Publications: Notes at the Margin

Broken Arbitrage (May 2, 2022)


Our dynamic simulation model has demonstrated the linkage between the price of crude and products for years. The errors have been small and relatively random. The average error is –$2.60 per barrel, and the standard error is $4.16 per barrel.


The model has failed, though, following Russia’s invasion of Ukraine. It puts Dated Brent today at $145 per barrel and at $152 if the US renewable fuels obligations are not included. The actual Dated Brent quoted on Friday was $108 per barrel. The error is ten standard deviations from the mean.


During April, the error averaged –$22 per barrel. This means crude producers selling oil tied to Dated Brent received $22 less per barrel than they might have if the model’s projection held. This Notes at the Margin seeks an answer for the sudden divergence in the relationship, a change we refer to as “broken arbitrage.”


The broken arbitrage obviously extends to the US crude markets because WTI prices are moving with Brent prices. Thus, most US oil producers also received around $22 per barrel less for their crude during April than they would have if the modeled relationship held.


We note at the outset that we have difficulty explaining the difference. We see the extreme backwardation in distillate fuel in New York as the primary cause of the breakdown. However, the distillate shortage explains only part of the difference. Tight credit may also be contributing by limiting crude demand.


We conclude that tight credit may give refiners an opportunity to constrain distillate supplies in New York artificially, boosting the price there well above prices elsewhere, even in Europe, where supply conditions are more uncertain. These actions may be happening for their own benefit. Limiting supplies to the New York and PADD I market also pushes CME distillate futures higher, and such increases affect other markets.


Alternatively, the unique geographic location of the New York market combined with the ill-advised US renewable fuels program might be creating conditions that make arbitrage very expensive today.


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