by Steve Everly

17-11-04

In a year that has seen oil prices reach record highs, it may seem odd that producers have been offering discounts to get rid of the stuff. But that has been happening with crude oil known as "heavy sour," which is different from the "light sweet crude" whose per-barrel price is most often quoted as the price of oil.

In fact, more than three-fourths of US refinery capacity can process heavy sour, which typically sells for a few dollars less than light sweet crude because it is not as easily refined. And this year, as Persian Gulf producers have flooded the market with additional supplies of the heavier sour crude, the sweet and sour price gap has grown even wider, reaching $ 17 to $ 18 the last week of October.

That's good news for US refiners, which are considered to be in a better position than those in other countries to take advantage of the discounts. Indeed, earnings announcements by US refiners are singling out the cheaper sour crude as a major reason for their growing profits.

"This has resulted in excellent refining margins," said Curtis Hyatt, an associate director for the Cambridge Energy Research Associates, an energy consulting firm. But it's unclear how much, if any, of the savings from the cheaper crude oil have benefited US consumers.

"I haven't seen anything that the savings have been passed through to consumers," said Tyson Slocum, research director for the energy program at Public Citizen, a public interest group in Washington.
Beyond improved refinery profits, the discounts are highlighting the growing role of heavy sour in meeting demand for petroleum products. Light sweet crude such as West Texas Intermediate is needed by a majority of the world's refineries. But the sweet crude is estimated to constitute only 30 % of the world's reserves. The heavier sour crude oil accounts for the balance.

Worldwide, OPEC estimates that 45 % of refining capacity can use heavy sour oil. Refineries, for a hefty price, can be upgraded to handle heavy sour. Still, few expected in 2003 that refineries would soon have to scramble to find light crude.
Such a scramble occurred this year when OPEC took most of its surplus oil production out of mothballs to try to moderate rising oil prices and meet rising demand. Most of the added oil was medium and heavy sour, which did not help greatly in some regions. In Asia, for example, where China's growth is driving demand, OPEC estimates that only 30 % of refineries can process heavy sour oil.

So, light sweet crude such as West Texas Intermediate remained in relatively short supply, putting more pressure on the price. In contrast, plenty of sour crude was on the market, which triggered additional discounts for it. At one point this year, a barrel of Arab Gulf Dubai heavy sour crude produced in the United Arab Emirates was $ 18 less than a barrel of West Texas Intermediate, the US benchmark. As the price of light sweet crude has dropped, that gap has narrowed, and it dipped just below $ 13.
But the gap is farmore than is historically normal -- it was about $ 4 a year ago -- and OPEC has clearly been irked by accounts of record prices for Texas sweet crude while its members have gotten far less for their sour crude.

"Not withstanding those headlines marking benchmark price levels, another major but less widely reported market characteristic is the increasing gap between light sweet and heavy sour grades," according to OPEC's Monthly Market Report for October.
Light sweet crude has its advantages. Light oil, compared with medium and heavy, is more easily refined into a high percentage of high-value products such as gasoline. And "sweet" oil contains less sulphur than sour does, and sulphur must be removed to meet environmental regulations. As a result, heavy sour costs more to refine, meaning its producers must offer it at a discount off the price of light sweet crude.

When the price gap widened between sweet and sour crude, US refineries were better able than most to take advantage of the gap. Refineriesalong the Gulf Coast, which account for about half of the country's refinery capacity, are considered the most sophisticated in the world. Venezuela, which is a major producer of heavy sour oil, became partners in some of those refineries to ensure a market for its oil.
"We're probably in a better position than most to handle these heavy oils," said Joanne Shore, an analyst for the Energy Information Administration. In addition, California refineries have been upgraded to handle heavy sour crude, and most of those in the upper Midwest are also thought to be capable of handling heavy sour crude.

Another indication of the country's increasing use of lower-quality crude oil is that the Strategic Petroleum Reserve, which is meant to help the United States in case of a major disruption in oil supplies, is two-thirds sour crude and one-third sweet crude.
So given that tilt toward lower grades, is it misleading to use the widely reported price of West Texas Intermediate, a US benchmark for light sweet crude? Analysts say no, in part because oil is a worldwide market and sweet crude is a crucial part of it. In addition, sweet crude is needed by many US refiners.

The wide difference between sweet and sour crude prices is important to most US refineries. Valero Energy, the country's third-largest refining company, in a recent filing with the Securities and Exchange Commission, said a "significant" percentage of the oil it used was sour crude, and the difference between sweet and sour crude prices affected its profitability.
Premcor, another US refining company, reported third-quarter earnings of $ 145 mm, dwarfing the $ 60 mm it made in the same quarter a year ago. Premcor singled out the use of sour crude for its contribution to those profits.
"Margins have been enhanced by what appears to be a longer-term widening of the differential between light low-sulphur crude oil and heavy high-sulphur crude oil," Thomas O'Malley, the company's CEO, said.

It can cost hundreds of millions of dollars to upgrade a refinery to process heavy sour, but the current discounts for sour crude are making such investments look good. However, there are concerns that the costs of converting more US refineries will be much harder to recoup if the discounts return to levels of just a year or two ago. Hyatt, of the Cambridge Energy Research Associates, said the wider price spreads between light and heavy crude should last through at least next year. But any reduction in worldwide demand for oil or more supplies of light sweet crude, which may be possible from Russia and Africa, could cause the price spread to narrow.
"If that happens, the shift would not be permanent," he said.

But longer term, the ability to use heavy sour crude is an issue that's expected to confront the refining industry because of the vast reserves of the oil. OPEC, whose members already have large amounts of sour crude to sell, think the time is now to upgrade more facilities worldwide -- and even in the United States -- to add more flexibilityin handling different types of crude.
The US refinery system could use the additional flexibility, according to OPEC. Though much of the industry can refine sour crude, refiners have no excess capacity to adapt to growing demand and the United States is importing about 10 % of the gasoline it needs. It is further pressed by the need to produce several "boutique" gasoline blends to meet environmental regulations in different parts of the country.
As S.A. Kermati, a petroleum products market analyst for OPEC, summed it up: "The situation is very fragile, especially for a market which is leading the rest of the markets."

Source: Kansas City Star