Supposed for argument that refined product demand is perfectly inelastic. If one refinery shuts down, then other refineries will have to pick up the slack. Those other refineries are necessarily less efficient at producing the desired mix of refined products given the supply of different kinds of crude available (otherwise they would already be producing more). In that case, a larger amount of crude would be required as input to produce the same refined output, resulting in higher crude prices.

So if you've got a situation with very inelastic product demand (reasonable), and very specialized refineries (true), you can indeed get higher crude prices when a refinery shuts down.

CNN last night was parroting the same line. Dean is correct. Similarly, hog prices in the midwest were influenced by a narrowing of packaging capacity in the late 1990's. Subsequently prices paid for live animals at the farm went below the cost of farm inputs. This narrowing was deliberate within the supply chain to maintain constant prices at retail, regardless of raw material supply. Thus, price substitution was never a factor in clearing the market. Farmers took their bath.
Also, Dean is right to point out the influence of a weakened dollar's purchasing power in the international crude market on dollar per barrel cost.

Nice theory Marc.

Now, do you have any evidence that it ever happened in real life?

Spencer, Marc has it right. If a refiner in Texas goes down, the total demand for refined oil products is not effected. Other, still operating refiners, will need to buy more crude for processing in order to satisfy the extra demand on them that is not being satsified by the shut down Texas refiner. Why is this so hard to understand?

Dan, why did crude oil rise 40% in price in 2005 while the USD STRENGTHENED 10% in the same period? A weak USD can have some influence on the price of oil in the very long term but it is negligble compared to the normal influences of supply and demand of crude oil itself.

It happens all the time. For example, pretty much every time one of the more complex US refineries shuts down. U.S. refineries are disproportionately engineered to refine cheaper, but harder-to-refine, crudes like from Venezuela. When those shut down, prices for harder-to-refine crudes (e.g. Dubai) fall, but prices for easier-to-refine crudes (like WTI) rise.

Do a news search for refinery shutdowns, then look at both WTI and Dubai crude prices around that date.

Dean,

Given that you are still forecasting a housing-induced recession, whose probability seems to be rising (and which could easily go global, if it starts in the US), and given that there seem to be some production increases in places like Iraqi Kurdistan that are not fully registering out there, would you agree that the probability of a crash in oil prices sometime next year that could further aggravate the real estate crisis like the 1986 crash did, which set of the S&L crisis, is higher than the markets are currently valuing it at (which I suspect is at near zero)?

Barkley,

I'll confess to being completely surprised by almost every move in oil prices. We are looking at oil prices, that in real mixed currency terms, are at least 60 percent higher than they were five years ago. So the question is how much of this rise is due to fundamentals and how much to speculation.

If it is a fundamental story, I doubt that there would be a crash in prices even in a severe recession. Demand in the U.S. and Europe will falloff, but it's hard to imagine that China and India would stop growing altogether. While some new sources of supply may come on line (Kurdistan being one obvious case), other sources are being depleted, so I doubt that the net increase in supply will be all that large.

On the other hand, if speculation is driving the run-up in prices, then even a modest rises in supply and falls in demand could lead to large drop in prices.

Speaking largely from ignornace, i'm incliined to think that fundamentals explain most of the story here. I would not be surprised to see oil prices fall back to $60 a barrel or maybe even into the mid $50s. I would be very surprised if it fell back to $40. I doubt that $55 a barrel oil changes the world much. $40 a barrel would.

Max and Marc, I think your argument is based on the ability of other refineries to increase production to meet the overall level of demand. In the short run, this is not doable if all refineries are currently operating at capacity.
I do not have an explanation at hand, Max, for your question, but I would suppose that price increase in 2005 was based on commodity speculation, not on market fundamentals changing.
A fundamental that is changing nowadays: the US dollar is rapidly losing its place in world oil markets as the settlement currency. This too supports the idea that dollar prices per barrel would go higher. Price volatility will increase for sure.

I don't mean to be a stickler, but I had a tough time making sense of the headline on this comment because of missing punctuation. Did Dean mean to write, "Shut Down Refineries; Don't Raise Crude Oil Prices" or "Shut-Down Refineries Don't Raise Crude Oil Prices"?

The fall of the dollar was inevitable. It is the only way to get the trade deficit down to size. The real problem was allowing the dollar to rise to the point that it made such a painful adjutsment necessary. This was the Clinton-Rubin high dollar policy. It felt good in the short-term (except for manufacturing workers), but just like tax cuts that lead to big budget deficits, it could not be sustained.

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