OPEC’s production cuts have changed the quality of the global oil supply, shaking up the relationship between important crude benchmarks and altering purchasing calculations for refiners.
Most oil from shale formations in the United States as well as from the North Sea and West Africa is relatively low density and contains only a small percentage of sulphur.
Crude from Saudi Arabia and other countries around the Middle East Gulf, on the other hand, is mostly denser and contains much more sulphur (giving it an acrid odour).
Atlantic basin crudes are mostly “light” and “sweet” while Arabian crudes are mostly “medium” or “heavy” and “sour”.
The bulk of OPEC’s cuts have come from members exporting medium and heavy sour oils while members exporting lighter oils have cut much less or been exempted.
Light and sweet crudes are generally more valuable to refiners because they are much easier and less expensive to process.
Light crudes require less secondary processing through cracking and coking and yield a greater proportion of high-quality premium fuels.
Medium-sour crudes, on the other hand, normally trade at a discount to compensate refiners for the extra energy and expensive equipment needed to refine them.
But the production cuts by the Organization of the Petroleum Exporting Countries, coupled with the revival of shale oil production, have upended the normal relationships between the different crude grades.
By restricting their production, Saudi Arabia and other Middle East members of OPEC have reduced the aggregate supply of medium and sour grades on world markets.
At the same time, more light, sweet grades have become available from Libya, Nigeria and now U.S. shale producers.
The result has been a sharp narrowing of the quality premium for light, sweet crudes such as Brent over medium sour crudes such as Oman (http://tmsnrt.rs/2mQyu93).
At the start of 2016, Brent futures for delivery in June 2017 were trading at a premium of almost $6 per barrel over Oman futures for the same date.
In the middle of November, shortly before the OPEC production-cut agreement, the Brent premium over Oman had shrunk to around $4 per barrel.
By Feb. 23, the Brent premium had narrowed to just 75 cents, though it has since widened modestly to around $1.25.
While the Brent futures curve is in contango between June and December, the Oman curve is flat, reflecting the anticipated tightness of supply in medium crude.
Most refineries are configured to operate on a fairly specific quality of crude (simple refineries generally need light, sweet oils while more complex refineries make most money from upgrading heavy, sour crudes).
Refineries are usually willing to buy a range of crude grades but will blend them to achieve a fairly steady quality of intake in terms of density and sulphur (a well as acidity and heavy metals content).
Asia’s big new refineries are designed to run on medium and heavy crudes and produce lots of diesel for local markets, so the reduction in OPEC production has left them scrambling to secure heavier grades.
Asia’s refineries are capable of processing light oils, but not as efficiently. Light oils also do not allow them to employ all the expensive capital equipment they have installed to handle discounted lower-quality crudes.
By contrast, North Atlantic refineries, which prefer lighter oils, are struggling to shift surplus stocks of gasoline and have no appetite to process more light oil.
And U.S. refineries are undergoing a heavy spring maintenance season, which has cut demand for light, sweet oils.
Surplus light, sweet oil is therefore being exported from the United States and competing with light oils from the North Sea, West and North Africa, depressing light, sweet prices.
At the same time, the quality premium for light crudes has eroded to make it worthwhile for Asian refineries to switch from heavier grades to process more light oils.