Sweet crude premium evaporating
London, June 5, 2013
By John Kemp
In future, light low-sulphur crudes will command a much smaller premium over heavy sour grades, as booming shale production in the United States and growing demand from Asian refineries upend traditional pricing relationships in the physical oil market.
Journalists and analysts have traditionally characterised light sweet crudes as "high quality" and heavy sour ones as "low quality," with light crudes more scarce and valuable than their heavy sour counterparts.
That simple characterisation no longer holds true.
The marginal barrel supplied to the market comes from North American shale plays and is light and sweet, while the marginal barrel demanded by refiners comes from the new complex mega refineries in Asia, equipped with crackers, cokers and desulphurisation equipment, and is much heavier and sourer.
The result is a growing mismatch between the crude slate on offer from oil producers and that demanded by refiners.
ALL CHANGE, PLEASE
Conventional premiums for light sweet crudes were the result of specific circumstances: (1) strong demand for gasoline rather than diesel; (2) limited refinery capacity to process heavier molecules; (3) limited capacity to strip sulphur from feedstock; and (4) limited supplies of light sweet crudes compared with abundant supplies of heavier and more sulphurous oils.
Each of these factors has now shifted substantially. It was only a matter of time before the shift in crude supplies and refinery demand transformed the traditional pricing relationships between different crude grades.
The market for light sweet oils is now increasingly oversupplied, while heavy sour grades are seeing stronger demand. Conventional premiums for light sweet crudes have eroded, and in some cases light crudes are even trading at a discount.
The price adjustment will continue until it makes sense for Asia's complex refineries to start buying light sweet crudes and forego the technological advantage of utilising their cokers and desulphurisation units fully.
It is already changing the balance of power among oil producers. Countries that produce heavier higher-sulphur crudes like Saudi Arabia and Iraq are the main winners, while countries like Nigeria and Libya with abundant light low sulphur supplies that compete directly with US shale oil lose out.
The shift is helping prop up struggling simple refineries in Europe and on the East Coast of North America, blunting competition from complex modern refineries in Asia and the US Gulf Coast, which no longer reap as much advantage from their heavy investment in coking and desulphurisation plants.
A QUESTION OF QUALITY
All crudes are mixtures of different molecules. But light crudes have a higher proportion of the light molecules used to make premium fuels like gasoline, naphtha and to some extent diesel, while medium and heavy crudes have a higher proportion of molecules that can only be used to make diesel or sold at a discount to ships and power producers as residual fuel oil.
Simple refineries that separate different molecules by distillation have always prized light crudes because they yield a higher proportion of more valuable products, especially gasoline, which explains why light crudes traditionally commanded large premiums.
Modern complex refineries, however, can convert and upgrade the heavy residuals left over from distillation into lighter and more valuable molecules by cracking and coking, squeezing out more premium products from gasoline and naphtha to jet fuel and road diesel.
Complex refineries also have some flexibility to decide whether to crack large molecules into very small ones to make gasoline or slightly larger ones to make diesel. Complex refineries can therefore tailor their output to meet seasonal variations in demand - maximising gasoline production to meet summer driving demand in the United States, and diesel production in the winter heating season.
Crucially, complex refineries can also make a strategic decision to upgrade a large proportion of the residuals from atmospheric and vacuum distillation into diesel rather than gasoline all year round.
Dieselisation policies in the European Union and strong demand for diesel as trucking fuel in emerging markets has left the global refining system producing too much gasoline and not enough diesel.
By processing medium and heavy crudes, which yield relatively small amounts of gasoline, and then upgrading the residuals into diesel, complex refineries can maximise diesel production and generate higher returns from every barrel of crude they process.
The same story can be told about sulphur, which must be removed from finished fuels like gasoline and diesel to meet quality specifications and increasingly stringent environmental regulations.
Simple refineries preferred low sulphur (sweet) crudes, but as more refineries have invested in hydrotreating units that strip sulphur from feedstock by reacting it with hydrogen, the advantage for sweet crudes has reduced and the price premium that they command has fallen.
Light sweet oils may always have a small advantage over heavy sour ones because conversion and desulphurisation require extra energy and add to refineries' operating costs, but the margin is likely to be much smaller than before.-Reuters
* John Kemp is a Reuters market analyst. The views expressed are his own