Monday, August 07, 2006

Alaskan Impact

Just when we were all looking to the Middle East, or possibly a Gulf Coast hurricane, for the next big oil market impact, it turns out that BP is shutting down operations of the Prudhoe Bay field, the largest field in Alaska and still one of the largest in the world, to repair corrosion in the pipeline system that gathers the crude from the wells from which it is produced. The New York Times estimated the loss at 400,000 barrels per day, and BP was not commenting on the expected duration of the outage. Since this took place over the weekend, outside of regular trading hours on the major world oil exchanges, we can only guess at the full impact on prices. It's worth thinking about how this will propagate through the system, to anticipate what the next several weeks could be like.

According to the Department of Energy, the Prudhoe Bay Field, the main oil field in the Alaskan North Slope and the largest single producer in the US, averaged 353,000 barrels/day (bpd) of production in 2004. Current production is probably a bit less than this, due to natural decline, but its not yet clear to what degree the shutdown will also affect the satellite fields that actually make up the larger share of Alaskan production today. Total production from the North Slope area amounted to 845,000 bpd in 2005. If we use the 400,000 bpd preliminary estimate, that equates to just under 8% of total US crude oil production, or a bit less than 0.5% of global production of 84.5 million bpd. Three or four years ago, with ample spare capacity, this would have hardly been noticeable.

In order to understand how an event like this will influence the market, you need to look at where this oil has been going. When the North Slope produced 2 million barrels per day in the early 1990s, it supplied most of the needs of the four Seattle-area refineries and constituted the primary source of California's oil imports. In addition, a steady volume found its way to the Gulf Coast, via tankers through the Panama Canal or transiting through Los Angeles and heading east via pipeline; these movements have essentially dried up. The bulk of Alaskan North Slope crude (ANS) deliveries now go to the Pacific Northwest, with another 150,000 bpd going to California. That means that the direct impact of this shutdown will be on the West Coast, particularly the Pacific Northwest region supplied by the Anacortes, Cherry Point and Ferndale, WA refineries--essentially Oregon, Washington and parts of Idaho--with a more modest impact on California.

Fortunately, West Coast crude oil inventories, like those in the rest of the US, are on the high side of average. This is crucial, because the alternate sources of supply for the West Coast are much farther away than Alaska. Refineries that have optimized around frequent receipts from smallish tankers that only spend a week or so in transit may be stretched by having to wait a month or more for supplies from Asia and the Middle East to make up the shortfall, via much larger tankers. This creates an entirely different inventory pattern.

The quality of the ANS crude will also play a role in how the shutdown will affect markets. For refineries that have enjoyed a diet of mostly ANS over the years, it won't be easy to switch to whatever else is available. Although not as easily refined as the benchmark West Texas Intermediate, ANS is a "medium" crude with much less sulfur than a likely short-term alternative, Saudi Heavy. Crude from Ecuador is a better match, but that's fully committed.

The likely outcome of all this is a massive reshuffling of oil supplies, first on the West Coast and eventually globally, to free up more optimum crudes for the Pacific Northwest refineries. Prices will drive that game of musical chairs: higher prices for the grades of crude oil that compete with ANS, and higher prices for the products that are made from it. In other words, Northwest refiners will have to outcompete the other outlets for the desired oil. And to the extent that the West Coast refineries can't find the right mix to match the output they achieved running the missing North Slope crude, they will have to import more products from elsewhere, competing with product imports going to other parts of the US.

When you follow that chain of consequences, a strictly West Coast supply disruption quickly snowballs to drive up the price of crude oil everywhere, and of petroleum products in regions entirely remote from the isolated West Coast supply system. So the price of WTI on the New York Mercantile Exchange will go up, but probably by less than the prices of the typical crude oils that most US refineries actually run, the heavier and higher sulfur grades that trade at a discount to WTI. And although the price of gasoline in San Francisco and L.A. may go up by less than in Seattle and Portland, it will go up, as will gasoline on the East Coast. This domino effect invariably prompts consumer advocates to decry "gouging" and sparks political hearings and investigations, but it's how a free market responds to a supply crunch.

And for anyone who doubts that potential production from the Arctic National Wildlife Refuge (ANWR) would be material to world or US oil prices, this will be an interesting test case, since the volumes we've just lost are comparable to the low estimate for ANWR.

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