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.