Crude oil quality differentials shrink as heavy sour grades tighten
The price differential between light sweet crude oils and heavier sour crudes has narrowed as OPEC and several non-OPEC oil producers’ continue to implement output cuts. Rising sweet crude production in Libya, Nigeria and the US have also contributed to exceptionally narrow sweet/sour differentials, leading refiners in the West to process more sweeter grades in their refineries.
The Brent/Dubai EFS has remained below $1/bbl for several months, while Urals in Europe is now trading at the narrowest discount against Dated Brent since November 2014. In the US, Mars is trading at a discount of less than $1/bbl to US benchmark West Texas Intermediate (WTI). At these levels, it does not pay to process too much medium and heavy sour crude, especially in the West as fuel oil demand in the Atlantic basin is falling.
OPEC agreed to implement production cuts of nearly 1.8 million bpd with a group of non-OPEC countries from January 2017, and the last OPEC meeting in May agreed that the cuts would be extended until March 2018.
Asia has been hit hard by OPEC production restraint, which have choked off its main source of medium and heavy sour crude oil supplies. Refiners in the East are either resorting to sweeter grades or buying spot barrels from other regions, as interregional spreads tighten. Indian refiners have already developed an appetite for Russia’s main export grade Ural. Now, they are switching to Mars. The state-owned Indian Oil Corporation (IOC) is bringing a VLCC carrying 1.6 million bbl of the US grade along with 400,000 barrels of Western Canadian Select (WCS) to its refineries.
Unlike in the West, fuel oil demand is still relatively healthy in Asia. Therefore, the East is unlikely to replace medium and heavy sour crude with sweeter crude. However, higher sweet crude processing in several parts of the world is further stretching the already tight fuel oil market. New sophisticated refineries in Asia and the Middle East are not capable of producing as much fuel oil as older and simpler refineries.
While sour crude supplies have been reduced significantly, oil storage tanks are brimming with light sweet supplies especially in the Atlantic Basin. Continued low oil prices prompted the Energy Information Administration in the US to revise down its production growth forecast for US shale oil recently to 310,000 bpd from its previous forecast of 320,000 bpd. However, the rising rig count is a harbinger of further production additions next year.
Libyan output has surpassed the 1 million bpd mark, the highest level since June 2013. Nigerian exports in August are expected to reach 2 million bpd. Indeed, OPEC might ask these African nations to limit their supplies but only if they continue to increase.
The upshot for OPEC and non-OPEC oil producers is that a cut of more than 1.5 million bpd of sour production has been replaced with a similar volume of sweet crude oil from Libya, Nigeria and the US. Sour crude availabilities could be hit further if geopolitical problems in Venezuela persist.
Some medium sour stocks are being drawn down to make up for production cuts but once these have been absorbed, the sour market will tighten further. This will impact gasoil and fuel oil supplies as medium and heavy sour crudes have higher middle distillate and heavy distillate yields.
This could mean that fuel oil supplies remain tight even after the peak demand period during the northern hemisphere summer, despite lower cooling demand.
Moreover, heating fuel supplies could be stretched especially if the winter is harsh. There are already signs of higher middle distillate demand. India is sucking up more and more diesel due to strong economic growth. European economies are recovering, resulting in higher diesel demand, while shale oil producers require more diesel to allow them to maximize oil production.
These are all ingredients which point to higher oil prices at the end of this year.