e

average margin increased by about $1, a l though netback was below

t h e s p o t p r i c e . The b r e a k i n e a r l y 1981 d o e s not c o r r e s p o n d t o

c l e a r l y i d e n t i f i a b l e f e a t u r e s , a s t h e e a r l i e r two did. The spot

p r i c e for Arab Light s t a r t e d t o f a l l i n December 1980 (but only

r e l a t i v e t o t h e except iona l l e v e l s of October and November). The

sharpes t permanent f a l l i n t h e spo t p r i c e appears t o have been in

F e b r u a r y 1 9 8 2 b u t n o movemen t i n t h e m a r g i n seems t o b e

a s s o c i a t e d w i t h t h e d a t a . The p i c t u r e is e x a c t l y t h e same for

N i g e r i a n L i g h t . As t h e p r i c e r o s e s h a r p l y f rom Oc tobe r 1978 t o

J u n e 1979 t h e p r o d u c t p r i c e s r o s e f a s t e r s t i l l and t h e "normal

margin" increased. Once p r i c e s were s t e a d i e r from July 1979 t h e

marg in f e l l by n e a r l y $6 . A f t e r e a r l y 1981 t h e a v e r a g e marg in

improved by more than $1 but t h e netback was s t i l l below t h e s p o t

p r i c e .

Not s u r p r i s i n g l y , g i v e n t h e s i g n i f i c a n t s h i f t s i n t h e

m a r g i n , t h e s t a n d a r d e r r o r s o f e s t ima tes ( r e s i d u a l v a r i a t i o n )

a round t h e m a r g i n i n t h e s u b - p e r i o d s a r e v e r y much l e s s t h a n

those f o r the whole per iod g i v e n i n T a b l e V I I . P a r t i c u l a r l y f o r

t h e pre-1979 p e r i o d t h e no rma l r a n g e of v a r i a t i o n e x p e c t e d f o r

t h e marg in would h a v e been be tween a b o u t +$0.55 and -$0.65.

These smal l e r v a r i a t i o n s made t h e concept of t h e "normal margin"

a much more u s e f u l t o o l i n h e l p i n g t o j u d g e t h e c u r r e n t m a r k e t

s i t u a t i o n . A t p resent t he re seems t o be an episode wi th a range

46

of j u s t under $3 i n which the a c t u a l margin might be expected t o

f a l l , wi thout being so unusual as t o a rouse s u s p i c i o n t h a t market

condi t ions were changing. Such a margin i s u s a b l e bu t c l e a r l y i t

would be d e s i r a b l e t o na r row i t f u r t h e r s t i l l . The m o d e l s , a s

judged by t h e Durbin-Watson s t a t i s t i c , a r e much improved on t h e

s i n g l e episode v e r s i o n s of Table VIII. However, t h e f i r s t sub-

period ( p a r t i c u l a r l y f o r Nigerian Light) s t i l l shows evidence of

mis-specif i c a t i o n .

S i m i l a r t e s t s a r e c a r r i e d o u t f o r o t h e r r e f i n i n g

c e n t r e s for t h e fou r sub-periods. The r e s u l t s shown in Table X

a r e r e m a r k a b l y c o n s i s t e n t . The f i r s t e p i s o d e shows a small

n e g a t i v e margin wi th a very c l o s e f i t . The second ep isode has a

v e r y l a r g e r e s i d u a l - t h e m a r g i n shows no s t r o n g p a t t e r n . The

t h i r d e p i s o d e a l s o h a s a poor f i t and a v e r y l a r g e n e g a t i v e

margin, w h i l e t h e f o u r t h per iod f i t s a lmost as w e l l as t h e f i r s t

p e r i o d and h a s a n e g a t i v e m a r g i n of be tween $1 and $ 2 (much

l a r g e r t h a n t h e 30 c e n t s of t h e f i r s t p e r i o d ) . The s h i f t s

between per iods a r e appa ren t ly s i m i l a r f o r a l l l o c a t i o n s .

A f i n a l check on t h e adequacy of t h e model i s c a r r i e d

o u t by r e g r e s s i n g a c t u a l m a r g i n s ( f o r a g i v e n e p i s o d e ) of one

crude on t h e same concept for t h e o t h e r crude. I f t h e d e v i a t i o n s

f rom t h e n o r m a l m a r g i n a r e p u r e l y random t h e n t hese c o n c e p t s

s h o u l d n o t b e c o r r e l a t e d . The i n t e r c e p t t e r m s h o u l d be

s i g n i f i c a n t ( b e i n g an e s t i m a t e o f t h e d i f f e r e n c e i n "normal

marg ins" f o r t h e p e r i o d ) , t h e slope term s h o u l d b e z e r o . T a b l e

X I g i v e s t h e r e g r e s s i o n s f o r t h e f o u r sub-periods.

47

Refinery Period Const ant S.E.E. D . W . S . Locat ion

Caribbean 76.09 - 78.10 -0.30 0.34 1.17

78.11 - 79.05 -0.10 2.40 1.61

79.06 - 81.06 -5.41 1.83 0.70

81.07 - 83.06 -2.10 0.65 1.48

...................................................................

(0.07)

(0.91)

(0.35)

(0.14)

Persian 76.09 - 78.10 -0.25 0.16 1.20 Gulf (0.03)

78.11 - 79.05 -0.97 2.37 1.65 (0.901

71.06 - 81.06 -3.72 1.98 1.23 ( 0 . 3 4 )

81.07 - 83.07 -1.16 0.90 1.55 (0.18)

--------------------__L_________________-------------------------

Singapore 71.09 - 78.10 0.08 0.20 1.02 ( 0 . 0 4 )

(0.92)

(0.37)

(0.22)

78.11 - 79.05 -0.39 2.44 1.75

79.06 - 81.06 -2.98 1.87 1.33

81.07 - 83.06 -0.93 1.10 1.58

.................................................................. I ta ly 76.09 - 78.10 -0.29 0.33 1.52

78.11 - 79.05 1.79 1.75 1.43

79.06 - 81.06 -3.81 1.40 0.96

81.07 - 83.06 -1.91 0.59 1.44

(0.06)

(0.66)

(0.28)

(0.12)

I'

48

WLE XI: BEGRESSIOB OF A U B LIGHT HARGIA OH BIGEBIAll LIGHT M E G I N

Dependent I n d e p e n d e n t P e r i od C o n s t a n t S 1 ope Sqd. SEE DWS Var iab le Variable (SE) (SE) Correl-

a t i o n

SNPIWR - SSM S N F I W R - SSM SWPIWR - SSM S N P I W R - SSM

NNPIWR - NSM NNPIWR - NSM NNPIWR - NSH NNPIWR - NSM

76.01 0.06 -78.10 ( 0 . 0 4 )

78.11 -1.06 -79.07 (1 .22 )

79.08 -2 .55 -81.03 (0.50)

81.03 -0.84 -83.06 (0.13)

0.44 0 .51 0.23 1.49

0.87 0.55 1.81 2.22

0.61 0.31 0.87 1.57

0 . 9 2 0 . 6 4 0.51 1 .21

(0.08)

(0.30)

( 0 . 2 2 )

(0.14)

The r e s u l t s i n T a b l e X I show v e r y c l e a r l y t h a t

d e v i a t i o n s from the normal margin a r e c o r r e l a t e d between crudes

f o r e a c h of t h e f o u r e p i s o d e s . T h a t i s , i f t h e n e t b a c k i s

p a r t i c u l a r l y high r e l a t i v e t o t h e s p o t p r i c e for a g i v e n crude it

is l i k e l y t h a t t h e n e t b a c k w i l l a l s o be h i g h r e l a t i v e t o t h e

spot-crudes f o r t h e o the r crude. The high c o r r e l a t i o n p o i n t s t o

a strong l i n k between markets which i t may be p o s s i b l e t o c a p t u r e

e x p l i c i t l y by some economic v a r i a b l e . If t h i s is t h e case , t hen

a sha rpe r p i c t u r e would emerge of t h e l i k e l y range of t h e margin

between t h e netback and i t s a s s o c i a t e d crude. However this must

be a l i n k s e p a r a t e from one l i n k i n g crude p r i c e s t o g e t h e r and t o

c o s t s . E f f e c t i v e l y i t m e a n s t h a t w h a t e v e r c a u s e s

' d i s e q u i l i b r i u m ' i n o n e c r u d e m a r k e t a l s o c r e a t e s

' d i s e q u i l i b r i u m ' i n o t h e r m a r k e t s s o t h a t t h e m a r g i n is

a b n o r m a l l y l a r g e ( s m a l l ) i n b o t h a t t h e same t i m e . T h i s i s an

i n t e r e s t i n g f i n d i n g , p a r t i c u l a r l y f o r t h e f i r s t sub-period where

t h e two s i d e s of t h e m a r k e t a r e v e r y c l o s e l y t i e d t o g e t h e r for

e a c h c r u d e v i ewed s e p a r a t e l y . However t h e s t u d y of r e l a t i o n s

49

between crudes i s a l a r g e s u b j e c t and i s n o t t r e a t e d any f u r t h e r

here .

I n summary, t h e s i m p l e view of a c o n s t a n t "normal

margin" between spo t netbacks and s p o t crudes i s n o t supported by

t h e d a t a . T h e r e h a v e b e e n a s e r i e s of e p i s o d e s i n which t h e

m a r g i n h a s s h i f t e d v e r y c o n s i d e r a b l y . T h i s p o i n t s t o t h e

i n e s c a p a b l e c o n c l u s i o n t h a t t h e m a r g i n must be a f f e c t e d by t h e

s t a t e of the market and hence t h a t i t s behaviour may be r e l a t e d

t o o b s e r v a b l e economic v a r i a b l e s .

Futher t es t s on t h e r e l a t i o n s h i p s between t h e margins

for d i f f e r e n t c r u d e s showed t h a t d e v i a t i o n s from t h e "normal

margin" f o r a g i v e n sub-period were s t r o n g l y c o r r e l a t e d between

crudes. This t o o p o i n t s t o t h e p o s s i b i l i t y t h a t t h e r e a r e o t h e r

sys t ema t i c v a r i a b l e s i n v o l v e d . It appears t h a t t h e use of t h e

m a r g i n t o a s s e s s t h e s t a t e o f t h e m a r k e t is c a p a b l e o f

c o n s i d e r a b l e ref inement , bu t t h a t t h i s must i n e v i t a b l y move t h e

d i s c u s s i o n away from a p u r e l y s t a t i s t i c a l d e s c r i p t i o n (which we

have shown t o be indadequate) t o a t e n t a t i v e economic a n a l y s i s of

t h e problem.

50

-2

- 3

-'t

c -2

I - 0

F i g u r e I

Netback Margin Inetback less spot) for A r a b L i g h t

I 1 1 I

1980

B . 4 ECORCMIC FACTORS DETRRMIBIHG THE =BA= TO CRUDE MARGIB

So f a r w e h a v e h y p o t h e s i s e d t h a t t h e p r i c e s on t h e

c r u d e and p r o d u c t s i d e s of t h e m a r k e t c a n be e x p e c t e d t o move

t o g e t h e r , w i th a cons t an t margin between them. However, s i n c e

w e h a v e s e e n t h a t t h e r e l a t i o n s h i p i s more complex t h a n t h i s ,

some t h e o r e t i c a l d i s c u s s i o n of t h e r e l a t i o n s h i p i s required. We

s t a r t w i th s imple a n a l y t i c a l models and then work towards more

r e a l i s t i c cases. F i n a l l y , w e t e s t some of t hose hypotheses f o r

which d a t a a r e a v a i l a b l e .

( a > S t a t i c equ i l ib r ium wi th a s i n a l e market of i d e n t i c a l buyers

and crude sold a t a s i n g l e p r i c e

The s t a r t i n g p o i n t for our a n a l y s i s is t h e s i t u a t i o n

where a l l c r u d e i s s o l d on a s i n g l e m a r k e t a t t h e same p r i c e ,

where a l l t h e buyers a r e i d e n t i c a l and where t h e market a d j u s t s

i n s t a n t a n e o u s l y t o e q u i l i b r i u m . I n s u c h a c a s e t h e (assumed)

p r o f i t maximising behaviour of t h e buyers of crude w i l l make them

pay a t t h e m a r g i n an amount e x a c t l y e q u a l t o what t h e c r u d e i s

w o r t h t o them a t t h e margin. T h i s M C = M R c o n d i t i o n is t h e

s t a r t i n g p o i n t f o r a l l OUT a n a l y s i s . Now t h e m a r g i n a l c o s t of

t h e c r u d e i s , of c o u r s e , not n e c e s s a r i l y e q u a l t o t h e p r i c e o f

t h e crude s i n c e the buyers may be b i g enough t o a f f e c t t h e p r i c e

( i e t h e l a r g e r t h e i r purchase t h e lower t h e p r i ce ) . However, w e

know t h a t t h e marginal c o s t of t h e crude i t s e l f w i l l be g r e a t e r

51

than or equal t o t h e p r i c e of crude:

MCC > Pc

To t h i s must be added t h e o t h e r cos t components and a t t h i s s t a g e

we make t h e same a s s u m p t i o n s a s a r e used i n c a l c u l a t i n g t h e

netback :

( i ) t h e r e i s no s u b s t i t u t i o n p o s s i b l e be tween i n p u t s ( i e

between crude, l abour , t r a n s p o r t e t c ;

I iil marginal c a p i t a l c o s t s a r e i r r e l e v a n t .

The f i r s t a s sumpt ion i s v e r y l a r g e l y t r u e e x c e p t t h a t some

f l e x i b i l i t y i s p o s s i b l e i n r e f k i n g techniques. However, i f w e

s t i c k t o t h e case of b a s i c r e f i n i n g for t h e moment then the ze ro

s u b s t i t u t a b i l i t y a s s u m p t i o n is s u s t a i n a b l e . This imp l i e s t h a t

t h e t o t a l m a r g i n a l c o s t i s t h e sum of t h e m a r g i n a l c o s t s of t h e

components which are i n f i x e d proport ions. Hence w e can d e r i v e

t h e t o t a l short-run marginal c o s t by adding marginal t r a n s p o r t ,

insurance and r e f k i n g cos t s :

SMCp = MCc + HCT + M% (8)

We n e x t t u r n t o t h e m a r g i n a l r e v e n u e t o b e o b t a i n e d f r o m t h i s

crude. The crude is r e f i n e d and ( a l lowing f o r r e f i n i n g l o s s e s )

t h e o u t p u t can b e sold. If t h e r e is demand e l a s t i c i t y f o r t h e

products (as t h e r e is) and i f t h e s e l l e r s a r e of s u b s t a n t i a l s i z e

(as they o f t e n a re ) then the marginal revenue from sales w i l l be

l ess then t h e pr ice of t h e sales:

pp MRP ( 9 )

5 2

Combining equat ions (8) and ( 9 ) we have:

Pp > PlRp = SMCp = MCC + MCT + MCR > Pc + MCT + M$ (10)

where t h e s u b s c r i p t s a r e

P = product

C = crude

T = t r a n s p o r t

R = r e f i n i n g

Pp - HCT - MCR = N > P c (11)

where N = netback

P = p r i c e

MC = marginal c o s t s

Hence t h e n e t b a c k s h o u l d be g r e a t e r t h a n t h e c r u d e p r i c e by

f a c t o r s r e l a t i n g t o t h e r e l a t i v e s i z e of t h e buyers of crude i n

t h e c r u d e m a r k e t and of s e l l e r s i n t h e p r o d u c t m a r k e t s , t o t h e

e l a s t i c i t y of t h e demand c u r v e and t h e c o l l u s i v e or non-col l u s i v e

behaviour of t h e agents . The reasons i n t h i s model for changes

i n t h e margin (N - Pc> r e l a t e d t o changes i n t h e s e t h r e e f a c t o r s .

This a n a l y s i s p r o d u c e s t h e s t r o n g p r e d i c t i o n t h a t t h e m a r g i n

( c o r r e c t l y c a l c u l a t e d ) s h o u l d be p o s i t i v e and s t a b l e e x c e p t

a g a i n s t s h i f t s in concen t r a t ion , t h e degree of c o l l u s i o n or t h e

e l a s t i c i t y of demand. I f t h e s e f a c t o r s change only slowly ( a s

seems p o s s i b l e ) t h e n t h e margin should b e s t a b l e .

W e n e x t n e e d t o r e t u r n t o t h e i s s u e of c a p i t a l c o s t s .

T h i s can be r e s o l v e d by r e f e r r i n g t o t h e s t a n d a r d a n a l y t i c a l

r e s u l t s t h a t e a c h p o i n t o n t h e l o n g - r u n m a r g i n a l c o s t c u r v e is

i n t e r s e c t e d by t h e short-run marginal c o s t cu rve corresponding t o

t h e ( f ixed ) amount of c a p i t a l g e n e r a t i n g t h a t output a t minimum

53

c o s t . Hence t h e s h o r t - r u n m a r g i n a l c o s t e q u a l s t h e long- run

m a r g i n a l c o s t i n e q u i l b r i u m ( a l t h o u g h t h e c o n t r i b u t i o n s f rom

va r ious f a c t o r s a r e d i f f e r e n t ) and s o i f w e a l l o w no s u b s t i t u t i o n

i n t e c h n i q u e t h e n i g n o r i n g c a p i t a l c o s t s i s c o r r e c t (and would

g i v e t h e same v a l u e a s i n c l u d i n g marginal c a p i t a l c o s t s , but a l s o

a l l o w i n g f o r marginal b e n e f i t s i n c o s t s from vary ing t h e input

mix i e us ing r e l a t i v e l y less crude t o produce t h e same v a l u e of

output). This s imple d i s c u s s i o n omits e x i t and e n t r y costs which

we r e t u r n t o below.

T h i s s i m p l e model i s c l e a r l y t h e p r o t o t y p e of t h e

However, as we c a n s ee i t f a i l s t o

a l l o w f o r two o b s e r v e d f a c t s . F i r s t l y , t h e m a r g i n i s o f t e n

n e g a t i v e and s e c o n d l y t h e m a r g i n v a r i e s i n a n a p p a r e n t l y non-

random d i s c r e t e f a s h i o n wh ich c o u l d s c a r c e l y b e r e l a t e d t o

d i s c r e t e changes i n concent ra t ion , e t c . A very important aspec t

of s u c h a model i s t h a t it d o e s n o t imply any c a u s a l i t y - e g

t h a t p r o d u c t p r i c e changes c a u s e c r u d e p r i c e changes ( o r v i c e

versa) . It m e r e l y s t a t e s what t h e r e l a t i o n would b e between them

i n an unchanging environment.

( b ) S t a t i c e q u i l i b r i u m w i t h a s i n g l e market of non- ident ica l

no rma l margin" approach . I f

buyers w i t h crude so ld a t a single pr i ce .

An o b v i o u s f e a t u r e of t h e r e f i n i n g i n d u s t r y (which w e

a r e t ak ing as t h e buyer of crude and s e l l e r of products ) i s t h a t

not a l l f i rms have i d e n t i c a l cos t s t r u c t u r e s . Some p l a n t s are

o l d e r t han o t h e r s and t e c h n o l o g i c a l advances of a g i v e n d a t e are

n o t i n c o r p o r a t e d i n p l a n t s b u i l t a t e a r l i e r d a t e s . Hence, w e

mus t examine t h e i m p l i c a t i o n s of h a v i n g a m a r k e t w i t h non-

54

i d e n t i c a l buyers.

T h e r e is, of c o u r s e , a n immedia t e and i m p o r t a n t

e m p i r i c a l c o n s e q u e n c e - i t i s no l o n g e r p o s s i b l e t o t a l k of a

s i n g l e c o s t b u t o n l y of some a v e r a g e o r r e p r e s e n t a t i v e c o s t .

T h i s l e a d s , f i r s t , t o t h e p o s s i b i l i t y of some fo rm of s a m p l i n g

e r r o r and, s e c o n d l y , i t r e q u i r e s a d e c i s i o n as t o t h e r e l e v a n t

c o s t f o r our theory.

I n a c o m p e t i t i v e e q u i l i b r i u m w i t h a d i s t r i b u t i o n of

c o s t s t h e h i g h e s t c o s t p r o d u c e r s a r e t h e o n e s who w i l l b e

squeezed out f i r s t , and so the r e l e v a n t marginal c o s t is t h a t of

2 t h e h ighes t c o s t buyer s t i l l l e f t i n t h e market.

I f t h e sequence of s t a t i c e q u i l i b r i a were such t h a t t h e

same p l a n t was always marg ina l , t h e n it would be c o r r e c t t o t a k e

f i x e d i n p u t / o u t p u t ( y i e l d ) c o e f f i c i e n t s t o c a l c u l a t e t h e

a p p r o p r i a t e margina 1 costs .

T h i s is i n d e e d what h a s b e e n done i n t h e p u b l i s h e d

d a t a (at l e a s t f o r v e r y l e n g t h y p e r i o d s ) . The u s e of f i x e d

y i e l d s t o c a l c u l a t e t h e n e t b a c k s o v e r t i m e l e a v e s u s w i t h two

ques t ions :

( i >

some average i n t r a - m a r g i n a l f i rm?

( i i ) d i d t h e t e c h n o l o g y o f t h e s e q u e n c e of m a r g i n a l

f i r m s remain cons t an t?

a r e t h e y i e l d s t h o s e of t h e m a r g i n a l f i r m o r of

I f t h e y i e l d s were f o r an i n t r a - m a r g i n a l p l a n t t h e n t h e m a r g i n

should be more s t r o n g l y p o s i t i v e , w h i l e i f t h e technology of t h e

s e q u e n c e of m a r g i n a l p l a n t s improved o v e r the p e r i o d , t h e gap

between t h e i n t r a - m a r g i n a l f i x e d y i e l d plant and t h e marginal and

5 5

c h a n g i n g y i e l d p l a n t s s h o u l d na r row. Hence t h e m a r g i n of t h e

f i x e d y i e l d p l a n t o v e r t h e c r u d e p r i c e would be e x p e c t e d t o

n a r r o w over t h e p e r i o d ( i e Of c o u r s e t h e m a r g i n s of

h ighe r but unchanging technology p l a n t s (complex r e f k i n g ) w i l l

be g r e a t e r than t h o s e f o r 8 f ixed y i e l d b a s i c r e f i n i n g p l a n t , but

bo th should f a l l o v e r time. Thus big s h i f t s i n demand o r supply

which changed t h e marginal p l a n t s u b s t a n t i a l l y would be expected

t o b e r e f l e c t e d i n t h e marg in for a f i x e d t e c h n o l o g y i n t r a -

marginal p l an t .

( c > S t a t i c equ i l ib r ium wi th many markets of non- iden t i ca l buyers

t o f a l l ) .

and crude s o l d a t a s i n g l e price.

An i m p o r t a n t f e a t u r e of t h e p r o d u c t m a r k e t is t h e

geographical d i s p e r s i o n of t h e r e f i n i n g c e n t r e s and hence of t h e

s p o t product markets. Data is a v a i l a b l e on product pr ices i n a

wide r a n g e of m a r k e t s . However, i n e q u i l i b r i u m t h e m a r g i n a l

revenue from r e f i n i n g a b a r r e l of crude i n a g i v e n l o c a l market,

w i t h l o c a l r e f i n i n g cond i t ions and s o l d a t l o c a l product p r i c e s ,

when n e t t e d back to t h e p o i n t of s a l e must e q u a l t h e m a r g i n a l

c o s t o f t h a t b a r r e l . Hence a l l n e t b a c k s f o r a g i v e n c r u d e , i f

c a l c u l a t e d c o r r e c t l y , would be equa l i n s t a t i c equ i l ib r ium. This

o b s e r v a t i o n i s t o b e d i s t i n g u i s h e d f rom a n a l y s i s o f what t h e

e q u i l i b r i u m p r i c e w i l l be. Such an a n a l y s i s would b r i n g i n t h e

r e l a t i v e s t r e n g t h s of demand i n e a c h g e o g r a p h i c m a r k e t . W e d o

not need t o consider such f a c t o r s in r e l a t i n g t h e v a r i o u s prices

i n equi l ibr ium.

The d a t a i n T a b l e V I showed c o r r e l a t i o n s , t h a t were

h i g h b u t c e r t a i n l y n o t p e r f e c t , for d i f f e r e n t c o u n t r i e s e g

56

SNPIWR and SNPIWU and SNRBI and SNRCI. However, i n b o t h c a s e s

t h e US d a t a a r e f o r complex r e f i n i n g w h i l e t h e R o t t e r d a m d a t a

a r e f o r b a s i c r e f i n i n g , so one is d e f i n i t e l y more in t ra -margina l

than t h e o ther . PIW does g i v e d a t a on f i v e c e n t r e s c a l c u l a t e d on

t h e assumption t h a t t h e y i e l d s a r e f o r b a s i c r e f in ing . However,

o n c e w e admi t t h e p o s s i b i l i t y t h a t c o s t c u r v e s d i f f e r w i t h i n

c o u n t r i e s , t h e n f o r t i o r i t h e y a r e l i k e l y t o d i f f e r be tween

coun t r i e s , I n e q u i l i b r i u m only t h e h ighes t c o s t remaining p l a n t

in t h e world i s marginal and a l l o t h e r s a r e in t ra -margina l . The

d i f f e r i n g degrees of in t ra -margina l i t y w i l l produce non-perf e c t

c o r r e l a t i o n s between t h e va r ious netbacks. This model does i m p l y

t h a t o n l y t h e r e l a t i o n of t h e l o w e s t v a l u e n e t b a c k t o t h e s p o t

p r i c e s h o u l d b e i n v e s t i g a t e d . T h e r e is n o t h i n g e x t r a i n t h i s

c a s e t o e x p l a i n why t h e marg in be tween the n e t b a c k for a g i v e n

refinery and t h e c r u d e p r i c e s h o u l d vary o v e r t i m e i n t h e way

observed. We p r e s e n t t h e ev idence on t h e varous PIW netbacks i n

o rde r t o f i l l ou t t h e p ic ture .

I d ) S t a t i c equ i l ib r ium with many markets of non- iden t i ca l buyers

and more t han one crude (each w i t h a s i n a l e p r i c e ) .

A s p e c i a l f e a t u r e of t h e o i l marke t (wh ich i t s h a r e s

w i t h most a g r i c u l t u r a l commodi t i e s ) i s t h a t c r u d e o i l f rom

d i f f e r e n t c o u n t r i e s has d i f f e r e n t t e c h n i c a l p r o p e r t i e s . This

means t h a t t h e mix of p r o d u c t s o b t a i n a b l e i s d i f f e r e n t . Of

c o u r s e r e f i n i n g t e c h n i q u e s may b e v a r i e d s o a s t o b r i n g y i e l d

p a t t e r n s t o g e t h e r b u t t h i s c o s t s money, and w e m u s t e n v i s a g e a

market w i th d i s t i n c t l y d i f f e r e n t y i e l d p a t t e r n s f o r each crude.

The p r i c e s o f t h e p r o d u c t s a r e of c o u r s e t h e same i n a g i v e n

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market and so t h e crude p r i c e s r e f l e c t t h e d i f f e r e n t v a l u a t i o n s

p l a c e d upon t h e i r p r o d u c t s when t h e most e f f i c i e n t r e f i n i n g i s

b e i n g used ( i e where t h e m a r g i n a l b e n e f i t s f rom c h a n g i n g t h e

y i e l d s a t t hose p r i c e s a r e j u s t equa l t o t h e marginal c o s t s of so

do ing) . I f r e f i n e r i e s a r e c r u d e s p e c i f i c , as t h i s a n a l y s i s

sugges ts , t hen f o r each crude t h e r e w i l l be a marginal r e f i n e r y

and t h e m a r g i n a l r e v e n u e from t h i s r e f i n e r y w i l l e q u a l t h e

marginal c o s t s of t h e crude. Hence t o g e n e r a l i s e equat ion (11)

t o t h e case of two crudes w e would have:

Pp ( 1 ) - MCT (1) - MCR (1) = N (1) > Pc (1)

Pp ( 2 ) - MCT ( 2 ) - M$ ( 2 ) = N ( 2 ) > Pc ( 2 ) ( 1 2 )

The two margins r e f l e c t t h e concen t r a t ion on both s i d e s (of t h e

c r u d e b u y e r s and p r o d u c t s e l l e r s ) f o r t h e two c r u d e s . I n t h e

same product market w e would expect market power t o be i d e n t i c a l

- t h e p r o d u c t s a r e sold w i t h o u t r e f e r e n c e t o t h e c r u d e used. 3

Market power and concen t r a t ion a r e more l i k e l y t o vary between

purchasing l o c a t i o n s f o r d i f f e r e n t crudes. Hence even i f w e had

i d e a l d a t a f o r t h e t r u l y marginal p l a n t s t h e normal margins f o r

t h e two c r u d e s c o u l d b e d i f f e r e n t . However, t h e d i f f e r e n c e

between margins should be s t a b l e u n l e s s concen t r a t ion changes in

one market r e l a t i v e t o t h e other .

I f t h e d a t a a r e f o r f i x e d t e c h n o l o g y i n t r a - m a r g i n a l

p l a n t s t h e n b o t h m a r g i n s c a n be e x p e c t e d t o na r row, w h i l e t h e

d i f f e r e n c e be tween m a r g i n s s h o u l d remain s teady ( t e c h n o l o g i c a l

p r o g r e s s s h o u l d a f f e c t t h e r e f i n i n g o f a l l c r u d e s more o r less

equal ly . Geographical s e p a r a t i o n of p l a n t s should n o t compl ica te

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t h e i s s u e in t h e two c r u d e c a s e any d i f f e r e n t l y t h a n i n t h e

s i n g l e crude case.

( e ) S t a t i c equ i l ib r ium wi th many markets of non- iden t i ca l buyers

and more than one crude wi th each crude s o l d on a two-tier

p r i c e s y s t e m .

We begin w i t h t h e s i m p l e s t ca se of a s i n g l e crude w i t h

a s i n g l e r e f i n i n g market and i d e n t i c a l buyers. The crude is s o l d

a t two p r i c e s wh ich w e s h a l l d e n o t e " o f f i c i a l " and "spot". The

o f f i c i a l p r i c e i s t h a t of a government agency - i t i s p r e s e t and

which i s l i k e l y t o remain cons t an t for l eng thy per iods, w h i l e t h e

s p o t p r i c e i s t h e p r i c e d e t e r m i n e d by s u p p l y and demand on a

p a r t i c u l a r day.

So f a r our a n a l y s i s and p re l imina ry t e s t s have ignored

t h e o f f i c i a l p r i c e and i n s t e a d c o n c e n t r a t e d on t h e s p o t p r i c e .

If t h e s p o t m a r k e t w e r e p r e d o m i n a n t , t h a t i s i f a l l c r u d e were

s o l d s p o t , our approach would be s t r i c t l y c o r r e c t and would need

no f u r t h e r j u s t i f i c a t i o n . However, t h e b u l k of c r u d e oil is

p u r c h a s e d a t o f f i c i a l p r i c e s , w i t h t h e b e g i n n i n g of o u r p e r i o d

( 1 9 7 6 ) s e e i n g v i r t u a l l y a l l t r a n s a c t i o n s a t o f f i c i a l p r i c e s ,

w h i l e t h e end of t h e p e r i o d h a s s e e n a n i n c r e a s e i n s p o t and

spo t - r e l a t ed t r a n s a c t i o n s ( f i g u r e s of up t o 40% f o r s p o t - r e l a t e d

t r a n s a c t i o n s are o f t e n quoted). We must i n v e s t i g a t e t h e e f f e c t

of a t w o - t i e r p r i c e o n ou r r e l a t i o n s h i p s and a l s o t h e e x t r a

impact of t h e changing importance of t h e s p o t market.

S i n c e w e a r e d e a l i n g w i t h e q u i l i b r i u m s i t u a t i o n s w e

need a c l e a r v i e w o f how two d i f f e r e n t p r i c e s f o r t h e same

product can be s u s t a i n e d (with t r a d e con t inu ing a t both prices).

5 9

Here t h e r e a r e two c l e a r l y d i s t i n c t s i t u a t i o n s bu t both r e q u i r e

t h a t t h e s u p p l y a t t h e o f f i c i a l p r i c e i s l i m i t e d ( a n L-shaped

supply curve) . I f demand a t t h e o f f i c i a l p r i c e i s g r e a t e r than

t h e r a t i o n e d supply then t h e spo t p r i c e w i l l be forced above t h e

o f f i c i a l p r ice . I n such circumstances the s p o t p r i c e is t h e t r u e

marginal concept and t h e netback should be r e l a t e d s o l e l y t o t h e

spo t pr ice . This looks l i k e t h e c l a s s i c case of a d i sc r imina t ing

p r i c e s t r u c t u r e where by t h e producers of crude have market power

in t h e t i g h t marke t and c a n i n c r e a s e t o t a l p r o f i t s by u s i n g

quotas and two-part pricing.4 However, i t i s c l e a r t h a t much of

t h e s u p p l y on t h e spot m a r k e t d i d n o t come d i r e c t l y f rom t h e

producers bu t from buyers of crude who r e s o l d a t h ighe r pr ices .

Since o i l , u n l i k e e l e c t r i c i t y , is r e s a l e a b l e t h e r e is

then the f u r t h e r problem of how the p r i c e s were k e p t apar t . This

w a s done by t h e producers u s ing i m p l i c i t and e x p l i c i t means ( e g

d e s t i n a t i o n c l auses ) t o s t o p t h e buyers of c rude from r e s e l l i n g

it. C l e a r l y i n a t i g h t market t h e e f f e c t s of l o s s of goodwi l l on

being caught i n t h e act of r e s e l l i n g would b a l a n c e a s u b s t a n t i a l

p r i c e d i f f e r e n t i a l . Hence w h i l e t h e m a r k e t was t i g h t t h e

d i f f e r e n t i a l could pers is t .

In s u c h a s i t u a t i o n , a l t h o u g h a c t u a l s p o t c r u d e

t r a n s a c t i o n s were r e l a t i v e l y uncommon, t h e s p o t p r i c e was t h e

genuine ly marginal pr ice . I f a t y p i c a l company suddenly needed

more c r u d e i t would h a v e h a d t o buy i t o n t h e s p o t marke t .

However, the s e l l e r would ve ry l i k e l y have been another company

r a t h e r than a producer of crude. The normal margin between spot

products and s p o t crude c o u l d have been expected t o ho ld during

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t h i s p e r i o d of t i g h t n e s s ( d e f i n e d as one when t h e s p o t c r u d e

p r i c e was s u b s t a n t i a l l y and p e r s i s t e n t l y g r e a t e r t h a n t h e

o f f i c i a l p r i c e ) . The normal m a r g i n wou ld n o t b e d i s t u r b e d by

small changes i n quotas , o f f i c i a l p r i c e s o r demand ( even though

t h e s e would a l l a f f e c t t h e s p o t c r u d e p r i c e ) . T h i s is a n

important p i ece of a n a l y s i s s i n c e it shows why t h e product p r i c e

would n o t be e x p e c t e d t o f o l l o w t h e l o w e r o f i t s two p o s s i b l e

input p r i ces . C r i t i c a l l y f o r our purposes i t i s a l s o a t e s t a b l e

hypothesis .

However, l a r g e changes i n demand could and d i d r e s u l t

i n a s i t u a t i o n where t h e s u p p l y a t o f f i c i a l p r i c e s cou ld s a t i s f y

a l l t h e demand a t t h o s e p r i c e s . Wi th f u r t h e r r e d u c t i o n s i n

demand t h e r e wou ld b e e x c e s s s u p p l y , and i f a n o t h e r s o u r c e of

s u p p l y ( t h e s p o t m a r k e t ) emerged consumers would look a t t h a t .

Hence i f c r u d e were r e l e a s e d o n t o t h e spot m a r k e t t h e n i f t h e

r e s u l t i n g price were below t h e o f f i c i a l p r i c e a s i m p l i s t i c view

would i n f e r t h a t a l l c r u d e must h a v e b e e n bough t a t t h a t p r i c e

w i t h o u t d r i v i n g i t up t o t h e o f f i c i a l p r i c e , s i n c e i t wou ld b e

more p r o f i t a b l e f o r buyers t o purchase a t t h e lower p r i c e . The

empi r i ca l puzz le i s t h e o b s e r v a t i o n t h a t s i n c e 1982 s p o t p r i c e s

have been p e r s i s t e n t l y (and o f t e n s u b s t a n t i a l l y ) below o f f i c i a l

p r i c e s and y e t have n o t been bid up by demand switching en masse

f rom t h e o f f i c i a l to t h e s p o t market . As w e p o i n t e d o u t t h e r e

c e r t a i n l y h a s b e e n a growth i n t h e u s e of t h e s p o t m a r k e t i n

r e c e n t y e a r s , b u t s t i l l t h e b u l k o f o i l i s s o l d a t o f f i c i a l

p r i c e s .

There a r e a t l e a s t two r e a s o n s why a buyer might p r e f e r

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t o choose o f f i c i a l r a t h e r t h a n s p o t d e s p i t e t h e e x t r a mone ta ry

c o s t : ( i ) t h e r e are f i x e d c o s t s of t r a n s f e r r i n g t h e

source of purchase;

( i i ) t h e r e a r e " i n s u r a n c e " g a i n s t o be made i n

b u y i n g f rom o f f i c i a l s o u r c e s where t h e r e i s f u t u r e

supply uncer ta in ty .

So, i f i t t o o k t h e buy ing d e p a r t m e n t of a company some t i m e t o

overcome i t s adherence t o t h e t r a d i t i o n a l method of p u r c h a s i n g

( o f f i c i a l market) and t o l e a r n t h e d e t a i l s of u t i l i s i n g t h e spot

m a r k e t o n a r e g u l a r b a s i s , t h e r e s h o u l d be a g r a d u a l move t o

using t h e spot whenever t h i s w a s below t h e o f f i c i a l . Hence l a r g e

d i f f e r e n c e s i n p r i c e s s h o u l d become h a r d e r t o s u s t a i n . One

i m p l i c a t i o n of t h i s l i n e of a rgument must be t h a t t h e s p o t

m a r k e t , once i t h a s grown i n i m p o r t a n c e , w i l l c o n t i n u e t o b e

i m p o r t a n t . The b u y e r s will n o t f o r g e t how to u s e it when it

would be t o t h e i r advantage t o do so.

However, we do not n e c e s s a r i l y expect t h e d i f f e r e n t i a l

be tween s p o t and o f f i c i a l p r i c e s t o d i s a p p e a r a l t o g e t h e r o v e r

t i m e . Our second reason , t h a t of buying o f f i c i a l a s an insurance

premium, w i l l s t i l l b e v a l i d even when buyers a r e p e r f e c t l y

f a m i l i a r w i th t h e spo t market. When t h e r e i s s t i l l u n c e r t a i n t y

about f u t u r e p r i c e s and hence about the p o s s i b i l i t y of be ing a b l e

t o o b t a i n c r u d e when r e q u i r e d , i t m a y a p p e a r a d v a n t a g e o u s t o a

buyer n o t t o d e s e r t h i s t r a d i t i o n a l sou rce of supply for a l i t t l e

e x t r a p r o f i t . Hence w h i l e memories of excess demand s i t u a t i o n s

a r e s t i l l f r e s h o f f i c i a l crude may command a s u b s t a n t i a l premium

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o v e r s p o t c r u d e , However, as s u c h e p i s o d e s r e c e d e and t h e

1 i k e l i h o o d of s u p p l y s h o r t a g e seems weak t h e s i t u a t i o n w i l l

r e v e r s e . The s e l l e r s h o u l d b e p r e p a r e d t o o f f e r a d i s c o u n t t o

r e g u l a r c u s t o m e r s ( n o t t o a1 1 p u r c h a s e r s ) t o a t t e m p t t o r e d u c e

h i s r e v e n u e u n c e r t a i n t y . T h i s would t e n d t o push t h e o f f i c i a l

p r i c e down r e l a t i v e t o t h e s p o t pr ice .

A s a f i n a l p o i n t w e s h o u l d t o u c h on t h e i s s u e of why

t h e s e l l e r i s prepared t o s e l l a t two p r i c e s (hav ing seen why t h e

buyer may be prepared t o buy a t both pr ices) . A f i r s t reason f o r

t h e p e r s i s t e n t e x i s t e n c e of s u p p l y o n b o t h m a r k e t s is t h a t t h e

s a l e s on spo t a r e pu re ly by d i s t r e s s purchasers who have bought

t o o much o f f i c i a l . The second p o s s i b i l i t y is t h a t t o o 'high" an

o f f i c i a l p r i c e may mean l o s t s a l e s (and r e v e n u e ) and t h e

t e m p t a t i o n f o r one of t h e c a r t e l t o ' ' ch i se l ' ' i n a d i s c r e t e

f a s h i o n , by s e l l i n g some e x t r a a t a l o w e r p r i c e , may be v e r y

s t rong .

For o u r p u r p o s e s t h e i n t e r e s t i n g a s p e c t i s t h e

r e l a t i o n s h i p between t h e ne tback and t h e purchase p r i c e of o i l i n

t h e s i t u a t i o n where t h e spo t p r i c e i s below t h e o f f i c i a l p r ice .

C l e a r l y t h e s i m p l e s t a rgument would be t h a t t h e lower p r i c e

( spot ) is t h e marginal cos t and hence t h e ne tback should aga in be

r e l a t e d s o l e l y t o t h e s p o t p r i c e . However, o u r a rgument t h a t

b u y e r s a l w a y s buy m a i n l y a t o f f i c i a l for i n s u r a n c e p u r p o s e s ,

would imply t h a t a p o r t f o l i o t y p e d e c i s i o n was invo lved . Under

u n c e r t a i n t y t h e r e a r e two s o u r c e s of s u p p l y w i t h d i f f e r e n t

a v e r a g e c o s t s and d i f f e r e n t v a r i a n c e s of c o s t s ( r e l a t e d t o t h e

f u t u r e b e n e f i t s of b e i n g a r e g u l a r cus tomer f o r t h e c r u d e a t

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o f f i c i a l p r i c e s ) . The m a r g i n a l p u r c h a s e i n a p o r t f o l i o model

i n c l u d e s b o t h components ( w i t h s h a r e s a d d i n g u p t o one hundred

p e r c e n t ) . I f t h e p e r c e i v e d i n s u r a n c e gain changed t h e n the

c o m p o s i t i o n of t h e p o r t f o l i o would a l t e r . The outcome o f this

l i n e of a n a l y s i s i s t h a t i n t h e c a s e of a s i n g l e c r u d e t h e

n e t b a c k s h o u l d be r e l a t e d t o a w e i g h t e d a v e r a g e of spot and

o f f i c i a l p r i c e s whenever t h e spo t p r i c e f a l l s below t h e o f f i c i a l

p r i c e . This is a l s o a t e s t a b l e hypothesis , s i n c e the pe r iods of

o f f i c i a l p r i c e i n f l u e n c e are i d e n t i f i a b l e from t h e data.

The i s s u e o f t w o - t i e r p r i c i n g r a i s e s f u r t h e r

p o s s i b i l i t i e s when t h e r e i s more than one v a r i e t y of crude. If

t h e s p o t p r i c e s f o r b o t h c r u d e s were b e l o w t h o s e of t h e i r

r e s p e c t i v e o f f i c i a l p r i c e s then w e cou ld appea l t o t h e p o r t f o l i o

a rgumen t f o r b o t h c r u d e s . However, s i n c e t h e u n c e r t a i n t i e s on

t h e two s o u r c e s of s u p p l y might w e l l b e d i f f e r e n t i t would b e

r a t i o n a l t o t r y t o keep i n w i t h b o t h s u p p l i e r s , e v e n a t some

e x t r a r e f i n i n g c o s t s . A p o r t f o l i o wou ld t h e n i n c l u d e a l l

o f f i c i a l p r i c e s a s w e l l a s one s p o t p r i c e ( i n e q u i l i b r i u m s p o t

pr ices a r e d r i v e n t o a p o i n t where buyers are i n d i f f e r e n t between

them, s i n c e t h e r e a r e no f a c t o r s i n v o l v e d i n t h e i r choice except

r e l a t i v e pr ices) . The netback would a l s o have t o be a d j u s t e d t o

inco rpora t e t h e mix tu re of y i e l d s . We do n o t a t t e m p t t o f o l l o w

up t h i s complex idea b u t merely acknowledge i t s exis tence.

The p o r t f o l i o p u r c h a s i n g a rgumen t g i v e s a r e a s o n why

t h e netback w i l l n o t always be r e l a t e d s o l e l y t o t h e s p o t p r i ce .

A t c e r t a i n times i t w i l l a l s o be r e l a t e d t o t h e o f f i c i a l p r i c e -

s i n c e t h i s i s p red ic t ed t o happen when t h e s p o t crude p r i c e f a l l s

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below t h e o f f i c i a l p r i c e it f o l l o w s t h a t the l a r g e r t h i s gap t h e

h i g h e r s h o u l d b e t h e m a r g i n of t h e n e t b a c k o v e r t h e s p o t c r u d e

p r i ce . T h i s e s t a b l i s h e s a n a rgument € o r a m a r g i n l a r g e r t h a n

t h a t d u e s o l e l y t o t h e c o m p e t i t i v e s t r u c t u r e , and a l s o a n

argument f o r a v a r y i n g margin . The l a t t e r c e r t a i n l y a c c o r d s

roughly wi th t h e empi r i ca l evidence presented e a r l i e r , t h a t t h e

marg in improved a f t e r 1981, and t h i s was a l s o t h e t i m e a t which

t h e spo t p r i c e moved below t h e o f f i c i a l p r ice . These arguments

w i l l be t e s t e d more r i g o r o u s l y in t h e f o l l o w i n g s e c t i o n of t h e

paper.

(f) S t a t i c Equi l ibr ium w i t h a s i n g l e crude and wi th products

so ld t o more t h a t one c l a s s of u se r

So f a r t h e a n a l y s i s has concent ra ted on t h e case where

t h e r e f i n e d products a r e s o l d t o a ' f inal ' buyer.

However t h e r e a r e two important i n s t i t u t i o n a l f e a t u r e s

of t h e marke t t h a t h a v e changed over t h e p e r i o d and which a

s i m p l e a n a l y s i s does n o t b r ing out.

(1) Some products are s o l d as i n t e rmed ia t e i n p u t s t o r e f i n e r i e s t h e m s e l v e s (eg n a p t h a f o r f i n i s h e d g a s o l i n e ) and as a p ropor t ion of t h e market t h i s can vary.

Some companies a r e f u l l y i n t e g r a t e d (upstream and downstream) s o t h a t some c r u d e i s b e i n g conver ted i n t o products wi thout going through an a c t u a l market.

( 2 )

The f i r s t c a s e where t h e a v e r a g e p r o d u c t mix i s n o t

s o l d onto t h e market but some is f u r t h e r conver ted does sugges t

t h a t t h e r e i s an e x t r a p r o f i t t o be made on t h i s second r e f i n i n g

s tage . However, i n a compe t i t i ve model, t h e w i l l i n g n e s s t o buy

product whatever i t s use i s t o be and however much p r o f i t can be

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t h e r e b y o b t a i n e d w i l l make t h e r e v e n u e f rom a l t e r n a t i v e uses

equa l so t h a t t h e spo t p r i c e is s t i l l a marginal revenue. It i s

of c o u r s e t r u e t h a t t h e p r o d u c t s p o t m a r k e t w i l l be t h i n a t

c e r t a i n t i m e s bu t t h i s shou ld n o t d i s t o r t t h e a n a l y s i s .

S i m i l a r l y i f some r e f i n e r s a r e f u l l y i n t e g r a t e d and for

i n t e r n a l company r e a s o n s u s e t r a n s f e r p r i c i n g , t h a t d o e s n o t

v a l u e products a t spot market v a l u e s , t h i s may a f f e c t t h e t o t a l

ou tpu t of products i e a group of non-profi t maximisers may l e a v e

a 'smaller' market f o r o t h e r f i rms. N e v e r t h e l e s s f o r t h e s e non-

i n t e g r a t e d firms t h e v a l u a t i o n a t t h e margin shou ld s t i l l d r i v e

marginal revenue equal t o marginal c o s t ( i t w i l l m e r e l y be a t a

d i f f e r e n t o u t p u t ) . We see t h a t i f p r o f i t m a x i m i s i n g b e h a v i o u r

r u l e s o v e r p a r t of t h e market we then would expect t o observe t h e

normal MC=MR r e l a t i o n s h i p .

F i n a l l y w e consider t h e f a c t t h a t some product is s o l d

a t c o n t r a c t p r i c e s r a t h e r t han o n t h e spot market. C l e a r l y t h e

s p o t m a r k e t i s t h e c o r r e c t m a r g i n a l c o n c e p t i f s p o t p r o d u c t

p r i c e s a r e a b o v e c o n t r a c t p r o d u c t p r i c e s . However i f t h e

c o n t r a c t p r i c e were e v e r h i g h e r t h e n i t wou ld be m a r g i n a l

( a l l o w i n g f o r t h e e x t r a c o s t s of b e i n g t i e d t o a c o n t r a c t ) . It

migh t b e a r g u e d t h a t i n s u c h c i r c u m s t a n c e s t r a d i n g on s p o t

p r o d u c t s wou ld d r y up u n t i l t h e p r i c e e q u a l i s e d t h e a d j u s t e d

c o n t r a c t p r i c e so t h a t a p a r t from short-run f l u c t u a t i o n s t h e s p o t

p r o d u c t p r i c e i s a l w a y s t h e m a r g i n a l c o n c e p t . However t h e r e

c o u l d be a p o r t f o l i o s e l l i n g a rgument f o r p r o d u c t s j u s t a s for

b u y i n g c rude . S i n c e t h e a d v a n t a g e s f o r a c o n t r a c t a r e n o t j u s t

t h e p r i c e r e c e i v e d but a l s o a measure of c e r t a i n t y , a s e l l e r (who

6 6

i s not a r i s k l o v e r ) should be w i l l ing to se1 1 a f r a c t i o n on s p o t

and a f r a c t i o n o n c o n t r a c t w i t h t h e e q u i l i b r i u m c o n t r a c t p r i c e

b e i n g b e l o w t h e s p o t p r i c e (by t h e r i s k premium). T h i s would

imp ly t h a t i f t h e s p o t p r o d u c t p r i c e were a b o v e t h e c o n t r a c t

p r i c e t h e s p o t p r o d u c t p r i c e o v e r s t a t e s t h e r e v e n u e o n a u n i t

s a l e basis . C l e a r l y t h i s argument p r e s e n t s no r eason t o e x p l a i n

a spo t product p r i c e being p e r s i s t e n t l y below t h e s p o t c o n t r a c t

p r i c e . However i f t h i s d i d happen t h e n t h e s p o t p r o d u c t p r i c e

would u n d e r s t a t e r e v e n u e a t t h e m a r g i n were s e l l e r s a b l e t o

o b t a i n t h i s p r i c e . J u s t a s when s p o t c r u d e p r i c e s a r e a b o v e

o f f i c i a l p r i c e s but a r e y e t marginal because buyers cannot o b t a i n

o f f i c i a l , w e n e e d t o a r g u e t h a t s p o t p r o d u c t p r i c e s c o u l d f a l l

be low a c o n t r a c t p r i c e i f s e l l e r s a r e n o t a b l e t o o b t a i n a

c o n t r a c t a t t h e c u r r e n t c o n t r a c t p r i c e . Thus if t h e m a r k e t

switches away from t h e l e v e l a t which e x i s t i n g c o n t r a c t s were s e t

t h e n t h e s p o t p r o d u c t p r i c e c o u l d t e m p o r a r i l y f a l l b e l o w t h e

c o n t r a c t p r i c e . S i n c e c o n t r a c t s t h e m s e l v e s a r e p o t e n t i a l l y

f l e x i b l e and s e n s i t i v e t o market f o r c e s it i s n o t expected t h a t

t h i s s t a t e of a f f a i r s would p e r s i s t . N e v e r t h e l e s s during t h i s

phase s p o t product p r i c e s a r e t h e r e l e v e n t marginal revenue. To

summarise we have argued t h a t i f s p o t product i s below c o n t r a c t

p r i c e t h e n t h e f o r m e r i s m a r g i n a l w h i l e i f t h e s p o t p r o d u c t i s

above c o n t r a c t p r i c e s t h e t r u e marginal revenue may be o v e r s t a t e d

by t h e s p o t p r o d u c t p r i c e s ( b e c a u s e o f t h e d i v e r s i f i c a t i o n of

se1 l i n g ) . N e i t h e r case s u g g e s t s an a n a l y t i c a l r e a s o n why t h e

n e t b a c k (wh ich is based on spot p r o d u c t p r i c e s ) c o u l d be

unde r s t a t ed and hence why t h e r e is an observed n e g a t i v e margin.

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(g ) Short-run dynamics wi th a s i n g l e crude t raded a t a s i n g l e

p r i c e .

While we d i s c u s s t h e model i n equi lbr ium w e do n o t have

t o spec i fy anyth ing about t h e mechanisms of supply o r demand f o r

c r u d e oil, o r how t h e t w o s i d e s of t h e marke t a r e b r o u g h t i n t o

equi l ibr ium. However, it is n o t n e c e s s a r i l y t r u e t h a t the market

i s a l w a y s i n e q u i l b r i u m and indeed i t may t a k e t i m e t o move

towards e q u i l i b r i u m i n a s y s t e m a t i c f a s h i o n . I f t h e r e i s some

form of p a r t i a l adjustment i n t h e market t hen t h e c u r r e n t netback

margin w i l l n o t n e c e s s a r i l y be on average a good r e p r e s e n t a t i o n

of t h e e q u i l i b r i u m or normal margin (but r a t h e r w i l l r e f l e c t t h e

s e r i e s of i n c o m p l e t e a d j u s t m e n t s b r o u g h t a b o u t by demand o r

s u p p l y s h i f t s i n t h e p e r i o d ) . Even w i t h o u t a t t e m p t i n g t o

i d e n t i f y t h e c a u s e s o f t h e s e demand and s u p p l y s h i f t s we can

r e c o g n i s e t h a t t h e i r e x i s t e n c e w i l l p r o d u c e a d y n a m i c

r e l a t i o n s h i p between product p r i c e s and crude p r i ces .

We b e g i n by l o o k i n g a t t h e t e m p o r a l s e q u e n c e i n t h e

t ransformat ion of crude i n t o products . Once t h e crude i s s o l d ,

i t w i l l need t o be t r a n s p o r t e d f rom t h e p o i n t of s a l e t o t h e

r e f i n i n g cent re . For Saudi crude bought a t o f f i c i a l p r i c e s and

b e i n g r e f i n e d a t Ro t t e rdam t h i s m a y t a k e up t o s i x weeks. The

l a g on spot purchases is more p r o b l e m a t i c a l , s i n c e it depends on

t h e l o c a t i o n of t h e cargo a t t h e p o i n t of s a l e . Remembering t h a t

o u r p r i c e d a t a i s l a r g e l y " i n t h e month" we c a n e x p e c t a l a g of

be tween z e r o and s i x weeks, g i v i n g a mean lag of up t o a month.

Once t h e crude a r r i v e s a t t h e r e f i n e r y i t w i l l be added t o stocks

and only g r a d u a l l y used t o produce products. There w i l l be some

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inventory of products which produces a f u r t h e r d e l a y before t h a t

crude i s a c t u a l l y sold a s a product a t t h e r e f i n e r y gate.

T h i s p r o d u c t i o n l a g i n t r o d u c e s a p r o b l e m n o t o f t e n

f a c e d i n e l e m e n t a r y economics , t h a t o f t h e t i m i n g of t h e

passing-on of p r i c e increases . Whatever p r i n c i p l e of p r i c ing i s

used, whether p e r f e c t l y c o m p e t i t i v e , mark-up or 01 i g o p o l i s t i c ,

t h e firm h a s a r a n g e o f o p t i o n s be tween LIFO and FIFO p r i c i n g

r u l e s . I f FIFO p r i c i n g i s used p r i c e s r e s p o n d w i t h a l a g e q u a l

to t h a t of t h e per iod of product ion ( i n c l u d i n g t h e two inventory

h o l d i n g p e r i o d s a s p a r t of t h e p e r i o d of p r o d u c t i o n ) . A t t h e

o t h e r ex t r eme , i f LIFO p r i c i n g i s used t h e n c o s t of c r u d e

i n c r e a s e s a r e i m m e d i a t e l y r e g i s t e r e d i n p r i c e of p r o d u c t

i n c r e a s e s . The s p i r i t of a rgumen t s u sed t o d e s c r i b e p e r f e c t

c o m p e t i t i o n s u g g e s t s t h a t FIFO would b e u s e d , with f i r m s

r e l u c t a n t t o push up pr ices because of l o s t demand u n t i l t h e loss

on p r o f i t s from t h e h igher c o s t s forced them (and competi tors) t o

do so. O l i g o p o l i s t i c p r i c i n g p r a c t i c e s may vary from t h i s (as i n

t h e e x a m p l e of f i r m s m a r k i n g u p s t o c k i m m e d i a t e l y a f t e r l a r g e

c o s t i nc reases , eg d e v a l u a t i o n s , a r e announced) but i t does not

seem t h a t L I F O w i l l b e a t t r a c t i v e i n n o n - c o l l u s i v e marke t s .

A c c o r d i n g l y w e e x p e c t t h e r e t o be some l a g i n t h e p a s s i n g on o f

c o s t s (crude p r i ces ) t o r evenues (product p r i c e s ) when the re a r e

s h i f t s i n t h e c o s t curves .

In a w o r l d w h e r e c o s t s a r e c h a n g i n g c o n s t a n t l y , o r a t

l e a s t f a i r l y o f t e n , t h e r e may b e some d e s i r e t o r e d u c e

v a r i a b i l i t y i n p r o d u c t p r i c i n g and s o p r o d u c t p r i c e s m i g h t

a t tempt t o smooth ou t s h i f t s in cos ts . This f a c t o r would perhaps

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a l l o w l o n g e r l a g s be tween changes i n c r u d e p r i c e s and t h e

a s s o c i a t e d changes i n product p r i c e s than a s i m p l e FIFO r u l e .

So f a r w e h a v e c o n c e n t r a t e d on s h i f t s coming on t h e

supply s i d e , which produce changes in crude p r i c e s and which are

t hen t r ansmi t t ed t o product p r i ces . However, much of t h e s h o r t

r u n d i s t u r b a n c e (as w e l l a s some o f t h e l o n g e r run e f f e c t s ) t o

t h e c r u d e o i l m a r k e t comes f rom the demand s i d e . I f t h e demand

f o r p r o d u c t s s u d d e n l y d r o p s ( b e c a u s e of a f a l l i n t h e g e n e r a l

l e v e l of economic a c t i v i t y ) t h e n p r o d u c t p r i c e s a r e l i k e l y t o

f a l l u n l e s s :

(i) p r i c i n g i s e n t i r e l y done on a mark-up b a s i s ;

( i i > p r i c i n g i s designed t o change r a t h e r more smoothly than demand, and i n v e n t o r i e s are used t o absorb t h e s h i f t s .

I n a l l cases t h e f a l l i n s a l e s o r p r o f i t s w i l l tend t o l e a d t o a

r educ t ion i n t h e quan t i ty of crude purchased. Most of t h i s w i l l

b e f e l t o n t h e o f f i c i a l marke t b u t i t w i l l a l s o s p i l l i n t o t h e

m a r g i n a l s p o t marke t . Hence 8 f a l l i n s p o t p r i c e s w i l l come

a b o u t . Again t h e r e i s t h e p o s s i b i l i t y of a l a g from p r o d u c t

p r i c e s t o crude p r i c e s because of t h e w i l l i n g n e s s of producers t o

l i v e wi th some v a r i a t i o n i n demand.

Hence c a u s a l i t y and l a g s c a n r u n in b o t h d i r e c t i o n s .

Furthermore t h e two s i d e s of t h e market may i n t e r a c t i n a dynamic

f a s h i o n . Suppose demand f o r p r o d u c t s f a l l s - t h i s l e a d s t o a

f a l l i n p r i c e s a t e x i s t i n e , c o s t s . The f i r m s a l s o d e c i d e t o

reduce t h e i r purchases of crude, which lowers t h e crude p r i c e and

w i l l a f f e c t t h e product p r i c e , magnifying i ts i n i t i a l f a l l .

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Hence a l t h o u g h w e need n o t s p e c i f i c a l l y model t h e f a c t o r s

s h i f t i n g t h e s u p p l y and demand c u r v e s w e c o u l d model t h e

a d j u s t m e n t p r o c e s s . The g e n e r a l s t r u c t u r e would be a p a i r of

dynamic equat ions:

S t f (Nt, N t - l ..... > Nt = f ( S t + st,2 .... 1 (13)

where t h e l a g s a r e long enough to c a t c h a l l t h e de layed response

f rom a s h i f t o n one s i d e of t h e m a r k e t t o t h e d i r e c t e f f e c t s on

t h e o t h e r s ide. The feedback e f f e c t s would of course be captured

by t h e s u b s t i t u t i o n of one e q u a t i o n i n t o t h e o t h e r . The e r r o r

terms i n these equat ions would be t h e supply and demand s h i f t i n g

v a r i a b l e s . The problem wi th these equat ions is one of e s t ima t ing

s t r u c t u r a l parameters without exogenous v a r i a b l e s . I f t h e t a s k

s e t were l e s s a m b i t i o u s i e e s t i m a t i o n of t h e a v e r a g e l a g s on

e i t h e r s i d e of t h e market then t h e r e is some way forward.

These dynamic m o d e l s show c l e a r l y t h a t t h e a c t u a l

margin w i l l no t n e c e s s a r i l y be a good e s t ima to r f o r t h e "normal

e q u i l i b r i u m " marg in b e c a u s e of t h e o m i s s i o n of t h e l a g g e d

v a r i a b l e s which r e l a t e t h e two concepts.

(h) Shor t run dynamics w i t h a s i n g l e crude t raded a t two prices.

I f t h e spot p r i c e were always above t h e o f f i c i a l p r ice ,

b e c a u s e o f r a t i o n e d demand, t h e n t h e dynamic a n a l y s i s wou ld

c o n t i n u e t o r e l a t e n e t b a c k s and s p o t c r u d e p r i c e s as i n t h e

p r e v i o u s s e c t i o n . Even i f t h e o f f i c i a l p r i c e changed t h e

r e l a t i o n be tween t h e two would be u n a l t e r e d a c c o r d i n g t o t h e

arguments put forward ( a l though t h e l e v e l of t h e spot p r i c e would

change). THe matter i s obv ious ly less s i m p l e i f t h e spot p r i c e

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were below t h e o f f i c i a l pr ice . Both lagged p r i c e s should a f f e c t

t h e n e t b a c k , b u t t h e l a g s be tween t h e two c o u l d b e d i f f e r e n t i f

s p o t were purchased i n a d i f f e r e n t l o c a t i o n from o f f i c i a l . Given

t h a t f o r some crudes t h e o f f i c i a l w a s changed r a t h e r i n f r e q u e n t l y

( r e l a t i v e t o m o n t h l y d a t a ) t h e l a g f rom o f f i c i a l p r i c e s t o

netbacks may be d i f f i c u l t t o s e p a r a t e from t h e c u r r e n t e f f e c t .

( i> Short run dynamics with more than one crude.

A l t h o u g h t h e a d j u s t m e n t p r o c e s s f o r a g i v e n c r u d e i s

f a i r l y easy t o fo rmula t e , t h e problem becomes much more d i f f i c u l t

when a second crude i s introduced. I n p a r t i c u l a r we may wish t o

d i s t i n g u i s h between supply shocks t h a t a r e crude s p e c i f i c or a r e

gene ra l . Demand shocks apply t o products and hence ( i n a g i v e n

l o c a t i o n ) w i l l a f f e c t a l l netbacks very s i m i l a r l y i n t h e s h o r t

run. Shocks which a r e p r o d u c t s p e c i f i c w i l l a f f e c t t h o s e

netbacks which are most i n t e n s i v e i n t h e product concerned. Thus

w e have fou r cases :

(i) g e n e r a l demand s h i f t s wh ich a f f e c t a 1 1 n e t b a c k s e q u a l l l y ;

( i i ) produc t - r e l a t ed demand, s h i f t s which w i l l a f f e c t netbacks d i f f e r e n t i a l l y ;

( i i i ) gene ra l supply s h i f t s which w i l l tend t o push up a l l crude p r i c e s evenly;

( i v ) c r u d e - s p e c i f i c s u p p l y s h i f t s w h i c h p u s h up one crude most.

While t h e new se t of e q u i l i b r i u m p r i c e s and netbacks a r e emerging

w e w i l l f i n d t h a t s h i f t s i n one m a r k e t w i l l show p a r t i a l

adjustments i n o t h e r markets a s w e l l a s own markets. This type

o f a d j u s t m e n t i s p o s s i b l e t o m o d e l , b u t w i t h o u t a n a r t i c u l a t e d

t h e o r y of t h e e q u i l i b r i u m r e l a t i o n s h i p between crude p r i c e s it

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would be d i f f i c u l t t o implement an i n t e r - r e l a t e d p r i c e adjustment

model.

S i m i l a r l y , demand shocks i n a s p e c i f i c g e o g r a p h i c a l

m a r k e t would g r a d u a l l y s p i l l o v e r i n t o o t h e r m a r k e t s , b u t t h e

formal adjustment p rocess would be t r i c k y t o hand le because of

t h e p o s s i b i l i t y of t r a d e i n t h e products.

(j) A s i n g l e crude when t h e r e a r e e x i t and e n t r y c o s t s and when

t h e r e a r e o m i t t e d c o s t s .

The p e r s i s t a n c e of a n e g a t i v e m a r g i n i e of n e t b a c k s

b e i n g be low c r u d e p r i c e s f o r a p e r i o d u p f o u r y e a r s r a i s e s a n

important p o i n t of i n t e r p r e t a t i o n . Since, as w e have argued, t h e

marg ina l r e f i n e r y might w e l l show an even g r e a t e r marginal loss

w e need t o d i s c u s s whether such a r e s u l t is compatible w i t h t h e

5 t ype of p r o f i t maximising behaviour t h a t we have so f a r assumed . One i n t e r p r e t a t i o n of t h e p e r s i s t a n c e of ( a v e r a g e )

l o s s e s of t h i s phenomenon i s t h a t t h e r e a r e l a r g e e x i t c o s t s

which persuade r e f i n e r s t h a t it is b e t t e r t o s t a y i n and o p e r a t e

t h e p l a n t even though t h i s shows a paper l o s s . The types of cos t

t h a t w o u l d e n t e r t h i s c a l c u l a t i o n a r e t h e s h u t down o r

m o t h b a l l i n g c o s t s . I f firms e x p e c t t h e m a r k e t t o expand a t a

l a t e r d a t e , having j u s t experienced a f a l l i n demand, t h e n t h e r e

is a l s o a r e - e n t r y c o s t t o c o n s i d e r ( b r i n g t h e p l a n t o u t of t h e

m o t h b a l l s e t c ) . However i n b o t h t h e case of a f a l l i n demand

t h a t i s seen as permanent and t h e f a l l t h a t i s seen a s temporary

( s h o r t to medium r u n ) i t i s s t i l l n e c e s s a r y t o c o n s i d e r t h e

cond i t ions under which exit would s t i l l be t h e b e s t po l i cy . We

can t a k e t h e f i r s t c a s e t o i l l u s t r a t e t h e arguments. Demand has

73

f a l l e n from a l e v e l a t which t h e market was i n e q u i l i b r i u m t o a

l o w e r l e v e l , wh ich i s s e e n a s permanent . The e x i t r u l e of

elementary economics sugges t s t h a t i f average r evenue does not

cover average v a r i a b l e c o s t s t h e n t h e r e should be immediate e x i t

- o t h e r w i s e e x i t s h o u l d t a k e p l a c e once t h e f i x e d c o s t e l e m e n t

has become v a r i a b l e . However i f t h e opportuni ty c o s t s i t u a t i o n

must i n c l u d e a s u b s t a n t i a l e l e m e n t f o r s h u t down c o s t s t h e n a

discounted cash f l o w c a l c u l a t i o n i s r e l e v e n t . This needs t o ask

f o r which f u t u r e y e a r i t i s loss m i n i m i s i n g t o s h u t down.

Suppose t h e s h u t down c o s t s v a r y i n r e a l terms w i t h t h e y e a r of

t h e shut down and t h a t t h e y e a r l y ope ra t ing l o s s is cons tan t (and

i s t h e minimum t h a t can be obtained) . Then t h e DCF is c a l c u l a t e d

for a series of hypo the t i ca l s h u t down years. I f i n t h e c u r r e n t

per iod t h e minimising year f o r s h u t down i s g r e a t e r t h a n zero t h e

whole process i s taken forward one year with t h e p l a n t k e p t open.

The c a l c u l a t i o n is r e p e a t e d t h e n e x t y e a r and so o n u n t i l i t s

m i n i m i s i n g v a l u e i s z e r o and t h e p l a n t i s s h u t down ( i f t h e r e

were n o r e d u c t i o n i n s h u t down c o s t s t h e p l a n t w o u l d e i t h e r be

c l o s e d down immediately or never). Hence i f t h e s h u t down c o s t

i s l a r g e r e l a t i v e t o running l o s s e s and i f it f a l l s s l o w l y then

t h e market can o p e r a t e a t a book-keeping loss f o r s e v e r a l years

( t h e l o s s being even bigger i f i t s h u t down immediately).

Clearly i f we g e n e r a l i s e t h i s t o t h e c a s e where demand

i s expected t o pick up again and t h e r e a r e r e -en t ry c o s t s (which

probably i n c r e a s e t h e longer t h e p l a n t i s i d l e ) t h e n t h i s should

extend t h e per iod du r ing which a l o s s would be s u s t a i n e d wi th t h e

p 1 a n t running.

74

However t h e r e is s t i l l t h e d i f f i c u l t y of e x p l a i n i n g why

t h e M C = M R c o n d i t i o n i s a p p a r e n t l y v i o l a t e d f o r such a l o n g

period. I f t h e p l a n t i s t o be ope ra t ed i t should s t i l l be run t o

m i n i m i s e l o s s e s and t h i s would b e where MC=HR - i e e x i t c o s t s

can e x p l a i n t h e p e r s i s t e n c e of ave rage l o s s e s but not marginal

10s ses . It i s a t t h i s p o i n t t h a t we must a l s o c o n s i d e r o t h e r

r e a s o n s for d e c i d i n g on t h e optimum o p e r a t i o n of a p l a n t .

S t r a t e g i c o r p o l i t i c a l f a c t o r s may d e t e r m i n e t h e c h o i c e of

o p e r a t i n g size f o r s e v e r a l p l a n t s a t a l e v e l which may not r e l a t e

t o c u r r e n t prof i t a b i l i t y issues . However t h i s would m e r e l y put

more p r e s s u r e on o t h e r r e f i n e r s to a d j u s t output (and hence would

a f f e c t p r i c e s on b o t h s i d e s of t h e marke t ) . Only a g e n e r a l

w i l l i n g n e s s t o s a c r i f i c e c u r r e n t p r o f i t s t o o t h e r g a i n s would

p e r m i t t h e p r i c e s t o s t a y a p a r t i n t h i s fashion. Hence w e c a n

n o t a p p e a l t o s e l e c t i v e non-prof i t maximis ing b e h a v i o u r t o

e x p l a i n t h e p e r s i s t e n c e of marginal l o s ses .

75

B . 5 FIIII'PHBB STATISTICAL TESTS ON THE RELBTIONSEIPS BETUEEA PRODUCT AND CRUD3 PRICES

B I 5 I 1 AlU UBCORSS1BBIl!lED BEIATIOHSEIP

The s t a t i s t i c a l a n a l y s i s so f a r has r e l a t e d t h e netback

t o t h e spo t crude pr ice w h i l e t h e t h e o r e t i c a l s e c t i o n has l a r g e l y

d i scussed t h e r e l a t i o n s h i p between marginal r evenue and marginal

cost . Given t h a t t h e netback i s a p u r e l y cons t ruc t ed series it

i s i m p o r t a n t t o c o n s i d e r w h e t h e r i t c a n be u s e d a s a m e a s u r e o f

marginal revenue (with c e r t a i n c o s t s deducted). The problems of

a c t u a l measurement h a v e b e e n d e a l t w i t h a t l e n g t h i n s e c t i o n

B.2.2 - i f t h e concept is c o r r e c t t hen w e have shown a very g r e a t

deg ree of concordance on t h e measurement of t h e s e r i e s from very

d i f f e r e n t sources. The problem, if it exists, is more l i k e l y t o

be c o n c e p t u a l - w e h a v e a l r e a d y d i s c u s s e d t h e d i f f i c u l t i e s

a s s o c i a t e d wi th cho ice of r e f i n e r y , measuring s h o r t or long-run

m a r g i n a l c o s t e l e m e n t s and t h e i m p o r t a n c e o f t h e a s s u m p t i o n o f

f i x e d c o e f f i c i e n t t e c h n o l o g y . We c a n n o t a s s e r t t h a t w e h a v e

measu red m a r g i n a l r e v e n u e s and c o s t s b u t m e r e l y t h a t we h a v e

obtained t h e b e s t estimates a v a i l a b l e a t present . A l l i n f e r e n c e s

w i l l be c o n d i t i o n a l on p o s s i b l e mis-specif i c a t i o n a t t h i s s t e p of

t h e a n a l y s i s . To a n t i c i p a t e t h e r e s u l t s w e n o t e t h a t when t h e

n e t b a c k i s b e l o w t h e c r u d e p r i c e t h e n i f t h i s i s a measurement

e r r o r a r i s i n g f o r c o n c e p t i o n a l m i s - s p e c i f i c a t i o n t h e n e i t h e r

r e v e n u e i s t o o low o r c o s t s a r e t o o h i g h . The r e v e n u e f i g u r e s ,

76

being based on product v a l u e s and average y i e l d s can s c a r c e l y be

too low f o r t h e marginal r e f i n e r y (even though they a r e c l e a r l y

lower t h a n f o r t h e i n t r a - m a r g i n a l r e f i n e r y ) . The c o s t f i g u r e s

a r e p e r h a p s v u l n e r a b l e i n t h e t r a n s p o r t c o s t o r r e f i n i n g c o s t

e l e m e n t s b u t t h e s e a r e r a t h e r s m a l l and i n o r d e r t o p roduce a

p o s i t i v e margin would need t o a lmos t disappear . C l e a r l y t h e r e i s

a l s o l i t t l e room in this approach t o a l l o w f o r o t h e r c o s t s t h a t

may have been omitted. Bearing these concept ional d i f f i c u l t i e s

i n mind we u s e t h e f i g u r e s a s o u r b e s t a v a i l a b l e e s t i m a t e s of

c o s t s and revenues.

Before we in t roduce any e x t r a v a r i a b l e s w e e s t i m a t e t h e

r e l a t i o n s h i p between t h e netback and t h e spot crude p r i c e i n i t s

leas t r e s t r i c t e d form ie:

Nt = a + bSt + ut (14)

G i v e n t h a t w e found t h e p a r a m e t e r s t o be v a r i a b l e be tween

e p i s o d e s i t is s e n s i b l e t o s t a r t w i t h t h e m o d e l s e s t i m a t e d for

sub-periods. To o b t a i n t h e longes t runs of d a t a w e h a v e f o r Arab

L i g h t t h e two n e t b a c k s ( S N R B I and SNPIWR) and t h e two p r i c e

s e r i e s (SSM a n d SSI) w h e r e t h e d a t a is f e l t t o b e m o r e

acceptab le . The r e s u l t s a r e shown i n Table X I I .

77

TABLE XII: Relations between Hetbacks and Spot Crude Prices For Arab Light

Dependent Independent Period Constant S 1 ope SEE DWS Var i a b l e Variable

SNPIWR SPJPIWR SNRBI SNRBI SNPrWR SWPIWR SNRBI SNRB I SNPIWR SNP IWR SNRBI SNRBI SNPIWR SNPIWR SNRBI SNRBI

S SM S SM SSI s SI S SM S SM SSI ssz S SM S SM SSI SSI S SM SSM s SI SSI

76.01-78.10 76.01-78.10 76.01-78.10 76 .01-79.10 78.11-79.05 78.1 1-79.05 78.11-79.05 78.1 1-79.05 79.06-81.06 79.06-81.06 79.06-81.06 79.06-81.06 81.07-83.06 81.07-83.06 81.07-83 06 81.07-83.06

-3.0(2.5) 1.2( 12.6) 0.30 1.44 0.996(220) 0.33 1.14

-0.9(0.7) 1.08(10.8) 0.30 0.96 1.009( 239) 0.30 0.92

6.7(3.0) O.gO(8.5) 2.1 1.59 1.06(25.7) 2.9 0.93

5.1(2.6) 0.84(10.2) 1.7 1.36 1.04(32) 2.3 0.76

5.0(1.5) 0.79(8.4) 1.22 1.18 0.90(129) 1.26 1.23

-0.3(0.1) O.gl(9.4) 1.13 0.77 0.90(146) 1.11 0.77

-0.3(0.1) 0.97(12.6) 0.74 1.32 0.96(203) 0.72 1.31

1.16(2.1) 0.93(13.7) 0.64 1.41 0.97I236) 0.63 1.45

The r e s u l t s of t h e unconstrained model are u s e f u l l y

compared wi th t h e cons t r a ined model :

f o r wh ich t h e r e s u l t s w e r e g i v e n i n T a b l e I X . The d i f f e r e n c e

between these two models is the r e s t r i c t i o n on t h e c o e f f i c i e n t of

t h e s p o t p r i ce . The unconstrained model a l l o w s t h e movements t o

be o t h e r than d o l l a r for d o l l a r responses. Since i n many c a s e s

t h e i n t e r c e p t term becomes i n s i g n i f i c a n t l y d i f f e r e n t f rom z e r o

t h e model is then cons t r a ined i n a d i f f e r e n t way:

The f i r s t comparison w e make is t h a t between t h e d i f f e r e n t d a t a

s o u r c e s . When t h e c o n s t r a i n t i s o m i t t e d t h e r e s u l t s a r e v e r y

s i m i l a r , i n gene ra l t h e indus t ry sources g i v e t h e b e t t e r fit .

Once we t u r n t o t h e a n a l y s i s of t h e s e p a r a t e pe r iods w e

c a n s e e t h a t f o r any g i v e n model t h e r e a r e s u b s t a n t i a l s h i f t s

78

be tween p e r i o d s in t h e c o e f f i c i e n t s . Hence t h e i n s t a b i l i t y w e

n o t e d w i t h t h e b a s i c "normal marg in" model i s n o t removed by

g e n e r a l i s i n g t o t h e "spot - re la ted margin" model. In p a r t i c u l a r

the short e p o s i d e 1978.11 t o 1979.05 is v e r y d i f f e r e n t from t h e

o t h e r p e r i o d s . It may w e l l n o t b e p o s s i b l e t o d e s c r i b e t h i s

t u r b u l e n t p e r i o d i n a s i m p l e m o d e l , and w e s h o u l d n o t be t o o

c o n c e r n e d by f a i l u r e t o f i t i t . E v e n t h e o t h e r t h r e e p e r i o d s

show v a r i a t i o n , and i n g e n e r a l t h e r e is l i t t l e e v i d e n c e f o r a

non-zero i n t e r c e p t when t h e "mark-up" is n o t c o n s t r a i n e d t o

uni ty . We can c i t e as a t y p i c a l r e s u l t t h e model u s i n g indus t ry

d a t a w i t h o u t a n i n t e r c e p t . I n t h e p e r i o d 1976.01 t o 1978.10 t h e

netback increased $1.01 f o r e v e r y d o l l a r r ise i n s p o t p r i c e s ; i n

1979.06 t o 1981.06 t h i s margin w a s down to $0.90; and f o r 1981.07

i t had r ecove red t o $0.97. Given t h e v e r y s m a l l s t anda rd e r r o r s

these c o e f f i c i e n t s a r e s i g n i f i c a n t l y d i f f e r e n t f r o m each o t h e r ,

and s o t h e r e i s some s t r u c t u r a l s h i f t b e i n g shown in t h e "spot -

r e l a t e d margin". The s t a n d a r d e r r o r s of e s t ima tes for t h e s e

t h r e e sub-periods vary a g r e a t d e a l , and add f u r t h e r ev idence f o r

s h i f t s .

When we r e p e a t t h e same e x e r c i s e for Niger i a we o b t a i n

very s imilar r e s u l t s (Table XIII).

7 9

TABLE XZII: Relations betveen Betbacks and Spot Prices for l iger ia .

NNP IWR NWPIWR NNRBI NNRB I

NNPIWR NNPIWR NNRB I NNRB I

NNP IWR MNPIWR NNRB I NNRB I

NNPIWR NNP IWR NNRB I NNRB I

ISM N SM MSI N S I

N SM NSM NSI MSI

MSM NSM NSI NSI

NSM NSM N S I NSI

76.01-78.10 -0.82(0.4) 1.04(7.1) 76.01-78.10 0.98( 149 76.01-78.10 1.20(0.6) 0.93(5.9) 76 .O 1-78.10 1.01(144)

78.1 1-79.07 6.5( 2.7) 0.88(9.6)

78.1 1-79.07 0 -8 9( 8 - 2) 78.11-7 9 -07 1.1 Z(31)

78.11-79.07 1.13(29) 6.5( 2 3)

79.08-81.02 5.86(2.44) 0.79(13)

79.08-81.02 -1.08(0.4) 0.98( 14) 79.08-81.02 0.95(187)

79.08-81.02 0.95(222)

81.03-83.06 0.40(0.2) 0.97(18) 81.03-83.06 0.98( 23 1 1 81.03-83.06 -0.95(0 - 6 ) 1.03(23) 81.03-83.06 1.00(298)

0.53 0.53 0.57 0.56

2 .08 2.80 2.50 3.10

0.75 0.84 0.74 0.72

0.91 0.70 0.56 0.55

0.40 0.39 0.40 0.42

2.38 1.47 2.18 1.44

1.09 1.24 2.54 2.47

1.61 1.62 1.59 1.57

As b e f o r e , t h e r e s u l t s €or t h e two d a t a s o u r c e s a r e

ve ry s i m i l a r , w i th those from t h e indus t ry source being s l i g h t l y

b e t t e r . The second episode (78179) is much less w e l l exp la ined

by t h e mode l , w i t h v e r y d i f f e r e n t c o e f f i c i e n t s and a l a r g e r

s t anda rd e r r o r of e s t ima te . The o t h e r episodes do n o t g e n e r a l l y

suppor t t h e presence of a constant a s w e l l a s a s l o p e term. When

t h e r e s t r i c t e d " spo t - r e l a t ed margin" model is considered the mark

u p on a d o l l a r i n c r e a s e in s p o t p r i c e s v a r i e s f rom $1.01 i n t h e

f i r s t per iod, t o $0.95 in t h e t h i r d , and r e c o v e r s to $1.00 i n t h e

f o u r t h . F o r N i g e r i a t h e m a r g i n s v a r y l e s s ( b u t s t i l l

s i g n i f i c a n t l y ) , and i n t e r e s t i n g l y i n two of t h e fou r ep i sodes a r e

in a d o l l a r f o r d o l l a r r e l a t i o n . The s t anda rd e r r o r of estimate

is much c l o s e r between per iods than f o r Arab Light.

80

B . 5 . 2 OFFICIAL PRICES AS EXPURATOBY VARIABLES

Raving o n l y p a r t i a l l y succeded i n p r o v i d i n g a s t a b l e

e s t i m a t e of t h e r e l a t i o n s h i p between netbacks and crude p r i c e s by

g e n e r a l i s i n g on t h e "normal margin" model it i s necessary t o go

on t o add e x t r a explanatory v a r i a b l e s . The f i r s t candidate is

t h e " o f f i c i a l p r i c e " . In S e c t i o n B.5.1 w e a r g u e d t h a t when t h e

o f f i c i a l p r i c e i s below t h e s p o t p r i c e t h e r e must be r a t i o n i n g ,

and so t h e s p o t i s marginal and t h e netback shou ld be r e l a t e d t o

t h e s p o t and not t o t h e o f f i c i a l p r i c e . For Arab L i g h t we p l o t

t h e t h r e e s e r i e s ( f i g u r e 111). From t h e beginning of t h e per iod

u n t i l 1 9 7 8 t h e two p r i c e s e r i e s a r e s o c l o s e t h a t t h e y would b e

i n t e r c h a n g e a b l e i n any r e g r e s s i o n . A f t e r t h i s d a t e t h e s e r i e s

d i f f e r s u b s t a n t i a l l y , w i th t h e o f f i c i a l series being t h e l a r g e r

from mid 1981 u n t i l t h e end of our period. Given t h a t t h e second

episode i s so u n r e p r e s e n t a t i v e w e r e a l l y have two pe r iods worth

t e s t i n g . The p e r i o d f rom 1979.06 u n t i l 1981.06, f o r which s p o t

i s g r e a t e r t h a n o f f i c i a l , and t h e 1981.07 t o 1983.06 p e r i o d €or

which o f f i c i a l i s g r e a t e r . It i s e x t r e m e l y s t r i k i n g t h a t t h e

switchover i n t h e r e l a t i o n s h i p between s p o t and o f f i c i a l crude

p r i c e s i s a t e x a c t l y t h e same p o i n t t h a t t h e r e l a t i o n between t h e

spo t p r i c e and t h e netback changes. According t o t h e hypothesis

p r e s e n t e d e a r l i e r i n t h e p a p e r b o t h s p o t and o f f i c i a l p r i c e s

should be r e l a t e d t o t h e netback i n t h e f i n a l pe r iod (when s p o t

i s b e l o w o f f i c i a l ) , b u t i n t h e t h i r d p e r i o d o n l y t h e s p o t p r i c e

81

should be r e l a t e d t o t h e netback. Tests on these r e l a t i o n s h i p s

p r i o r t o 1980 a r e u n l i k e l y t o show a c l e a r p i c t u r e because of t h e

v e r y s t r o n g c o r r e l a t i o n be tween s p o t and o f f i c i a l p r i c e s ( f o r

Arab Light between 1976.01 and 1978.10 t h e c o r r e l a t i o n is +0.866,

w h i l e be tween 1979.06 and 1983.06 t h e c o r r e l a t i o n i s +0.244).

The r e s u l t s a r e shown i n Table X I V .

TABLE XIV: The Impact of Spot and O f f i c i a l Prices on Hetbacks for Arab Light.

Dependent Independent Per iod Spot O f f i c i a l DWS SEE Var iab le Var i ab le C o e f f i c i e n t C o e f f i c i e n t

SNPIWR SSM, SO 79.08-81.06 0.90(23) O.OOl(0.02) 1.23 1.28 SNRBI SSI,SO 79.08.81.06 0.90(26) 0.006(0.14) 0.77 1.13

....................................................................

SNPIWR SSM,SO 81.07-83.06 0.88(9) O.OS(O.9) 1.17 0.73 SNRB I* SSI,SO 81.07-83.06 0.83(10) 0.13(1.6) 1.23 0.60 SNRB I SSI,SO 81.07-83.06 0.77(9) 0.19(2.2) 1.67 0.58 SNPIWR" SSM,SO 81.07-83.06 0.78( 7) 0.17( 1.7) 1.68 0.68

* Estimated by Cochrane - Orcut t procedure.

We see t h a t f o r t h e t h i r d pe r iod , when t h e o f f i c i a l was

l o w e r t h a n t h e s p o t p r i c e , the o f f i c i a l p r i c e i s c o m p l e t e l y

i n s i g n i f i c a n t while t h e s p o t p r i c e is s i g n i f i c a n t . This confirms

our f i r s t important hypothesis t h a t when t h e spo t is t h e higher ,

i t is s t i l l t h e marginal cost .

For t h e f i n a l per iod, when s p o t w a s lower than o f f i c i a l ,

we s e e some ev idence t h a t both s p o t and o f f i c i a l are r e l a t e d t o

t h e n e t b a c k o n c e s e r i a l c o r r e l a t i o n is a l l o w e d f o r i n t h e

r e g r e s s i o n . The p r e s e n c e of s e r i a l c o r r e l a t i o n p o i n t s t o some

s y s t e m a t i c s p e c i f i c a t i o n e r r o r . The g o o d n e s s of f i t i m p r o v e s

s l i g h t l y o n t h o s e shown i n T a b l e XI1 and it would p r o b a b l y b e

wrong t o emphasise t h e s e r e s u l t s too much. Again i t can be seen

82

t h a t the sum o f t h e c o e f f i c i e n t s i s j u s t l e s s t h a n u n i t y ,

suggest ing less than complete pas s ing on a t t h e margin.

The r e s u l t s f o r Nigerian Light a r e shown i n T a b l e XV and

t h e d a t a i n f i g u r e IV.

WL3 XV: The Impact of Spot and Official Prices on the Hetback for Nigerian Light.

NNPIWR NSM,NO 79.08-81.02 0.97(35) 0.03(0.9) 1.46 0 -85 NNPRBI NSI,NO 79.08-81.02 0.97(43) -0.02(0.7) 2.60 0.73

NMPIWR NSM,NO 81.03-83.06 l.OO(16) -0.02(0.03) 1.51 0.73 NNRBI NSI,NO 81.03-83.06 1.18( 16) -0.18(2.5) 1.32 0.75

For t h e t h i r d p e r i o d , when t h e s p o t w a s a b o v e t h e

o f f i c i a l p r i c e w e a g a i n f i n d no ev i d e n c e t h a t the l o w e r of t h e

two p r i c e s w a s r e l a t e d t o t h e n e t b a c k . However, for t h e fourth

period when t h e s p o t was lower t h a n t h e o f f i c i a l p r i c e t h e r e i s

no evidence of a p o s i t i v e r e l a t i o n between the o f f i c i a l p r i c e and

t h e n e t b a c k . The i n d u s t r y d a t a shows a s i g n i f i c a n t n e g a t i v e

e f f e c t but t h i s does not f i t any t h e o r e t i c a l e x p l a n a t i o n and must

b e r e j e c t e d . Adjust ing t h e equa t ions f o r s e r i a l c o r r e l a t i o n does

n o t a f f e c t t h e s e conc 1 us ions.

The sample s e p a r a t i o n has so f a r been made a t t h e po in t

where i n s p e c t i o n of t h e d a t a suggested t h a t t h e netback t o s p o t

p r i c e d i f f e r e n t i a l changed. I t i s l a r g e l y t r u e t h a t this d a t e

c o i n c i d e s w i t h t h e t i m e when s p o t p r i c e s changed f rom b e i n g

higher than the o f f i c i a l p r i c e t o being lower. However t h e r e are

a few months w h i c h do n o t confo rm to t h i s p a t t e r n . Fo r S a u d i

83

1981.08, 1 9 8 1 . 1 1 , 1981.12 and 1982.01 a l l saw spot a b o v e

o f f i c i a l . For Nigerian t h e r e were some months w i t h spot below

o f f i c i a l (1980.01, 1980.08, 1980.09, 1980.12) and then there were

some months w i t h s p o t above o f f i c i a l (1981.10, 1981.11, 1 9 8 1 . 1 2

and 1982.01). Regressions were tried for Nigerian for just those

months i n which the spot was below the o f f i c i a l b u t this too gave

no e v i d e n c e f o r any i n f l u e n c e of t h e o f f i c i a l pr ice on t h e

netback.

84

45

40

35

30

25

m cc < A J 0 0.

20

i 5

10

F i g u r e 111

Netback , Spot and O f f i c i a l Prices f o r A r a b L i g h t

NETBACK

1P76 1977 I 978 i 0753 i 9 8 0 1 9 B i 1982 1983 9A T ES

F i s u r e IV

45

40

35

30

25

rr, rx < -I J 0 a

20

I S

i Q

Netback, Spot a n d O f f i c i a l Prices for N i g e r i a n L i g h t

NETBACK

1

! I ! !

I

I

I OFF IC I AL

1 - J

I I

I

U

I I

I I

I 1 I I I i i I

1970 1 P77 1073 1979 1985, 1?61 1 PB2 1 sa3 DATES

B . 5 . 3 DYHBMC WUATIOAS

The a n a l y s i s s o f a r h a s b e e n c o n d u c t e d o n t h e

a s s u m p t i o n t h a t m a r k e t s d o n o t t a k e t i m e t o come i n t o

equ i l ib r ium. We have o u t l i n e d c e r t a i n r e a s o n s why netbacks might

l a g behind spo t p r i c e s ( i f FIFO p r i c i n g were used and t h e r e were

long d e l i v e r y times and h igh inventory l e v e l s ) . Clear ly shocks

c a n a l s o o r i g i n a t e o n t h e p r o d u c t side of t h e m a r k e t , b u t o n l y

s t o c k s of p r o d u c t s and c r u d e s c o u l d s t o p t h i s b e i n g p a s s e d o n

immediately t o higher input p r i c e s (which have t o be spo t pr ices

s i n c e o f f i c i a l p r i c e s a r e changed i n f r e q u e n t l y ) .

A s e r i e s of t e s t s w a s c a r r i e d o u t t o check f o r l a g s

between t h e two s e t s of p r i ces . It on ly seemed necessary to t e s t

f o r a l a g of one month o r less i n i t i a l l y . Given t h a t even t h i s

l a g ( w i t h one i m p o r t a n t e x c e p t i o n ) was n e v e r found t o be

s i g n i f i c a n t it seemed n e i t h e r necessary nor s e n s i b l e t o look f o r

e v e n l o n g e r l a g s . The t e s t s were c a r r i e d o u t f o r t h e t h i r d and

f o u r t h sub-periods p r e v i o u s l y i d e n t i f i e d , u s i n g b o t h t h e netback

and s p o t p r i c e s as d e p e n d e n t v a r i a b l e . As w e l l as t h e l a g g e d

independent v a r i a b l e t h e o f f i c i a l p r i c e was a l s o included i n a l l

r e g r e s s i o n s t o check f o r i t s i n f l u e n c e . T a b l e XVI g i v e s t h e

r e s u l t s f o r Arab Light - and Tab le XVII f o r N ige r i an Light. Two

se t s of d a t a a r e used t o g i v e a check on t h e f ind ings .

85

TABLE XVI: Lags between Spot Prices and Hetbacks for Arab Light

SMRB I

S SM

S N P m 79.10-81.06 SSM 0.80 (7.6) 0.81

( 7 . 8 ) s SI 0.89

( 7 . 2 ) 0.91 (7.6)

S S I

SNF'IWR 81.09-83.06 SSM 1 .oo

( 9 . 0 ) 0.91 (7.4)

S SM

SNRBI 81.09-83.12 SSI 0.96 (10) 0.89 (9)

SSI

0.10 (0.90) 0.03 (0.3)

0.01 (0.08) -0.08 (0.6)

-0.04 (0.4) -0.12 (1 . O )

0 .or (0.1)

SMPIWR 1.04

(8.8) 1.05 (8.8)

SNRB I 1 .oo

(8.3) 1.01

( 8 . 4 )

SNPIWR 0.81 (7.5) 0.81 (6.6) 1.04 (190)

-0.06 (0.6)

SNRBI 0.85 (8.9) 0.86

( 7 . 9 ) 1.03

(262)

0.06 (1.2)

0.09 (1.6)

0.07 (0.6) 0.11 -0.06

( 0 . 9 ) ( 0 . 9 )

0.11 ( 0 . 9 ) 0.15 -0.07 (1.2) (1.0)

0.16 (1.5)

0.23 (2 .2 ) 0.23 -0.0 (1.7) (0.02)

0.14 (1.6)

0.18 (1.9) 0.18 -0.01 (1.7) (0.07)

1.01 1.29

1.00 1.31

1.04 0 .84

1.00 0.89

1.13 1.18

1.14 1.19

1.14 0.68

1.14 0.71

0.76 1.32

0.74 1.14

0.73 1.18

0.77 1.30

0.61 1.45

0.59 1.23

0.59 1.27

0.61 1.26

0.73 1.17

86

TABLE XVII: Lags Between Spot Prices and Betbacbs for l i g e r i a n Light

Dependent P e r i o d Spot Lagged Netback Lagged O f f i c i a l SEE DWS V a r i a b l e spot Netback

NNPIWR 7 9 .10-81.02 NSM 0.85 (13) 0.85 (13)

0.91 (10) 0.91 (10)

NNRBI NSI

p1 SM

NSI

NNPIWR 81 .O5-83.06 MSM 1.07

1.07 (12)

(1 1)

N SM

NNRBI 81.05-83.12 MSI 1.10 (10) 1.17 (10)

N S I

0.09 (1.4) 0.10 (1.4)

0 .04 (0.5) 0.06 (0.6)

-0.08 (0.9) -0.08 (0.9)

NNP IWR 1.10 -0.03 (12) ( 0 . 3 ) 1.10 -0.05 (11) (0.5) NNRB I 0 . 9 4 0.11 (11) (1.3) 0 . 9 4 0.10 (11) (1.1)

NNPIWR 0.80 0.22 (10) (2.9) 0.77 0.19 1.02 (230)

-0.10 (0.9) -0.04 ( 0 . 4 )

NNRB I 0.81 0.19 (9.4) (2.2) 0.71 0.11

( 9 . 4 ) (1.5)

0.69 1.53

-0.01 0.71 1.59 (0.5)

0.71 1.95

-0.01 0.73 1.96 (0 .5)

0.77 1.81

0.01 0.80 1.87 (0.4)

0.71 1.61

0.01 0.73 1.61 (0.3)

0.73 1.54

0.00 0.75 1.54 (0.01)

0.66

0.06 0.65 0.74 1.47

0.76 0.85

-0.13 0.72 1.10 (1.9)

0.72 0.63

0.18 0.59 1.01 (4.0)

1.01 ( 244)

0.76 0.86

87

Neither Tab le XVI nor Tab le XVII show any evidence of

l a g g e d r e l a t i o n s h i p s i n t h e t h i r d p e r i o d o r e v i d e n c e f o r t h e

i n f l u e n c e of t h e o f f i c i a l p r i c e when l a g s a r e i n c l u d e d . T h e s e

f i n d i n g s a r e t h e same when n e t b a c k s a r e r e l a t e d t o l a g g e d s p o t

pr ices and when s p o t p r i c e s a r e r e l a t e d t o lagged netbacks. For

t h e f i n a l per iod t h e r e i s no evidence that netbacks a r e r e l a t e d

t o l a g g e d s p o t p r i c e s ( w h e t h e r or n o t o f f i c i a l p r i c e s a r e

inc luded a s suggested by t h e previous r e s u l t s ) . However,the d a t a

f o r both c o u n t r i e s , according t o both sources , shows a r e l a t i o n

between spo t p r i c e s and lagged netbacks. In one case t h e c u r r e n t

o f f i c i a l p r i c e a l s o has a c o e f f i c i e n t s i g n i f i c a n t l y d i f f e r e n t

from z e r o b u t w i t h a n u n e x p e c t e d p o s i t i v e s i g n . Hence w e f i n d

t h a t i n t h e f i n a l p e r i o d , when s p o t p r i c e s were be low o f f i c i a l

p r i c e s , netbacks had a lagged e f f e c t on s p o t p r i ces . The ave rage

l a g l e n g t h i n b o t h c a s e s i s around one week. O b v i o u s l y f o r

sha rpe r t e s t s of t h e l a g s t r u c t u r e i t would be necessary t o use

d a t a based on a s h o r t e r t i m e i n t e r v a l t h a n one month. Moreover

t h e p o s s i b l y s i g n i f i c a n t c o e f f i c i e n t of t h e o f f i c i a l p r i c e a s a

determinant of t h e netback sugges t s t h a t a s y s t e m of equat ions i s

p r e s e n t ( t h e r e be i n g a p p a r e n t 1 y two s e p a r a t e r e l a t i o n s h i p s

be tween t h e s p o t p r i c e and t h e n e t b a c k ) . R e - e s t i m a t i o n of t h e

Arab L i g h t e q u a t i o n s by TSLS d o e s n o t change t h e c o e f f i c i e n t s

very much but does dec rease t h e "t" s c o r e t o below s ign i f i cance .

G i v e n t h e l a c k o f good i n s t r u m e n t s ( t h e c o n s t a n t and o f f i c i a l

p r i c e were used) t h i s l a c k of f i t i s not s u r p r i s i n g .

There i s a l s o a t h e o r e t i c a l problem i n e x p l a i n i n g t h e

lagged e f f e c t of netbacks on spo t p r i c e s which on ly occurs when

88

s p o t p r i c e s a r e be low n e t b a c k s . The l a c k of l a g g e d e f f e c t s of

s p o t p r i c e s o n n e t b a c k s would h a v e t o b e p r o v i s i o n a l l y

i n t e r p r e t e d a s i n d i c a t i n g t h a t s h i f t s i n supply are immediately

t r a n s l a t e d i n t o p r o d u c t p r i c e s whe the r or n o t t h e r e is "excess

supply' ' ( i e spot i s less than o f f i c i a l ) , w h i l e s h i f t s i n demand

have no l a g when t h e r e i s "excess demand" ( spot above o f f i c i a l )

b u t d o show a s h o r t l a g when t h e r e i s e x c e s s s u p p l y ( s p o t b e l o w

o f f i c i a l ) . Rowever, t h e change i n "goodness o f f i t " due t o t h e

lagged v a l u e s i s very s l i g h t i n n e a r l y a l l cases , so t h a t adding

a l a g is appa ren t ly o n l y a minor adjustment t o t h e equation.

Experiments w i th l a g s longer than one month all f a i l t o

show s i g n f i c a n c e f o r t h e l o n g e r l a g (and o f t e n make e v e n t h e

s i n g l e l a g i n s i g n i f i c a n t ) .

The r e s u l t s of t h e s e t e s t s s u g g e s t t h a t t h e two s i d e s

of t h e market a d j u s t t o shocks i n t h e o t h e r s i d e very qu ick ly and

t h a t i f i t is d e s i r e d t o i n v e s t i g a t e t h e speed of a d j u s t m e n t a t

a l l a c c u r a t e l y then it would be necessary t o u s e d a t a bssed on a

t i m e per iod of one week a t longes t .

89

B .5.4 VARIATIOHS B-I BEFIHEEIES

So f a r a l l t h e f o r m a l s t a t i s t i c a l t e s t s h a v e b e e n

c a r r i e d o u t f o r n e t b a c k s c a l c u l a t e d f o r a b a s i c r e f i n e r y a t

Ro t t e rdam. As T a b l e s V I , VII, and VI11 showed, t h e v a r i o u s

c e n t r e s a n d t y p e s o f r e f i n e r y u s e d a s t h e b a s i s f o r t h e

c a l c u l a t i o n produce s e r i e s t h a t are n o t p e r f e c t l y c o r r e l a t e d wi th

one another. The d i f f e r e n c e s a r e n o t just i n t h e month by month

f l u c t u a t i o n s but i n t h e g e n e r a l l e v e l s of t h e ser ies , as Table

VI11 showed.

A s w e a r g u e d i n S e c t i o n B.4, i n a n e q u i l i b r i u m

s i t u a t i o n wi th i d e n t i c a l r e f i n e r i e s a l l netbacks should be t h e

same. Once improvements i n t e c h n o l o g y a r e i n t r o d u c e d t h e n w e

move t o t h e v i e w t h a t t h e h i g h e s t c o s t p l a n t i s g o i n g t o be

marginal. I t s "output" p r i c e w i l l be l i nked t o t h e crude p r i c e

w h i l e a l l o t h e r p l a n t s w i l l be intra-marginal . This o b s e r v a t i o n

s u g g e s t s t h a t t h e s p o t p r i c e should be r e l a t e d t o t h e l o w e s t

n e t b a c k i n t h e v a r i o u s t e s t s used. The e s t i m a t i o n of no rma l

m a r g i n s p e r i o d by p e r i o d f o r Arab L i g h t a t d i f f e r e n t l o c a t i o n s

shows t h a t t h e n e t b a c k f r o m R o t t e r d a m i s not t h e l o w e s t a s

between t h e d i f f e r e n t sources. The Caribbean netback appears t o

be t h e lowest and should perhaps be taken a s t h e marginal market.

However, s i n c e n e t b a c k s a r e h i g h l y c o r r e l a t e d ( b e c a u s e t h e

v a r i a t i o n i s c a u s e d by t h e same v a r i a b l e s , a l b e i t w e i g h t e d

90

d i f f e r e n t l y ) we should n o t be s u r p r i s e d i f t h e g e n e r a l p a t t e r n of

r e s u l t s were r epea ted f o r a l l series. Accordingly w e re-estimate

t h e "standard" models f o r t h e t h i r d and f o u r t h pe r iods , viz. t h a t

i n t h e t h i r d p e r i o d t h e n e t b a c k i s r e l a t e d t o t h e s p o t , and i n

t h e f o u r t h per iod t h e netback is r e l a t e d t o both spo t and o f f i c a l

for Arab Light. Tab le s X V I I I and XIX show the r e s u l t s .

91

SWPIWI 79.08-81.06 SSM 0.89 151 1.02 0.83 0.84 91 1.61 0.55 SNPIWC 0.90 99 1.57 0.72 SNPIWP 0.91 123 1.29 1 .ll SNPIWS 0.92 88 1.81 0.81 SWIWU 0.89 139 1.11 0.78 S NP IW6

II f I I t

I 1 f l I 1

I 1 II I f

I t *I II

I 1 I 1 T I

0.90 157 1.00 1.35 II 11 tf SNPIWR

TABLE XIX: Relation Between Wetback and Spot and Official Prices for Arab Light for Various Refineries for the Fourth Episode ...........................................................................

Dependent Spot Period Spot Spo t O f f i c i a l O f f i c i a l SEE DWS Var iab le Var i ab le C o e f f i c i e n t 't' C o e f f i c i e n t 't'

SNPIWI SSM 81.07-83.06 0.84 11 0.10 1.3 0.57 1.17 SNPIWC I t I t I' 0.87 10 0.06 0.7 0.65 1.39

It 0.64 6.8 0.31 3.5 0.70 1.49 SNPIWP I' 0.50 4.8 0.45 4.4 0.79 1.70 SNPIWS I' 1.07 7.1 -0.09 0.6 1.14 0.87 " 0.83 5.7 0.14 1.0 0.92 1.85 I' 0.78 7 .O 0.17 1.7 0.68 1.68 SNPIWR I T

SNRCI* SSI 81.07-83.12 0.93 8 .O 0.12 1.05 0.90 0.70 SNRCI* 11 lf 0.80 6.7 0.24 2.09 0.74 1.59 SMUCI* s SI 'I 0.74 6.5 0.24 2.19 0.71 1.59

" 0.78 9.3 0.18 2.3 0.55 1.72 SNRBI

'I 0.76 9.1 0.18 2.2 0.52 1.62 11 'I 0.83 8.8 0.10 1.1 0.63 1.70

SNPIWP* f I f l " 0.59 5.7 0.36 3.7 0.67 2.00 S NP IW S* I f f I 'I 0.48 4.2 0.47 4.4 0.78 1.99

" 0.74 9.5 0.21 2.8 0.51 1.76 S N P I W 6

----------------------------------------------------------,------------------

I 1 I 1

11 I 1

II SNPIWv* I T

sNPIwu* I t 11

I!

II

t l

II t l

sNPIW1; I1 f I

SNPIWC* 11

f I I f

* = Estimated by Cochrane-Orcutt t echn ique .

The r e s u l t s for t h e t h i r d ep i sode ( s t a r t i n g i n 1978.08

t o conform t o t h e t e s t s f o r lags) show very u n i f o r m r e s u l t s .

The Rotterdam s e r i e s i s ( just) t h e most s t r o n g l y c o r r e l a t e d wi th

t h e spot price. I n a l l cases the margin is l e s s than 1002, w i th

t h e C a r i b b e a n b e i n g t h e l o w e s t . The US and C a r i b b e a n n e t b a c k s

92

seem to be t h e l e a s t r e l a t e d t o t h e Arab Light s p o t p r i ce . This

r e f l e c t s p e r h a p s t h e l a c k of p e r f e c t a d j u s t m e n t i n t h e m a r k e t

t o g e t h e r w i th a l o c a l higher dependence on o the r crudes.

For t h e f o u r t h episode t h e r e s u l t s a r e very s i m i l a r i n

p a t t e r n . Once s e r i a l c o r r e l a t i o n i s t a k e n i n t o a c c o u n t t h e

n e t b a c k is s t r o n g l y r e l a t e d t o t h e s p o t p r i c e and t h e o f f i c i a l

p r i c e f o r a l l a r e a s e x c e p t t h e C a r i b b e a n and t h e US when PIW

n e t b a c k s a r e u s e d . F o r i n d u s t r y d a t a t h e U S a l s o shows

c o r r e l a t i o n of both s p o t and o f f i c i a l p r i c e s . F u r t h e r , b o t h

complex and b a s i c r e f i n i n g a t R o t t e r d a m show t h e i n f l u e n c e of

both p r i ces . The goodness of f i t i s f a i r l y s i m i l a r f o r a l l cases

and t h e X m a r g i n is v e r y s i m i l a r f o r a l l t h e PIW s e r i e s - o n l y

t h e i n d u s t r y complex r e f i n i n g s e r i e s f o r R o t t e r d a m shows a

netback higher t h a n t h e weighted sum of t h e input prices.

The g e n e r a l congruity of t h e r e s u l t s sugges t s t h a t t h e

v a r i o u s markets a re c l o s e l y t i e d t o g e t h e r , and t h a t t h e arguments

used t o e x p l a i n t h e i n t e r - r e l a t o n s h i p s of p r i c e s i n t h e two

p e r i o d , h a v e some g e n e r a l v a l i d i t y . A t t h e same t i m e t h e r e i s

s u f f i c i e n t v a r i a t i o n i n t h e r e s u l t s t o s u g g e s t t h a t t h e

d i f f e r e n c e s c a n n o t be a s c r i b e d s o l e l y t o d i f f e r e n c e s i n

technology b u t r a t h e r t o imper fec t ions i n t h e market.

93

Data Appendix : Kev t o Abbreviations

SNPIWR - PIW‘s n e t b a c k f rom R o t t e r d a m t o S a u d i A r a b i a ( b a s i c r ef i n ing ) .

SNPIWC - PIW’s n e t b a c k f r o m t h e C a r i b b e a n t o S a u d i A r a b i a ( b a s i c r e f i n i n g ) .

SNPIWP - PIW’s n e t b a c k f rom t h e P e r s i a n G u l f t o S a u d i Arabia ( b a s i c r e f i n i n g ) .

SNPIWI - PIW’s n e t b a c k f rom I t a l y t o S a u d i A r a b i a ( b a s i c r e f i n i n g ) .

SNPIWS - PIW‘s n e t b a c k f rom S i n g a p o r e t o S a u d i A r a b i a ( b a s i c r e f i n ing ) .

SNFIWU - PIW’s n e t b a c k f rom US t o S a u d i A r a b i a ( complex r e f i n i n g ) .

SNpIW6 - Average of above s i x series.

SMRBI - I n d u s t r y n e t b a c k f rom R o t t e r d a m t o S a u d i A r a b i a ( b a s i c r e f i n e r y ) .

SNRCI - I n d u s t r y n e t b a c k f rom R o t t e r d a m t o S a u d i A r a b i a (complex r e f i n i n g ) .

SNUCI - Industry netback from US t o Saudi Arabia (complex r e f i n i n g ) .

SNOPAB - OPAL netback from Rotterdam t o Saudi Arabia ( b a s i c r e f i n i n g ) .

SNOPAC - OPAL n e t b a c k f rom R o t t e r d a m t o S a u d i A r a b i a (complex r e f i n i n g ) .

s so - Spot p r i c e for Arab Light by OPEC B u l l e t i n .

S SM - Spot p r i c e f o r Arab Light by MEPEP, MEES.

S S I - Spot p r i c e for Arab L i g h t g i v e n by i n d u s t r y source.

s SP - Spot p r i c e for Arab Light g i v e n by PIW.

9 4

so

NNPWR

NNPIW5

NNRB I

N N R C I

NNUCI

NNOPAB

NNOPAC

NSM

NSI

NPO

NSP

NO

O f f i c i a l pr ice of Arab Light.

PIW n e t b a c k f rom R o t t e r d a m t o N i g e r i a ( b a s i c r e f i n i n g ) . PIW 5 c e n t r e a v e r a g e n e t b a c k t o N i g e r i a (bas i c r e f i n i n g ) .

Industry netback from Rotterdam t o Niger ia ( b a s i c r e f i n i n g ) . I n d u s t r y n e t b a c k f r o m R o t t e r d a m t o N i g e r i a (complex r e f i n i n g ) .

I n d u s t r y n e t b a c k f rom U S t o N i g e r i a (complex r e f i n i n g ) . OPAL n e t b a c k f r o m Rot t e rdam t o N i g e r i a ( b a s i c r e f i n i n g ) . OPAL n e t b a c k from R o t t e r d a m to N i g e r i a ( complex r e f i n ing . Spot p r i c e for Nigerian Light by MEES.

S p o t p r i c e f o r N i g e r i a n L i g h t g i v e n by i n d u s t r y source . Spot p r i c e f o r Niger ian Light by OPEC Bul l e t in.

Spot p r i c e f o r Nigerian Light by PIW.

O f f i c i a l p r i c e of Nigerian Light.

9 5

1 . The v a r i a n c e of t h e v a r i a b l e s f o r t h e f u l l p e r i o d 1 9 7 6 t o 1983 i s a b o u t 1 0 0 w h i l e t h e v a r i a n c e of the e r r o r be tween t h e ser ies exc luding 1979 and 1980 is about 0.05.

2. In a s i t u a t i o n where u n p r o f i t a b l e p l a n t s a r e m o t h b a l l e d r a t h e r t h a n s c r a p p e d t h e same argument a p p l i e s and t h e r e l e v a n t c o s t i s t h a t of t h e h i g h e s t c o s t p l a n t s t i l l i n p r oduc t ion.

3 . D i f f e r e n t marke t power f o r d i f f e r e n t products c o u l d mean d i f f e r e n t e f f e c t i v e power f o r t h e b u n d l e o f p r o d u c t s produced by one crude r e l a t i v e t o those of t h e o t h e r crude.

4. The ana logue w i t h m u l t i - p a r t p r i c i n g , o f t e n adopted by power supp ly i n d u s t r i e s is c l e a r .

5. O f c o u r s e temporary l o s s e s m i g h t be i n c u r r e d i n o r d e r t o r e a p l a r g e r l ong- t e rm r e w a r d s eg p r o d u c i n g t o stock a p r o d u c t f o r which demand was v e r y s e a s o n a l . However t h i s can n o t exp la in long-term l o s s e s .

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