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Report to Congressional Requesters: 

January 2007: 

Crude Oil: 

California Crude Oil Price Fluctuations Are Consistent with Broader 
Market Trends: 

GAO-07-315: 

GAO Highlights: 

Highlights of GAO-07-315, a report to congressional requesters 

Why GAO Did This Study: 

California is the nationís fourth largest producer of crude oil and has 
the third largest oil refining industry (behind Texas and Louisiana). 
Because crude oil is a globally traded commodity, natural and 
geopolitical events can affect its price. These fluctuations affect 
state revenues because a share of the royalty payments from companies 
that lease state or federal lands to produce crude oil are distributed 
to the states. 

Because there are many varieties and grades of crude oil, buyers and 
sellers often price their oil relative to another abundant, highly 
traded, and high quality crude oil called a benchmark. West Texas 
Intermediate (WTI), a light crude oil, is the most commonly used 
benchmark in the United States. The price difference between a crude 
oil and its benchmark is commonly expressed as a price differential. In 
fall 2004, crude oil price differentials between WTI and Californiaís 
heavier, and generally lower valued, crude oil rose sharply. 

GAO was asked to examine (1) the extent to which crude oil price 
differentials in California have fluctuated over the past 20 years and 
(2) the factors that may explain the recent changes in the price 
differential between Californiaís crude oil and others. GAO analyzed 
historical data on California and benchmark crude oil prices and 
discussed market trends with state and federal government officials and 
crude oil experts. 

What GAO Found: 

California crude oil price differentials have experienced numerous and 
large fluctuations over the past 20 years. The largest spike in the 
price differential began in mid-2004 and continued into 2005, during 
which the price differential between WTI and a California crude oil 
called Kern River rose from about $6 to about $15 per barrel. This 
increase in the price differential between WTI and California crude 
oils occurred in a period of generally increasing world oil prices 
during which prices for both WTI and California crude oils rose. 
Differentials between WTI and other oils also expanded in the same time 
period. The differentials have since fallen somewhat but remain 
relatively high by historical standards. 

Recent trends in California crude oil price differentials are 
consistent with a number of changing market conditions. First, 
beginning in mid-2004, Middle East producers began to increase the 
supply of heavy crude oils in the world marketplace, which helped 
depress prices for heavy crude oils, including those produced in 
California, and contributed to the expanding price differential between 
California crude oils and WTI. Second, the price differential of 
California crude oils to WTI increased when the rise in global crude 
oil prices caused prices of light crude oils to increase faster than 
the prices of heavier crude oils. This occurred because the petroleum 
products from heavy crude oils compete against other fuels, such as 
coal. Third, events that only impact regional crude oil markets or 
individual crude oils can also affect price differentials. For example, 
in September 2004, Hurricane Ivan disrupted crude oil production in the 
U.S. Gulf Coast region, resulting in decreases in the regionís crude 
oil supply. The resulting scarcity of crude oil in the Gulf Coast 
region caused the prices of WTI and other regional oils to increase 
relative to crude oils produced outside the region. This also would 
have increased the price differentials between WTI and California crude 
oils. Finally, manipulation of crude oil prices could also affect price 
differentials, but experts and officials GAO interviewed generally 
believed that this was not a factor during this recent period. 

Figure: WTI and Kern River Crude Oil Price Differentials, December 1987 
to August 2006: 

[See PDF for Image] 

Source: GAO analysis of Platts data. 

[End of figure] 

[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-07-315]. 

To view the full product, including the scope and methodology, click on 
the link above. For more information, contact Jim Wells at (202) 512-
3841 or wellsj@gao.gov. 

[End of section] 

Contents: 

Letter: 

Results in Brief: 

Background: 

Price Differentials between California and Other Crude Oils Have 
Fluctuated Significantly over the Past 20 Years but Have Risen 
Significantly in Recent Years: 

Recent Increases in California Crude Oil Price Differentials Are 
Consistent with Other Market-Based Factors: 

Appendixes: 

Appendix I: Objectives, Scope, and Methodology: 

Appendix II: GAO Contact and Staff Acknowledgments: 

Tables: 

Table 1: API Crude Quality Classes and Representative California Crude 
Oils: 

Figures: 

Figure 1: WTI and Kern River Crude Oil Prices and Price Differentials, 
December 1987 to August 2006:  

Figure 2: Quantities of Crude Oil Grades Produced in California, 1987 
to 2005: 

Figure 3: Sources of California Crude Oil and Major Refining Centers, 
2005: 

Figure 4: Quantities and Sources of Crude Oil Consumed in California, 
1987 to 2005: 

Figure 5: WTI, Kern River, Thums, and Line 63 Crude Oil Prices and 
Price Differentials, December 1987 to August 2006: 

Figure 6: WTI, Maya, and Arab Heavy Crude Oil Prices and Price 
Differentials, July 1988 to August 2006: 

Figure 7: Wyoming Sweet and WTI Crude Oil Prices and Crude Price 
Differentials, December 1987 to August 2006: 

Abbreviations:  

ANS: Alaska North Slope: 

API: American Petroleum Institute:: 

bpd: barrels per day: 

CEC: California Energy Commission: 

CIPA: California Independent Petroleum Association: 

DOE: Department of Energy: 

EIA: Energy Information Administration: 

MMS: Minerals Management Service: 

NYMEX: New York Mercantile Exchange: 

OPEC: Organization of Petroleum Exporting Countries: 

WSPA: Western States Petroleum Association: 

WTI: West Texas Intermediate: 

January 19, 2007: 

The Honorable Henry A. Waxman: 
Chairman: 
Committee on Oversight and Government Reform: 
House of Representatives: 

The Honorable Dianne Feinstein: 
United States Senate: 

California is the nation's largest consumer of gasoline and consumes 
about 44 million gallons every day. California is also the nation's 
fourth largest producer of crude oil, behind Texas, Louisiana, and 
Alaska, and has the third largest oil refining industry, behind Texas 
and Louisiana. Despite a history of self-reliance in petroleum 
supplies, California crude oil production has been declining since 
1996, and California increasingly relies on oil from other states and 
countries. California currently produces about 37 percent of the crude 
oil it uses, with the remainder coming largely from Alaska, Saudi 
Arabia, Mexico, Ecuador, and Iraq. Crude oil is a globally traded 
commodity, so natural and geopolitical events worldwide can affect its 
prices. These fluctuations can affect state revenues because a share of 
the royalty payments collected from companies that lease state or 
federal lands to produce crude oil are distributed to the states. For 
example, in fiscal year 2006, the Department of the Interior's Minerals 
Management Service (MMS), which collects royalties from federal lands, 
distributed more than $303 million to the states, with California's 
share totaling over $44.7 million, or roughly 15 percent of the total 
state disbursements. States rely on these revenues to fund education 
and infrastructure projects and to assist local counties where the oil 
production occurs. Consequently, oil producing states typically monitor 
crude oil price fluctuations and are interested in ensuring that the 
crude oil produced in their state trades at a fair price in the 
marketplace. 

Crude oils produced from different regions and geologic structures vary 
in important ways that also affect each crude oil's value in the 
marketplace. Specifically, the value of a given crude oil is determined 
by its inherent quality and the amount and value of petroleum products 
that can be refined from it. Crude oil is commonly classified according 
to two parameters: density and sulfur content. Less dense crudes are 
known as "light," while denser crudes are known as "heavy." Crudes with 
relatively low sulfur content are known as "sweet," while crudes with 
higher sulfur content are known as "sour." In general, heavier and more 
sour crudes require more complex and expensive refineries to process 
the oil into usable products but are less expensive to purchase than 
light sweet crudes. Because much of the oil produced in California is 
heavy and sour, California refiners have made significant investments 
in more technically complex equipment that enables them to process 
these crudes into higher value products such as gasoline, jet fuel, and 
diesel. 

Because of the large number of grades of crude oils, buyers and sellers 
use benchmark crude oils as a reference in pricing crude oil. A 
benchmark crude oil is typically an abundantly produced and frequently 
traded crude oil. There are currently three widely used crude oil 
benchmarks--West Texas Intermediate (WTI), Brent, and Dubai. WTI is a 
very high quality light crude oil produced in Texas and refined in the 
Midwest and Gulf Coast, and it is typically the benchmark for crude oil 
produced in North and South America. Other oils are often priced with 
reference to one of these benchmark crude oils. The relationship 
between the prices of specific crude oils and a benchmark crude oil is 
commonly expressed as a price differential--calculated by subtracting 
the specific crude oil price from the benchmark price. For example, if 
WTI is selling for $60 per barrel and Kern River (a California crude 
oil) for $45 per barrel, the WTI-Kern River price differential is $15. 

Crude oil price differentials are generally not constant over time; 
they reflect changes in world crude oil markets, as well as more local 
or crude oil specific factors. When prices of the crude oil produced in 
a state fall to an unusual degree relative to prices of benchmark oils 
or similar quality oils, crude oil producers and state collectors of 
crude oil royalty revenues become concerned. In fall 2004, crude oil 
price differentials in California rose sharply when the price of WTI 
increased relative to California crude oils. In this context, you 
requested that we provide additional information on crude oil price 
differentials in California. As agreed with your office, this report 
discusses (1) the extent to which crude oil price differentials in 
California have fluctuated over the past 20 years and (2) the factors 
that may explain the recent changes in the price differential between 
California and other crude oils. To provide additional context for this 
report, we also evaluated recent increases in the price differential 
between WTI and crude oils produced in the Rocky Mountain region. 

To determine the extent to which California crude oil price 
differentials have fluctuated over time, we obtained historical data on 
California and benchmark crude oil prices from Platts--a major provider 
of news and information on energy commodities. We obtained data on 
three California crude oils: two heavy crude oils (Kern River and 
Thums) and an intermediate crude oil (Line 63). We used these data to 
calculate price differentials by subtracting the price for California 
crude oils from benchmark crude oils and analyzing these differentials 
for trends over time. We also interviewed officials from the Energy 
Information Administration (EIA), MMS, and the California Energy 
Commission (CEC). To identify factors that may explain the recent 
changes in the California oil price differentials, we interviewed 
officials from EIA, MMS, CEC, and the California State Controller's 
Office. In addition, we interviewed industry experts from state, 
regional, and national trade organizations, such as the California 
Independent Petroleum Association, the Western States Petroleum 
Association, and the Independent Petroleum Association of America; 
representatives from crude oil production and refining companies in 
California and the Western United States; and independent energy sector 
consultants. We also discussed the possibility of price manipulation 
with numerous officials and experts to determine whether or not it was 
a relevant factor in explaining recent changes in crude oil price 
differentials. We conducted our work between May and December 2006 in 
accordance with generally accepted government auditing standards. 

Results in Brief: 

California crude oil price differentials have experienced numerous and 
large fluctuations over the past 20 years. The largest spike in the 
price differential began in mid-2004 and continued into 2005, during 
which the price differential between, for example, WTI and Kern River 
rose from about $6 to about $15 per barrel. This increase in the price 
differential between WTI and California crude oils occurred in a period 
of generally increasing world oil prices during which prices of both 
WTI and California crude oils rose. Price differentials between WTI and 
other oils also expanded in the same time period. Specifically, price 
differentials between WTI and two other California crude oils, Thums 
and Line 63, as well as price differentials between WTI and other non- 
California heavy crude oils, such as Mexican Maya and Arab Heavy, also 
increased. The price differentials have since fallen somewhat but 
remain relatively high by historical standards, while world crude oil 
prices and the price of crude oil in general have risen further. Figure 
1 shows historic prices of WTI and Kern River, as well as the price 
differentials between these two crude oils. 

Figure 1: WTI and Kern River Crude Oil Prices and Price Differentials, 
December 1987 to August 2006: 

[See PDF for image] - graphic text: 

Source: GAO analysis of Platts data. 

[End of figure] - graphic text: 

The recent trends in California crude oil price differentials are 
consistent with a number of changing market conditions. First, 
beginning in mid-2004, Middle East producers began to increase the 
supply of heavy crude oils in the world marketplace. This increase in 
supply helped depress prices for crude oils of similar quality, such as 
California's crude oils, and contributed to the expanding price 
differential between California crude oils and WTI. In addition, EIA 
officials told us that the recent increases in global crude oil prices 
caused prices of light petroleum products, such as gasoline and diesel, 
to increase more than the prices of heavier products, such as residual 
fuel oil, because these heavier products compete against other fuels, 
such as coal, that are not immediately affected by rising oil prices. 
As a result, prices for light crude oils, which produce greater amounts 
of lighter, higher value products, increase faster than heavy crude 
oils, which produce greater amounts of heavier, lower value products, 
and thus the price differential widens. Third, events that impact 
regional crude oil markets or individual crude oils can also affect 
price differentials. For example, in September 2004, Hurricane Ivan 
disrupted crude oil production in the U.S. Gulf Coast region, resulting 
in decreases in crude oil supply, primarily in that region. Some 
experts believe that the resulting scarcity of crude oil in the Gulf 
Coast region caused the prices of WTI and other regional oils to 
increase relative to crude oils produced outside the region. This also 
would have increased the price differentials between WTI and other 
crude oils, including those from California. Finally, the state of 
California has alleged in the past that some crude oil producers in 
California manipulated prices of their crude oil to reduce their 
royalty payments, which would, in turn, cause crude oil price 
differentials between WTI and California crude oils to rise. Most 
officials and experts we interviewed did not believe that this type of 
price manipulation was a factor in explaining recent changes in price 
differentials. However, we cannot completely rule out this possibility 
or other possible factors that we could not observe that could explain 
some of these recent changes. 

Background: 

Two-thirds of all crude oil consumed in the United States is used by 
the transportation sector, with gasoline accounting for two-thirds of 
that total. The second largest consumer of crude oil is the industrial 
sector, including refineries and petrochemical industries, which 
account for another 25 percent of that total. In the residential and 
commercial sectors, crude oil consumption was as high as 15 percent of 
that total in 1970 but had since fallen to 6.5 percent in 2004. 
Similarly, the burning of crude oil to generate electricity peaked in 
1975 at 8.6 percent, declining to 2.5 percent in 2004. 

Crude oil is supplied through onshore and offshore domestic production 
and international imports. In 2005, the United States produced 6.8 
million barrels per day (bpd), a 5.5 percent decrease from 2004. 
California is currently the fourth largest oil producer (including 
onshore and offshore production) in the United States, behind 
Louisiana, Texas, and Alaska, respectively, but its production has 
declined at a rate of 2.4 percent per year for the past 10 years. 
California produced 731,150 bpd in 2004 (the most recent year for which 
numbers are available). Figure 2 shows the decline in California crude 
oil production and the quantity of various grades of crude oil produced 
in California. 

Figure 2: Quantities of Crude Oil Grades Produced in California, 1987 
to 2005: 

[See PDF for image] - graphic text: 

Source: CEC, California Department of Conservation, MMS. 

[End of figure] - graphic text: 

In 2005, the United States imported 13.5 million bpd, or 27.1 percent 
of total global oil imports. The EIA estimates that California imported 
40.7 percent of all crude processed by the state's refineries, with the 
bulk of imports coming from Saudi Arabia, Ecuador, Iraq, and Mexico. 
The remainder of California's crude oil was either produced in state, 
or transported by tanker from Alaska. Figure 3 shows the sources of 
California's crude oil and the state's major refining centers as of 
2005, the last full year of data available, and figure 4 shows the 
trend of California's crude oil supply over the past two decades. 

Figure 3: Sources of California Crude Oil and Major Refining Centers, 
2005: 

[See PDF for image] - graphic text: 

Source: GAO, CEC, and EIA; California map, Map Resources. Images Corel 
Corp. All rights reserved. 

[End of figure] - graphic text: 

Figure 4: Quantities and Sources of Crude Oil Consumed in California, 
1987 to 2005: 

[See PDF for image] - graphic text: 

Source: CEC. 

[End of figure] - graphic text: 

WTI crude oil is a widely traded oil that is commonly used as a 
benchmark for measuring crude oil prices in the United States. Prices 
for WTI are collected at Cushing, Oklahoma. Crude oils delivered by 
pipeline generally use WTI first month delivery (WTI crude oil 
delivered 1 month from a specific date) as a price benchmark, and crude 
oils delivered by tankers use WTI second month delivery (WTI crude oil 
delivered 2 months from a specific date) as a price benchmark.[Footnote 
1] 

Crude oils are commonly classified by their density and sulfur content. 
The gravity of a crude oil is specified using the American Petroleum 
Institute (API) gravity standard, which measures the weight of crude 
oil in relation to water, which has an API gravity of 10 degrees. As 
shown in table 1, crude oil is generally classified as heavy (API 
gravity of 18 degrees or less), intermediate (API gravity greater than 
18 and less than 36 degrees), and light (API gravity of 36 degrees or 
greater). In addition, crude oils vary by their sulfur content--crude 
oil is classified as sweet when its sulfur content is .5 percent or 
less by weight, and sour when its sulfur content is greater than 1 
percent. Other natural characteristics, such as the presence of heavy 
metals and level of acidity, are also taken into account when 
classifying crude oils. In general, heavier and more sour crude oils 
require more complex and expensive refineries to process the oil into 
usable products but are less expensive to purchase than light sweet 
crude oils. Based on the API's classification, California crude oils 
are almost all in the heavy and intermediate range. WTI, on the other 
hand, is a very light oil with an API gravity of just under 40. Table 1 
shows the API classification and the API gravity of California's three 
primary crude oils. 

Table 1: API Crude Quality Classes and Representative California Crude 
Oils: 

Crude type: Heavy; 
API gravity: 18 degrees or less; 
Percentage of Calif. crude oils, 2005: 51%; 
Representative Calif. crude oils with API gravity in parentheses: Thums 
(17) Kern (13.4). 

Crude type: Intermediate; 
API gravity: >18 degrees; <36 degrees; 
Percentage of Calif. crude oils, 2005: 48.8%; 
Representative Calif. crude oils with API gravity in parentheses: Line 
63 (29). 

Crude type: Light; 
API gravity: 36 degrees or greater; 
Percentage of Calif. crude oils, 2005: 0.2%; 
Representative Calif. crude oils with API gravity in parentheses: 
[Empty]. 

Sulfur type: Sweet;  
Description: .5% or less by weight;  
Percentage of Calif. crude oils, 2005: [Empty]; 
Representative Calif. crude oils with API gravity in parentheses: 
[Empty]. 

Sulfur type: Sour; 
Description: greater than 1% by weight; 
Percentage of Calif. crude oils, 2005: [Empty]; 
Representative Calif. crude oils with API gravity in parentheses: 
[Empty]. 

Sources: API, CEC, Platts. 

[End of table] 

The sale of crude oil primarily occurs through one of three types of 
transactions: a spot transaction, a contract arrangement, or as a 
futures contract. Spot transactions are agreements to sell or buy one 
shipment of oil at a price agreed upon at the time of the arrangement. 
Spot transaction prices in various regional markets are available 
through private publishers that monitor and record market transactions 
and prices. Oil is often traded in long-term contracts at prices that 
are tied to a market indicator, such as the spot market or the futures 
market. While most contract prices are set in reference to a market 
index or a benchmark crude oil, some domestically produced crude oils 
are also sold using posted prices, which are usually set by buyers, 
refiners, and gatherers, and apply to a particular crude stream (a 
crude oil or blend of oils of standardized quality). International 
crude oils sold through contract arrangements are generally priced 
using a formula that includes a base price, which is referenced to a 
market indicator, plus or minus a quality adjustment. A futures 
contract is a standardized agreement that obligates the holder of the 
contract to make or accept delivery of a specified quantity and quality 
of a crude oil during a specific month at an agreed upon price. Futures 
contracts are bought and sold on a commodities exchange, such as the 
New York Mercantile Exchange (NYMEX). However, unlike spot transactions 
and contract arrangements, futures contracts very rarely result in the 
delivery of physical barrels of oil. Instead, the contract may be 
satisfied by a cash settlement prior to contract expiration by selling 
or purchasing other contracts with terms that offset the original 
contract or by exchanging a futures contract for the 
commodity.[Footnote 2] 

Price Differentials between California and Other Crude Oils Have 
Fluctuated Significantly over the Past 20 Years but Have Risen 
Significantly in Recent Years: 

From December 1987 to August 2006, price differentials between WTI and 
California crude oils fluctuated significantly, generally increasing 
since mid-2004 and reaching a high in January 2005. This recent 
increase in crude oil price differentials coincided with a general 
increase in world crude oil prices and reflected a more rapid increase 
in WTI prices relative to prices of the three California crude oils we 
evaluated (Kern River, Thums, and Line 63).[Footnote 3] Large price 
differentials also occurred in 2004, 2005, and 2006 for heavier crude 
oils imported into California, such as Maya and Arab Heavy. Since 
January 2005, the price differentials between WTI and these heavier 
California and imported crude oils have fallen somewhat from their peak 
in 2005 but remain large by historical standards. 

During the period from December 1987 through August 2006, all crude oil 
prices we evaluated tended to follow similar patterns, rising and 
falling in concert. However, the rate of increase or decrease in prices 
often varied by crude oil type and, consequently, the price 
differentials between these crude oils fluctuated. For example, 
California crude oil prices rose and fell in relation to WTI during the 
same period, with the higher quality Line 63 mirroring the price of WTI 
more closely than the lower grade Kern River and Thums. Specifically, 
the price differential between WTI and Kern River ranged from a low of 
$3.20 in July 1995 to a high of $14.99 in January 2005. Similar 
variable changes also occurred for the WTI-Thums price differential, 
which fluctuated between a low of $2.47 in June 1995 and a high of 
$13.92 in February 2005. For Line 63, the price differential was lowest 
in September 2000 at $0.84 and highest in January 2005 at $9.57. 
Fluctuations in prices for WTI, Kern River, Thums, and Line 63, as well 
as price differentials between WTI and the three California crude oils 
can be seen in figure 5. 

Figure 5: WTI, Kern River, Thums, and Line 63 Crude Oil Prices and 
Price Differentials, December 1987 to August 2006: 

[See PDF for image] - graphic text: 

Source: GAO analysis of Platts data. 

[End of figure] - graphic text: 

While numerous fluctuations in crude oil prices and crude oil price 
differentials have occurred over the 20-year period, global crude oil 
prices rose precipitously in mid-2004, with the price of WTI rising 
from $40.79 in July 2004 to $75.83 in August 2006--an increase of about 
86 percent. This general rise in oil prices also occurred in California 
crudes, where prices for Line 63 rose from $41.44 in August 2004 to 
$70.72 in August 2006--an increase of about 71 percent, followed by 
Kern River and Thums, which rose from $40.45 and $41.41, respectively, 
in October 2004, to $63.32 and $65.02, respectively, in August 2006 -- 
both increases of about 57 percent. Because WTI rose faster than 
California crude oils, price differentials between California crude 
oils and WTI also increased during this period. The price differential 
for Line 63 rose from $6.54 in September 2004 to a peak of $9.61 in 
December 2004--an increase of about 47 percent. The price differential 
between Kern River and WTI rose from $5.95 in June 2004 to a peak of 
$14.99 in January 2005--an increase of about 152 percent. The price 
differential for Thums and WTI followed a similar pattern, rising from 
$7.13 in August 2004 to a peak of $13.92 in February 2005--an increase 
of about 95 percent. 

Crude oils imported into California, including Arab Heavy and Maya, 
followed a similar pattern of fluctuating prices and increasing price 
differentials during the same recent period. These intermediate crude 
oils compete with Kern and Thums in the California marketplace because 
of their similar quality and characteristics.[Footnote 4] Price 
differentials between WTI and Arab Heavy increased from $7.84 in June 
2004 to a high of $16.24 in January 2005--an increase of about 107 
percent. Price differentials for Maya and WTI were $8.39 in June 2004 
and rose to a peak of $18.68 in March 2005--an increase of about 123 
percent. Figure 6 provides an overview of the rise in prices for WTI, 
Arab Heavy, and Maya and price differentials between WTI and these 
imported crude oils from July 1988 to August 2006. 

Figure 6: WTI, Maya, and Arab Heavy Crude Oil Prices and Price 
Differentials, July 1988 to August 2006: 

[See PDF for image] - graphic text: 

Source: GAO analysis of Platts data. 

[End of figure] - graphic text: 

Since mid-2005, price differentials for the three California crude oils 
and the two imported crude oils have moderated somewhat but remain high 
by historical standards. For example, the price differential for Kern 
River fell to $12.17 in August 2006 (the last month for which data was 
available), a decrease of about 19 percent from its high of $14.99 in 
January 2005. For the lighter California crude oil, Line 63, the price 
differential fell to $5.11 in August 2006, a decrease of about 47 
percent from a peak of $9.61 in December 2004. The price differentials 
for Arab Heavy and Maya followed similar patterns. For example, the WTI-
Arab Heavy price differential fell to $12.56 in August 2006, a decrease 
of about 23 percent from its high of $16.24 in January 2005. 
Nonetheless, all the crude oil price differentials between WTI and the 
heavier crude oils we evaluated remain high by historical standards. 

Recent Increases in California Crude Oil Price Differentials Are 
Consistent with Other Market-Based Factors: 

According to EIA officials and other crude oil market experts we 
interviewed, a range of market-based factors have affected recent crude 
oil price differentials. First, changing conditions and events in the 
global crude oil market influenced the relative prices of light and 
heavy crude oils, causing crude oil differentials between WTI and 
heavier crude oils to increase. Second, local and regional events that 
impacted specific regional crude oil markets affected crude oil prices 
and affected the price differential with WTI. This was particularly 
evident in oil production in the Rocky Mountain region in early 2006 
when an increase in crude oil supplies and a lack of crude oil 
transportation capacity caused a decrease in prices and an increase in 
the price differential. In addition, the state of California has 
alleged in the past that crude oil producers in California manipulated 
prices lower to avoid making royalty payments. While most of the 
officials and experts we interviewed did not believe that California 
crude oil producers have recently engaged in this type of price 
manipulation, we cannot rule out this possibility or other possible 
factors that we could not observe that could explain some of the 
changes in price differentials. 

Changing Conditions and Events in Global Crude Oil Markets Have 
Affected Price Differentials: 

EIA and other officials we interviewed told us that price differentials 
between light and heavier crude oils are driven primarily by supply and 
demand economics in the global crude oil and petroleum products markets 
and stated that these factors have influenced recent trends in price 
differentials between heavy California crude oils and the light crude 
oil benchmark WTI. For example, increases in the supply of light crude 
oil result in lower prices for those crude oils, which would decrease 
the price differential in comparison to heavy crude oil, such as those 
oils typically produced in California. Conversely, an increase in the 
supply of heavy crude oil can result in lower prices for those crude 
oils, thus increasing the price differential between heavy crude oils 
and WTI. For example, according to EIA officials, between January 2003 
and January 2005, world demand for crude oil increased substantially, 
in China and the United States in particular and in response, crude oil 
producers in the Middle East increased their production of heavy crude 
oil to meet the rising overall demand for crude oils. EIA officials and 
others stated that this caused prices of WTI to rise at a faster rate 
than heavy crude oils and contributed to rising price differentials 
between WTI and heavier crude oils such as those produced in 
California. EIA officials also told us that when crude oil prices 
increase, as they have in recent years, prices of lighter petroleum 
products, such as gasoline and diesel, rise faster than prices of 
residual fuel oils and other heavier crude oils because the latter 
products face greater competition from coal and natural gas, which are 
not initially affected by increases in crude oil prices. Because 
heavier crude oils typically generate a greater proportion of heavier 
petroleum products than do lighter crude oils, the value of the heavier 
crude oils falls relative to lighter crude oils. This causes the price 
differentials between WTI and heavier oils to rise further. Both of 
these factors helped push the price of heavy crude oils lower in 
relation to light crude oils. Specifically, between January 2003 and 
January 2005, the price of WTI increased by about 42 percent, while the 
price of Kern increased by about 16 percent. Consequently, the price 
differential between these two crude oils expanded from about $6 to 
about $15. 

Local and Regional Events Have Affected Prices of Specific Crude Oils 
and Markets: 

Local and regional events, such as hurricanes off the U.S. Gulf Coast 
and refinery outages, can cause fluctuations in the price of crude oils 
produced in the region and benchmark crude oils. Consequently, these 
events can increase or decrease price differentials. These events are 
tracked by analysts in the private sector crude oil markets, financial 
markets, and the federal government. From 1970 through the end of 2005, 
EIA examined 72 different events and their effects on crude oil prices, 
such as the Organization of Petroleum Exporting Countries oil embargo 
in 1973, the terrorist attacks of September 11, 2001, and the multiple 
hurricanes that struck the U.S. Gulf Coast in 2004 and 2005. For 
example, when Hurricane Ivan hit the Gulf of Mexico region in September 
2004, oil tankers importing crude oil into the Gulf were delayed, and 
oil producers were forced to evacuate 3,000 employees from the region. 
MMS estimated that Hurricane Ivan caused crude oil production to 
decrease by 61 percent and resulted in spikes in the price of WTI. This 
would have increased the price differential between WTI and other crude 
oils, including those California crude oils we evaluated. 

In addition, in early 2006, the price differential of local crude oils 
in the Rocky Mountain region rose to an unusual extent. The increase 
was most pronounced with the price differential between WTI and Wyoming 
Sweet, a regionally produced crude oil with a gravity and sulfur 
content very similar to WTI. From 1988 through mid-2005, the price of 
Wyoming Sweet was roughly equal to WTI, with price differentials 
ranging between zero and $3. However, beginning in January 2006, the 
price of Wyoming Sweet dropped suddenly. Consequently, the price 
differential between Wyoming Sweet and WTI increased from about $2 in 
the beginning of 2004 to over $24 in February 2006. In contrast to 
California, where crude oil prices and price differentials to WTI have 
experienced regular fluctuations, there was no historic precedent for 
crude oil price differentials of this magnitude occurring in the Rocky 
Mountain region. Although the Wyoming Sweet price differential has 
since fallen to less than $10, this is still unusually high for this 
region. Figure 7 shows prices for WTI and Wyoming Sweet and their price 
differential between December 1987 and August 2006. 

Figure 7: Wyoming Sweet and WTI Crude Oil Prices and Crude Price 
Differentials, December 1987 to August 2006: 

[See PDF for image] - graphic text: 

Source: GAO analysis of Platts data. 

[End of figure] - graphic text: 

State officials and officials representing crude oil producers in the 
region told us that the principal cause of the expanding Wyoming Sweet 
price differential was inadequate crude oil transportation 
infrastructure. In 2005, crude oil production in this region increased, 
and Canadian producers also increased imports into the region. However, 
the existing pipeline, railroad, and trucking infrastructure for 
transporting crude oil was insufficient to move this large influx of 
crude oil out of the Rocky Mountain region to other markets where it 
could have received a higher price. The resulting oversupply of crude 
oil in a region with comparatively low demand prevented the price of 
the regional crude oils from increasing similar to WTI prices, causing 
a large price differential. State officials we interviewed predicted 
that, until transportation infrastructure can be expanded, price 
differentials for oils produced in the Rocky Mountain region will 
continue to be above the historical trends. 

Manipulation of Crude Oil Prices Could Affect Price Differentials: 

Market manipulation is a final factor that could cause crude oil price 
differentials to increase. In the past, the state of California alleged 
that crude oil companies in California manipulated crude oil prices to 
lower their royalty payments to the federal government. While we did 
not find any evidence that any market players had manipulated crude oil 
prices in California or elsewhere during the recent period of 
increasing crude oil price differentials, we cannot rule out this or 
other possible factors or events that we could not observe that could 
explain some of the changes in price differentials. 

The sales price of crude oil is an important variable in the equation 
that determines the amount of royalties paid by oil companies who 
produce crude oil on federal lands. Royalty revenues are calculated 
using the following formula: 

Volume of Crude Oil Sold times Sales Price times Royalty Rate = Royalty 
Revenues: 

Consequently, changes in either the sale prices or the volume sold can 
greatly affect the total amount of royalties oil companies pay and the 
states receive. Historically, posted prices were widely accepted as the 
true market value and the measure that should be used in determining 
royalty payments by crude oil producers, refiners, state governments, 
and the federal government. 

In litigation starting in 1975 and continuing through 1995, the state 
of California and the city of Long Beach alleged that seven major oil 
producing companies had conspired to keep posted prices low and that 
their posted prices did not reflect the true market value of their 
crude oil, thus illegally reducing the amount of royalties the oil 
companies paid. Six of the companies eventually settled their cases, 
while the seventh went to trial and was exonerated. Although MMS was 
not a party to this litigation, it continued to independently evaluate 
whether posted prices reflected market value. In June 1994, MMS formed 
an interagency task force with some of the agencies that had previously 
reviewed the issue, including the Departments of Energy, Justice, and 
Commerce, to evaluate documents from the litigation and other data and 
determine whether the companies had wrongfully undervalued crude oil to 
avoid paying royalties. In May 1996, the task force concluded, among 
other things, that (1) oil companies in California typically received 
proceeds higher than posted prices and, therefore, royalties were 
underpaid and (2) much of the crude oil produced in California was not 
sold as contemplated in the royalty revenue formula, but rather moved 
through various transfers or exchanges either within a company that 
owned both the production and refinery operations, or between two 
companies for purposes of reducing transportation costs. Consequently, 
the reported sale price was frequently lower than actual market prices. 

In March 2000, MMS changed its regulations for valuing crude oil from 
federal lands to address the conclusions of the task force. Among other 
things, the regulations changed for determining the value of crude oil 
sold in a "non-arms length" transaction--crude oil transferred within 
an oil company between its production and refining affiliates. 
Currently, royalties for these non-arms length transactions are 
calculated using a sales price that is imputed based on the price of 
Alaska North Slope (in California) or NYMEX (for the rest of the 
country) and adjusted for differences in quality. In arms-length 
transactions--sales between two separate and unaffiliated companies-- 
the actual sale price, and not the posted price, is used to calculate 
royalties. 

In the course of our work, most of the officials and experts we 
interviewed thought the new MMS regulations were effective in 
addressing this problem and neither believed that crude oil producers 
were engaging in this sort of price manipulation during the recent 
period of increasing crude oil price differentials, nor did they 
provide any evidence of such manipulation. However, we cannot rule out 
this or other possible factors or events that we could not observe that 
could explain some of the changes in price differentials. 

As agreed with your offices, unless you publicly announce the contents 
of this report earlier, we plan no further distribution until 30 days 
from the report date. At that time, we will send copies to interested 
congressional committees and Members of Congress, the Secretary of 
Energy, and the California State Controllers Office. We also will make 
copies available to others upon request. In addition, the report will 
be available at no charge on the GAO Web site at [Hyperlink, 
http://www.gao.gov]. 

If you or your staff have any questions about this report, please 
contact me at (202) 512-3841 or wellsj@gao.gov. Contact points for our 
Offices of Congressional Relations and Public Affairs may be found on 
the last page of this report. GAO staff who made key contributions to 
this report are listed in appendix II. 

Signed by: 

Jim Wells: 
Director, Natural Resources and Environment: 

[End of section] 

Appendix I: Objectives, Scope, and Methodology: 

The objectives of this review were to determine (1) the extent to which 
crude oil price differentials in California have fluctuated over the 
past 20 years and (2) the factors that may explain the recent changes 
in the price differential between California's crude oil and others. As 
part of the second objective, in order to provide additional context to 
the issue of price differentials in California, we also evaluated the 
unusually high crude oil price differentials that occurred in the Rocky 
Mountain region in late 2005. 

To determine the extent to which California crude oil price 
differentials have fluctuated over time, we obtained data on the spot 
prices of the North American benchmark crude oil, West Texas 
Intermediate (WTI), and three California crude oils: two heavy crude 
oils (Kern River and Thums) and an intermediate crude oil (Line 63). We 
also obtained price data for two heavy crude oils that are imported 
into California in large volumes: Arab Heavy, a Saudi Arabian crude 
oil, and Maya, a crude oil imported from Mexico. These data included 
prices from December 1987 through August 2006. While most of the data 
we obtained listed a monthly average price, some crude streams used 
daily or weekly averages. In these instances, we calculated the monthly 
average price in order to make appropriate comparisons. We used this 
data to calculate price differentials by subtracting the price for the 
subject crude oil from the price of the benchmark crude oil and 
analyzing these differentials for trends over time. We interviewed 
officials from the Energy Information Administration (EIA), Minerals 
Management Service (MMS), and the California Energy Commission (CEC) to 
get background information on the major crude oils produced in 
California and imported into the region. 

To identify factors that may explain the recent changes in the 
California price differentials, we (1) interviewed key officials and 
experts, (2) reviewed studies on crude oil prices and price 
differentials, and (3) reviewed historical studies and interviewed 
agency officials about the history of crude oil price manipulation in 
California. To better understand the key factors that affect crude oil 
price differentials in general and specifically in California, we 
interviewed federal agency officials from EIA and MMS; state agency 
officials from CEC and the California State Controller's Office; and 
experts from organizations representing crude oil producers and 
refiners, including the California Independent Petroleum Association 
(CIPA), the Western States Petroleum Association (WSPA), and the 
Independent Petroleum Association of America. We reviewed studies, 
reports, and presentations on crude oil pricing and differentials 
written by or produced for EIA, MMS, CEC, CIPA, and WSPA. We also 
reviewed a study prepared for the California State Controller's Office 
on crude oil price differentials in California, written by IIC Inc., 
and interviewed its author. To evaluate the issue of crude oil price 
manipulation in California, we reviewed documents, regulations, and 
studies from the 1980s and 1990s regarding the history of allegations 
of oil producers manipulating prices to avoid making royalty payments. 
We also interviewed officials with the California State Controller's 
Office, MMS, CIPA, and WSPA, regarding the history of manipulation in 
California, and whether they believed or had evidence that such price 
manipulation might have occurred in the recent period of unusually high 
price differentials. We did not seek to acquire proprietary records on 
the prices received for sales of crude oil from crude oil producers or 
their buyers for this engagement. 

To evaluate the unusually high price differentials in the Rocky 
Mountain region, we obtained data on the spot price of Wyoming Sweet, a 
light sweet crude oil similar in quality to WTI. We used this data to 
calculate price differentials by subtracting the monthly average price 
for Wyoming Sweet from the monthly average price of the WTI and 
analyzed these differentials for trends over time. To understand the 
causes of the high price differential in the Rocky Mountain region and 
to learn what stakeholders in the region are doing to address the 
issue, we interviewed officials with the Wyoming Pipeline Authority, 
the North Dakota Petroleum Council, the Interstate Oil and Gas 
Commission, the Colorado Oil and Gas Commission, and oil producers and 
refiners in the region. 

We conducted our work between May and December 2006 in accordance with 
generally accepted government auditing standards. 

[End of section] 

Appendix II: GAO Contact and Staff Acknowledgments: 

GAO Contact: 

Jim Wells, (202) 512-3841, or wellsj@gao.gov: 

Staff Acknowledgments: 

In addition to the individual listed above, Frank Rusco, Assistant 
Director; Jeffrey Barron; Casey Brown; Alison O'Neill; Kim Raheb; 
Barbara Timmerman; and Wilda Wong made key contributions to this 
report. 

(360701): 

FOOTNOTES 

[1] Crude oil is primarily transported using oil tankers and pipelines, 
with tankers generally providing intercontinental transport and 
pipelines used for transcontinental transport. 

[2] Commercial interests typically use futures to hedge (or offset) 
unwanted price risk by shifting the risk to investors who hope to 
profit from taking on that risk. By hedging the risk, commercial 
interests seek price certainty, aiming to avoid losses due to falling 
prices, but at the same time willing to forgo the opportunity to make 
large profits from an unexpected rise in prices. A speculator may 
profit by accurately predicting either a rise or fall in prices. 

[3] Kern River is a heavy crude oil with an API gravity of 13 degrees 
and a sulfur content of 1.1 percent. Thums is also a heavy crude oil 
with an API gravity of 17 degrees and a sulfur content of 1.5 percent. 
Line 63 is an intermediate crude oil with an API gravity of 28 degrees 
and a sulfur content of 1.02 percent. WTI is a light crude oil with an 
API gravity typically between 38 to 40 degrees and a sulfur content of 
approximately 0.3 percent. 

[4] Arab Heavy is produced in Saudi Arabia with a gravity of 27 
degrees, and Maya is produced in Mexico with an API gravity of 22 
degrees and a sulfur content of 3.3 percent. 

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