Question:
In Canada, where I live, there has been much talk lately about the need to build more pipelines to export oil from Alberta. Western Canadian Select (WCS), the benchmark for bitumen from the oil sands, trades at a discounted price compared to higher quality products like West Texas Intermediate (WTI), for example. While the difference in quality accounts for most of the price differential between the two, the rest of the price discount can be explained by export bottlenecks, apparently. Since oil production in Canada exceeds the capacity of existing pipelines to export the oil to refineries in the US, oil producers turn instead to rail companies to export the oil.1) Why does a transportation bottleneck cause Canadian oil to trade at a discounted price? Is it simply because rail companies have more leverage in this situation, as they have an effective monopsony as a buyer, a.k.a. near-monopoly over transportation? And if that's the case, is the oil sold to the rail company, who is able to negotiate a discounted price at which to purchase the oil from the producer?
I suspect it may have something to do with the fact that rail companies seek to secure long-term contracts with clients, so when oil producers want to use rail services just for the short-term, until new pipelines can be built, rail companies refuse to pay a high price for the commodity being transported (alternatively, rail companies demand a higher fee to transport the commodity). But again, I'm not clear about whether or not rail companies actually purchase the oil and then sell it on to refineries. And if a Canadian rail company does purchase the oil, then the revenue stays in Canada, doesn't it?
2) I have read that rail transport only adds marginal export capacity compared to what's needed, so perhaps the oil producer/rail transaction has a negligible effect on price? If that's true, then I'm really confused.
3) Is it simply just that a transportation bottleneck causes excess oil supply to build up, reducing its market price? But I thought that a bottleneck would equate to less supply, since it can't be exported as quickly, and therefore its market price should rise.
Answer:
Great question! In general, we don’t need a monopsonistic setting to explain crude differentials between WCS and WTI. In a competitive market, prices for the same product (oil, corn, etc.) can diverge in different markets for two reasons: (i) quality differences; and (ii) transactions cost. Moving crude by rail is expensive. A recent paper studying rail versus pipeline costs in North Dakota shows that rail costs averaged around $5/bbl to ship crude 1,000 miles. Someone has to pay for these costs. Crude oil is a global commodity – refiners can acquire crude oil from a large number of sources. As a result, the burden of transportation costs often falls on suppliers. While I am not familiar with Canadian crude or rail markets, capacity constraints can be thought of as increasing the transportation costs. My guess is that if suppliers can lease oil cars (as they can on secondary markets in the U.S.), those lease rates increase as the bottleneck increases since suppliers compete to ship their oil to outside markets. This, again, will decrease the value of crude oil in Canada. Expanding or building out pipeline capacity, given its low transportation costs, would alleviate this problem and WCS prices would converge with WTI. One caveat: there is some evidence that rail companies have some monopsony power. The story and explaining who benefits from the supply constraints gets much more complex.
References:
Covert, T., and R. Kellog (2017). Crude by Rail, Option Value, and Pipeline Investment. NBER Working Paper 23855.