Friday, July 02, 2004

Is The Incremental Oil Too Sour?
An article in last Saturday's NY Times reminded me of an issue I've meant to cover for some time, namely the impact of changes in the sulfur content of oil as production shifts around the world. The Times focused on the impact on China, suggesting that rapidly growing demand and strains on its economy have lowered the quality of the crude oil China can afford to buy, with consequences for the level of sulfur emissions into the air. But this is only one aspect of a bigger picture.

While the rest of the world watches Saudi Arabia to see if it really can increase its oil production to meet the needs of the market, there has been little discussion about what kind of oil this will be. Oil quality varies tremendously from field to field and region to region. Saudi oil is typically light, indicating good yields of gasoline and diesel fuel with minimal processing, but sour, reflecting high sulfur content. Without additional processing, this sulfur will end up in the fuel products, and ultimately in the atmosphere. As a result, Saudi oil trades at a discount to West Texas Intermediate and North Sea Brent, the main marker crudes, which are light and sweet.

(These sweet vs. sour labels go back to the days before laboratory analysis was readily available in the field, and the standard way to gauge the sulfur content of oil was to taste it!)

Not only is the incremental oil from Saudi Arabia going to be sour, but many of the fields that are in decline in mature areas such as the US and North Sea have historically produced lighter, sweeter crudes. As a result, the average crude oil in the world will become increasingly sour, both in the near term as Saudi Arabia ramps up to fill the current gap, and in the longer term as more of the global production burden falls on the enormous reserves throughout the Middle East.

Although the developed countries can compensate for changing crude oil sulfur levels through investment in refinery hardware, this is harder for the developing world, where investments in environmental quality often take a back seat to building basic capacity. For example, if China has $1 billion to invest in refineries, will they spend it on desulfurization hardware to improve the environmental characteristics of fuels, or will they use it to expand refinery capacity, so they can meet the growing demand for fuels without higher imports of finished products? If the latter, then air quality will suffer.

Sulfur is only one aspect of changing crude oil quality. In the years ahead, refiners must find the capital for hardware to process crudes that are both higher in sulfur and contain fewer of the direct precursors of gasoline, while producing a slate of products meeting ever more restrictive quality requirements. Such investments have historically performed poorly, and more will be made only if refining margins—the difference between the price of crude and the value of its products—remain attractive, as they are this year. Otherwise, existing capacity will be strained further, and consumers will suffer, as we are seeing today.

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