Wednesday, October 15, 2014

The Impact of the Global "Sweet" Crude Bulge

  • The recent slide in global oil prices has been compounded by the pressure that rising US shale oil production is putting on the price of sweet crude benchmarks like Brent.
  • OPEC's producers may suffer as much as those in the US, while consumers benefit from significantly lower fuel prices than last year.
When the US went to war in Iraq in 2003, the price of oil embarked on a trend that took it from around $30 per barrel to nearly $150 before collapsing in the recession in 2008. This time, as a new US-led coalition takes on ISIS with a bombing campaign in Iraq and Syria, the price of oil is falling, down 20% in the last two months. It's not just that global economic growth has weakened recently, or that soaring shale oil output in the US has averted another oil crisis. Oil's current downturn also reflects the fact that new production from the Bakken, Eagle Ford and other shale deposits is particularly well-suited to undermine oil's global benchmark prices, for Brent and West Texas Intermediate, both of which are made up of light sweet crude oil streams.

The numbers for US shale, or "light tight oil" (LTO) as it's often called, are impressive, especially to those accustomed to watching the gradual ebb and flow of different oil sources over long periods. In the 12 months ending in June 2014, US oil production grew by 1.3 million barrels per day (MBD), not far short of Libya's pre-revolution exports. Since January 2011, the US added 3 MBD, or about what the UK produced at its peak in 1999. In fact, since 2010 incremental US LTO production has exceeded the net decline of the entire North Sea (Denmark, Norway and UK) by around 2 MBD, contributing to a significant expansion of Atlantic Basin light sweet crude supply.

The New York Mercantile Exchange defines light sweet crude as having sulfur content below 0.42% and an API gravity between 37 and 42 degrees. That's less dense than light olive oil. The specification for Brent is similar. Much of the LTO produced from US shale formations fits those specifications, and what doesn't is typically even lighter and lower in sulfur.

The current "contango" in Brent pricing, in which contracts for later delivery sell for more than those for delivery in the next month or two, is another sign of a market that is physically over-supplied: more oil than refineries want to process, with the excess going into storage. However we also see indications that the historical premium assigned to lighter, sweeter crude versus heavier, higher-sulfur crude is under pressure.

One example of this is the gap or "differential" between Louisiana Light Sweet, which wasn't caught up in the delivery problems that plagued West Texas Intermediate for the last several years, and Mars blend, a sour crude mix from platforms in the Gulf of Mexico. From 2007-13 LLS averaged around $4.50 per barrel higher than Mars, while for the first half of this year it was only $2.75 higher and today stands at around $3.40 over Mars.

And while OPEC's reported Reference Basket price has been falling in tandem with Brent, its discount to Brent had also narrowed by about $1 per barrel, prior to the price plunge of the last couple of weeks, compared with the average for 2007-13. Considering that OPEC's basket includes light sweet crudes from Algeria, Libya and Nigeria that sell into some of the same Atlantic Basin markets as Brent, that looks significant.

By itself a narrowing of the sweet/sour "spread" of only a dollar or so per barrel isn't earth-shattering. However, because the surge of US oil production is effectively focused on the oil market segment represented by the price of Brent, it compounds the pressure on OPEC, many of whose members link the price of their output to Brent. This might help explain why the response of OPEC's leading producer, Saudi Arabia, has been to cut prices rather than output, in an apparent effort to maintain market share rather than price level.

The Saudis know better than anyone how that movie could end. The Kingdom's1986 decision to implement "netback pricing", linking the price of its oil to the value of its customers' refined petroleum products, helped precipitate a price collapse so deep that it took oil prices 18 years to reach $30/bbl again, by which time the dollar had lost a third of its value.

Whether aimed at US shale producers or as a reminder to the rest of OPEC, which appears to be unprepared to make the output cuts necessary to defend higher oil prices, the Saudi action increases the chances that oil prices will over-correct to the downside, rather than rebounding quickly. If so, the impact of the sweet crude bulge in the Atlantic Basin--only a little more than 3% of global oil supplies--could play a disproportionate role in prolonging the pain producers will experience until oil markets eventually reach a new equilibrium.

In the meantime, US consumers are benefiting from gasoline prices that are already $0.15 per gallon lower than this week last year. Today's wholesale gasoline futures price for November equates to an average retail price well below $3.00 per gallon, after factoring in fuel taxes and dealer margins, compared to last year's average retail price for November of $3.24. After factoring in lower diesel and heating oil prices, the fall in oil prices could put an extra $10 billion in shoppers' pockets for this year's holiday season.

A substantially different version of this post was previously published on the website of Pacific Energy Development Corporation

No comments: