The Dynamics of Crude Oil Price Differentials

Despite the wide variety of internationally traded crude oils with different qualities and
characteristics (the 2006 International Crude Oil Market Handbook describes more than 160
traded crude oil streams), many observers consider the world oil market as ‘one great pool’
(Adelman, 1984). Others argues that oil markets are ‘globalized’ in the sense that supply and
demand shocks that affect prices in one region are transferred into other regional markets
(Weiner, 1991). One implication of the globalization thesis is that prices of similar crudes in
different markets should move closely together such that their price differential is more or
less constant. This is in contrast to oil markets being ‘regionalized’ in which oil prices of
similar qualities move independently to each other in response to shocks. Whether the oil
market is one great pool or is regionalized has important implications in terms of energy
policy and market efficiency. For instance, Weiner (1991) argues that the effectiveness of
government policies, such as releasing crude oil from the Special Petroleum Reserve (SPR),
depends to a large extent on whether the impact of such policy action extends to other regions
or remains confined to the US market. In terms of efficiency, Gülen (1999) argues that
regionalization gives rise to arbitrage opportunities across local oil markets and may render
the market inefficient if arbitrage fails to push prices of similar crude oils in different markets
in line with each other.

By: Bassam Fattouh

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