The Financial Times reports today that refiners are paying prices higher than those indicated by the futures market for the lightest, meaning best, grades of crude oil. This points to an issue raised in an earlier post, namely, that to the extent oil supplies are tight, it’s due to demand for sweet crude, which has become more sought-after due to tightening environmental standards. Another factor mentioned by the Financial Times is insufficient refinery capacity to refine heavier grade “sour” crude into diesel.
First, from the earlier post:
Reader Rajiv sent a link to the testimony of Philip Verlegger, a well regarded energy consultant and visiting fellow at the Institute of International Economics before the Senate Committees on Homeland Security and Energy and Natural Resources last December. Verlegger’s remarks ran to 20 pages. The two parts that diverged most from conventional thinking was that the the Strategic Petroleum Reserve’s purchases were having a marked impact on oil prices and most observers were completely misreading the significance of inventory rises and falls. First, a summary of his argument on the Strategic Oil Reserve:
…the rise in light sweet crude prices to almost $100 per barrel in November came about because the U.S. Department of Energy has been removing a significant share of the daily volume of this type of crude from the market for storage in the Strategic Petroleum Reserve. The volumes have amounted to as much as 0.3 percent of the global supply of light sweet crude available. DOE’s actions may have added as much as 10 percent to the light sweet crude price, given the very low estimated price elasticity of demand for crude and the likely even lower price elasticity of demand for light sweet crude. This conclusion is supported by the fact that producers of sour crude oils such as Saudi Arabia have had to institute price cuts of as much as $10 per barrel for sour crude.
Verlegger presents his case in considerable detail: how tightened environmental standards have increased demand for light, sweet crude and how it therefore has much lower demand elasticity than crude in general. Thus comparatively small change in demand can produce large price moves. He also thought demand from India and China did not contribute to the price rise.
Consider this statement, which although now six months old, was after a price increase in WTI from $70 in the late summer to $100 in early December, seems to support the Saudi claim that they don’t see enough demand to warrant lifting more oil:
Each month the Saudi oil company, Aramco, announces a differential to WTI for firms buying Saudi crude for delivery to the United States in that month. For example, buyers lifting Arab Light Crude from Saudi Arabia this month will pay the WTI price that prevails 50 days from now less $11.65. (The delay allows for the oil’s transit time from Saudi Arabia to the United States.) Aramco adjusts this differential every month to reflect changes in market conditions.
As can be seen from Figure 3 (page 5), the differential set by Saudi Arabia for oil loaded in August was $2.15 per barrel. Five months later, the Saudis boosted the discount to $11.65. As every shopper knows, discounts do not deepen when supplies are tight. Rather, they increase when goods do not sell. Apparently, Saudi Arabia has been having trouble selling its oil.
The Saudis dropped prices when WTI prices were rising.
Now to the Financial Times:
Refiners are paying record premiums for the high-quality crude oil they use to produce diesel and petrol, a sign of strong demand in the physical oil market that calls into question claims that soaring oil prices are being driven by speculators.
Refiners are paying up to $5-$6 a barrel on top of current record prices to secure high-grade oil, traders said, double the level of a year ago. The mark-ups are four times higher than the 2000-2008 average…
The fact that refiners are willing to pay a higher price for physical supplies than the futures benchmark lends weight to the argument that speculators are not the cause of record oil prices. At the same time, though, refiners are obtaining unusually large discounts for low-quality crude oil, traditionally refined into fuel oil. Traders said supplies of low-grade oil, typically produced in the Middle East, are relatively plentiful.
The premium for Nigeria’s high-grade Bonny Light oil has surged this month to $4 a barrel, up from $2.50 a year ago. In the same period, the discount for low-grade Iran Heavy oil has widened to $13.05 a barrel from $7.
The split in the physical market explains Opec’s reluctance to boost its production as most of the cartel’s spare capacity is of low-quality oil. However, the situation could change as Saudi Arabia plans to bring on stream its Khursaniyah high-quality oil field. It also highlights a lack of capacity at refineries that can turn heavy, low-quality oil into products such as diesel. Francisco Blanch, head of commodities research at Merrill Lynch, said the price of Middle East low-grade oil was falling behind because of refining bottlenecks.
“Middle East heavy crudes have been unable to keep up with the growing appetite for low sulphur middle distillates products, such as diesel,” he said, adding the difference between Saudi Arabia’s high- and low-quality oil was at a record high.
The scarcity of premium oil has been aggravated by shortfalls in Nigeria.
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oil will fall a little though in the coming months as people twig that demand will fall as the global economy slows.
In Verlegger’s testimony, he says “Over the last six months, U.S. refiners liquidated as much as 50 million barrels of crude oil stocks. This liquidation occurred because holding stocks was no longer profitable.” If futures prices are higher than spot prices, how can holding stocks not be profitable? Please help me understand this.
Verlegger’s statement flies in the face of the idea that prices are up because oil is being stashed somewhere.
Reading further in Verlegger’s presentation, he is claiming that oil companies have liquidated their inventories because the return on investment for holding oil is negative due to recent changes in the cost of money and buyers liquidating futures positions to free up cash to solve financial liquidity problems due to the financial crisis. This seems absolutely wrong to me.
I fail to see how paying a price over an already very inflated futures price calls the role of spec into question when the latter has been of some duration.
On a different line, refiners’ effective acquisition costs within a integrated firm are most likely distinct from those which are not — has the FT author considered intrafirm cross-subsidization or that EIA form 14 (acquisition cost) disallows gains/losses from hedging activities?
Scott, inventory liquidation might also have to do with the shape of the forward curve since this effects what’s called the oil storage trade.
juan,
I agree with your point about the shape of the forward curve…I just checked and light crude is flat all the way out to 2016. Also, your point about the integrated firms is good…the actual production cost from an existing well of WTI for an integrated oil company is certainly far below the current spot or forward price.
This post confirms the swindle and collusion that has taken hold in petroleum markets. Refiners are basically paying $150 for light sweet crude and we have no efficient price finding mechanism for sour crude. Sour crude is stored away in tankers and sold at a big discount.
Imagine a split of the WTI contract in sweet and sour, with sweet at $150 and sour at $40 per barrel. How long would it take for refiners to switch to sour and bring down the price of sweet?
This energy problem can be solved, but first we have to get rid of the opportunistic crowd that is enjoying this unchallenged windfall for too long.
alfred…from what i know about refining, its anything but “flipping a switch” when it comes to diffeences in refining higher quality light/sweet versus heavy/sour crude. I think some refiners have been spending heavily on ramping refinereries to efficiently handle heavy/sour crude. Valero comes to mind…However its very difficult to refine heavy/sour without running into problems from epa
I only know about minerals smelting but the scenario looks similiar.
Keep the plant producing at maximum capacity while prices are high and do not exceed the environmental permit threshhold. A very positive attitude. I mean, what would they do, shut us down? uh huh.
Ultimately, the road to profitability is to redesign, re-engineer, and just do it. American engineering is sufficient to accomplish this goal. If not, it will come out in the wash.
Let’s take this opportunity to develop an environmentally efficient mix of domestic energy production using oil shale, coal to liquid fuel, coal fired plants, geothermal, nuclear, natural gas, solar, wind, wave, delta T, carbon fiber, neodymium-iron-boron magnetic storage, traffic lights, etc.
This is a chance for America to redefine itself and the world once again.
PS: I won’t say what my position on global warming is… too dangerous and politicized for many of my colleagues.
ardano-
EPA restrictions shouldn’t be a problem in China, India, or the Middle East.
If the underlying proposition of this post is that there is a growing disconnect between light and heavy crude, rather than an overall supply problem per se (or perhaps in addition to an overall supply problem, as 140-11 is still more than 70-2), then this post raises the obvious question: what is changing so rapidly in global oil consumption that the composition of oil demand is changing so quickly?
As a non-oil expert, I can speculate (wildly and without basis :-) on a couple of possible scenarios.
1) Are light and heavy oil used for different things (e.g. gas / diesel / transport fuel vs plastics / industrial uses? This would imply that transportation requirements of goods is rising faster than the production of oil-based goods (e.g. we’re spending more diesel to transport a plastic toy from China than before when it was made here).
2) Light and heavy oil is used for the same things, but refining heavy oil costs more money, and causes more pollution. Thus, the differential in price between light and heavy grades reflects rapid global increases in environmental restrictions leading to cost escalations that in turn require higher heavy-grade discounts in order to be economically competitive.
3) Light oil is peaking much earlier than heavy oil. Thus, even if global consumption patterns and refining cost differentials remain the same, there is a shortage of light crude while heavy crude supplies remain stable (for now). Interestingly, Saudi Arabia’s largest field, Ghawar, produces much of the Saudis’ light oil, and this is the one the peak oil folks keep saying is due for a massive decline. Perhaps we should be talking about Peak Light Oil?
Anyway, consider those a layman’s attempts to connect the dots…
Refiner crack spreads have suffered (and actually went negative a few weeks back) b/c there has not been a concomitant increase in distillate prices.
That is, the total refined products have been selling for less than the price of raw oil…that’s why refiners are at sub-90% capacity (and bottomed in the low 80%’s…aka Katrina/Rita levels).
Put another way, there is more demand for oil than there is for the actual distillates…or, one more way – the distillate paper market isnt responding like the crude paper market is (aka one of them might be broken).
In either case, this is the point where traders would short oil and buy distillates, arbing away the spread…but, as we saw last week, the shorts keep getting leveled, so that trade doesn’t work…
“The fact that refiners are willing to pay a higher price for physical supplies than the futures benchmark lends weight to the argument that speculators are not the cause of record oil prices.”
If anything, that makes me think speculation is even more of a problem given that the primary consumers in futures markets can’t rely on these markets to lock in the contracted future/spot prices.
Why can’t refineries lock in delivery at futures prices like they always have? That sounds dangerously similar to what is happening w/ grain markets where farmers are dropping out due to lack of reliability in spot/future convergence.
Put another way, there is more demand for oil than there is for the actual distillates…
Futures market specualation ?
So mxq, thanks for the usual concise realtiy check. Distillates (gasoline, diesel, jet fuel) have come up, but not _nearly_ by the level that raw oil has risen, in particular not at the level that the light, sweet oil FROM WHICH THEY ARE REFINED has soared. Refiners [not that I love ’em, but] are getting whipsawed, at least on every barrel they import. And as you say, refiners can’t use the futures markets ‘the way they were designed’ to arb it out ’cause they get their hide taken off with Brillo by the specs when they try. Refiners are getting parboiled in a classic squeeze: supply costs THEM more than demand pays.
—But the conclusion that light, sweet premiums speak against speculation seems to me unwarranted. Remember, we are entering the driving season when distillate demand peaks, and so demand for light, sweet peaks. Refiners risk having empty tanks when customers’ tank trucks hook up, so even if they are groaning about it refiners must bid a little over market to ensure that they aren’t the one with the dry hole. What strikes me about the folks cited in the post, as often elsewhere, is that they don’t seem to put the whole delivery chain in the same picture, only pieces of it, so they don’t get the supply-cost-volume-demand components to sum.
Hey people, the world does not end at the borders of the United States. You people who live up there in bubble world (I am talking about the United States) need to expand your horizons.
Just what does the fact that local (U.S.) crack margins are low have to do with the price of oil, a fungible comodity that is traded globally? That’s a very provincial mentality.
I live in Mexico and the price of diesel is 5.5 pesos per liter, about $2.11 dollars per gallon. What kind of a crack margin does that imply?
Death to classical liberal economics!
Long live subsidies!
☺☺”Put another way, there is more demand for oil than there is for the actual distillates…
Futures market specualation ?”–June 13, 2008 12:06 AM
Or does it mean that while they sell their product in a local market, they buy their feed stock in an international market?
With respect to cracks, what I am about to imply could be purely coincidental, however, I am not aware of any heavy-hitting, Middle-distillate futures index funds.
US Gasoline (UGA) is an index that tracts movements in rbob contracts, but it has only $31m in AUM.
If anyone knows any distillate vehicle with significant AUM, please post it.
anon 12:13 PM,
It wasn’t clear to me whether the FT article was speaking to some global average or taking a more regional perspective, nevertheless
If you are using the term ‘fungible’ to imply equivalance as though there is some generic oil, please take a look at the differences in API gravity and sulfur contents among the world’s crude oils.
(Higher API = lighter oil; Sulfur over 0.50 usually = sour)
See: Crude Oils and their Key Characteristics
http://www.piwpubs.com/DocumentDetail.asp?document_id=200017
Which also relates to refiners’ different configurations, which can’t be changed overnight but have been changing towards ability to use heaver and/or more sour grades.
Aside from that, crack spreads can be hedged.
Here is a recent Valero Presentation. If you go to page 5, specifically, the chart on the right. Management’s accompanying dialogue (courtesy of Thomson One Street Events) was as follows:
“And unlike the chart on the left, a substantial rise in the differentials on the chart on the right means that we suffered greater losses on each barrel of these products that we produced. The issue here really is that asphalt prices, six oil prices, and so on just haven’t been able to increase at the same rate that crude oil has increased”
Refiner Insiders Buy Most Stock Since 2000 on Oil Bet
imo, either oil has to come down, or gas has to go up (i.e. rbob “only” up 35% ttm; wti up 90%)…bbg paints a picture that some insiders and big funds are screaming for one of these to happen.