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THE CRUDE STORY
by Elliott H.
Gue
Editor, The Energy
Letter
April 7, 2006
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The importance of crude for transportation is obvious when one glances at a chart of total energy consumption in the US by fuel type.
Petroleum remains by far the most important source of energy for a simple reason: Transportation is the most important use of energy in the US. Moreover, nearly 70 percent of the oil consumed is used to power vehicles. Unfortunately, powering our cars and trucks isn’t as simple as importing crude and filling our tanks. That crude must first be processed into usable products like gasoline, diesel fuel and jet fuel. Crude oil is nothing more than a raw material; in its raw state it's not much more flammable than the whale oils and paraffin waxes burned in old-fashioned oil lamps. In fact, the earliest commercial use of crude oil (then known as “rock” oil) was just that, an alternative to scarce whale oil. That often overlooked step is the domain of the refiners. But the refining business isn’t as simple as it might first appear. That’s because there are actually hundreds of different types of crude oil found all over the world. Each type has slightly different properties; different types of crude require vastly different technologies to refine. A few terms are worth noting. The term light refers to the specific gravity of the oil. Lighter grades of crude oil are easier and cheaper to refine; each barrel of crude oil refined yields a relatively large amount of high-value products like gasoline and diesel fuel. The term sweet refers to the sulphur content of the oil--sweet oils have relatively low sulphur content. Sulphur is a pollutant controlled by most governments around the world--low sulphur oil is easier and cheaper to refine. As you probably suspect, heavy and sour are simply the opposites of light and sweet respectively. Long-time readers of this journal are well aware of my belief that the world has limited capacity to grow oil production from current levels. But that’s only one aspect of the problem; the most acute shortage isn’t just crude but light sweet varietals of crude. While oil production has grown globally over the past 25 years, production of light sweet crude has barely budged. Looking into the future, the Energy Information Administration projects that light sweet crude production will continue to grow anemically at best. To the extent that the world can grow production, that growth will be heavier and sourer grades of crude. Even worse, not all refineries are capable of handling that crude. The shortage of capacity to refine light sweet crude is most acute in Asia, the very market where crude oil consumption is growing fastest. A clear secondary bottleneck is emerging. In the February 17, 2006 issue of The Energy Letter, I highlighted the potential downside risks near term for select refiners. I received several e-mails asking what the exact distinction is between different refining stocks; as they all perform basically the same function, why would he stocks perform differently. The answer: The capacity to refine heavy sour crude is the key to profitability. Specifically, check out my final chart.
I created this chart using two different types of crude oil. The first is simply a standard grade of light sweet crude oil known as West Texas Intermediate (WTI). This is the standard crude you often see quoted on the financial news. The second oil benchmark is known as Maya, Mexican benchmark crude that is a blend of several different types of heavy sour crude oils. I simply subtract the price of Maya crude from that of West Texas Intermediate to derive the data for the chart. Throughout the 1990s the WTI traded at a premium of only $1 to $2 over Maya. But as the light sweet bottleneck emerged in this decade that all changed--WTI has been trading at a $15 to $20 premium to Maya; this is proof of the shortage of the highest grades of crude. The reason for this is simple. Because many refineries can only refine light sweet crude oil, they're bidding up the price of that crude. Meanwhile, because the heavy sour crude is not usable for some refiners, there's a relative glut of heavy sour--the price drops. But for some American (and, to an extent, European) refiners this is great news. Because thee refineries are highly advanced, they're able to refine almost any type of crude oil available on the world market. In other words, they're buying crude oil at a $15 to $20 discount and selling gasoline and diesel at full market prices. This is behind an explosion in profit margins for the high-tech refiners. This is also the primary key to picking the best-placed refining stocks. Some US refiners have only limited capacity to refine cheaper varietals; they’re facing huge capital spending over the next few years to upgrade their facilities. Meanwhile, others are profiting from the heavy sour discount. In the upcoming issue of The Energy Strategist, I'll be taking a closer look at alternative energies. I'll be examining the Fischer-Tropsch process, a way of turning America's vast and high-quality coal reserves into synthetic natural gas and diesel fuel. This technology will help the nation meet new environmental regulations for sulphur content in fuels going into effect over the next few years. And it's hardly pie-in-the-sky as it's already being used extensively in other parts of the world. And I'll also take a look at wind and solar energy. While both are limited in terms of their potential to replace fossil fuels, they are rapidly expanding technologies. And where's there's growth there's money to be made.
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