In the spring of 1971, the Texas Railroad Commission announced, for the first time, that it would allow 100% production.  In other words, producers in Texas were free to produce at capacity.  On that date, the marginal price of crude oil was no longer set in Texas.  In mid 2004, OPEC announced, for the first time, that it would allow 100% production.  The OPEC quota still stood but the valves were open.  On that date, the marginal price of oil was no longer set by OPEC.

Now that we have passed the point where prices could be set by fiat, energy analysts and politicians are at a loss for words.  The widespread belief is that even with surging demand from the U.S. and China, oil prices “should” be around $30/bbl. and that the difference between this price and current prices exceeding $50/bbl. represents fears of terrorism, actual or potential disruptions in Iraq, Venezuela, and Nigeria, the possible bankruptcy of Yukos, speculation on the NYMEX, and so on.  What these analysts and politicians are missing is that the marginal price of oil is much closer to $30/bbl. than $50/bbl.  It is just that the marginal barrel of oil is no longer what they think it is and the benchmarks used to determine whether prices are “too high” are no longer appropriate.

The most widely used crude oil price benchmarks in the world are West Texas Intermediate (WTI), used primarily in the U.S; Brent, used primarily in Europe; and the OPEC market basket, used around the world.  (Other benchmarks, like Dubai, are used in Asia.)  WTI is very light and very sweet.  This makes it ideal for producing products like low-sulfur gasoline and low-sulfur diesel.  Brent is not as light or as sweet as WTI but it is still a high-grade crude.  The OPEC basket is slightly heavier and sourer than Brent.  As a result of these gravity and sulfur differences, WTI typically trades at a dollar or two premium to Brent and another dollar or two premium to the OPEC basket.  The OPEC basket typically trades in OPEC’s official price range, currently $22-28/bbl.  In recent months, however, WTI has traded at $20-25/bbl. above the OPEC price range and even the OPEC basket has traded as much as $15-20/bbl. above the OPEC price range.  Something is obviously wrong here.

In fact, four trends unrelated to terrorism, disruptions, bankruptcies, or speculation are changing world oil pricing dynamics.  All of these trends are highly significant and some are permanent.  The trends are towards: 1) increasingly heavy, sour crude production, 2) increasingly stringent sulfur standards in the major consuming regions, 3) increasingly mismatched marginal refining capacity and both marginal crudes and marginal products, and 4) less short-run price elasticity of demand throughout the world.

First, with respect to crude production, while WTI, Brent, and the OPEC basket are benchmark grades and important contributors to world supply, none comes close to representing the marginal barrel any longer.  Barring a worldwide recession and a collapse in demand, the marginal barrel will now forever be heavier and sourer than these grades.  Wishful thinkers hoping that Saudi Arabia can open its valves a little further will be disappointed to know that the incremental production offered by the Saudis is heavy, sour.  Although there is considerable disagreement within the industry over the date Hubbert’s Peak will be reached, there is no disagreement that the worldwide peak in production for the lightest, sweetest grades has long passed. 

Second, sulfur standards for gasoline and diesel have been growing tighter in the major consuming regions over the past few years.  This trend will continue.  Gasoline sulfur standards were tightened in the U.S. and Japan this year, will be tightened next year in the U.S., Europe, and Canada, and will be tightened the following year in Europe and Japan.  The trend in diesel sulfur standards is similar.  These increasingly stringent standards would reduce the yield of gasoline and diesel per barrel of crude even if the quality of the crude inputs were not declining.  Starting with heavier, sourer crudes means even lower yields of gasoline and diesel. 

Third, the marginal refining capacity in the world cannot process heavy, sour crudes at all, let alone process these crudes into light, sweet products.  Converting existing refining capacity to process heavy, sour crudes to produce light, sweet products is expensive and time-consuming.  In the U.S., the conversion (for the refiners who are converting) is a multi-year, multi-billion-dollar project.  Some refiners have elected to produce light, sweet products only from light, sweet crudes.  Others have elected to shut-down refining capacity.  In parts of the world that supply markets with only higher sulfur products or that have dropped out of the market to supply low-sulfur products, little or no conversion will take place and the demand will continue for the diminishing fraction of light, sweet crudes.

Fourth, crude and refined product prices, while high in nominal terms, are far from historic peaks in real terms.  At least as important in the developed world, crude and refined product costs represent a much smaller fraction of economic output than in the 1970s and 1980s.  This combination of relatively modest real price levels per Btu and relatively large improvements in GDP per Btu mitigates the economic stress on major consuming countries from today’s “high” oil prices and thus supports continued high demand.  At the same time, rapid and accelerating GDP growth in countries like China and India is also supporting high demand.  While it is true that these countries use much less oil per capita than the developed countries it is also true that they use more oil per unit of GDP than the developed countries.  In other words, absent a worldwide recession demand for oil and refined products will continue to increase. 

Taken together, we have a situation where 1) the marginal crude supply is increasingly heavy, sour; 2) the marginal product demand (in the major consuming regions) is increasingly light, sweet; 3) the marginal refining capacity is neither qualified to handle the inputs nor produce the outputs, and 4) the marginal prices of the products are thus far insufficient to induce any meaningful demand response anywhere in the world.  This combination means not only that refining margins have widened to historically high levels on the output side (i.e., crack spreads) but that discounts for heavy, sour crude have widened to historically high levels on the input side (i.e., crude spreads). 

Whether OPEC literally produces the marginal barrel of oil is not the relevant question any longer.  The question is whether the marginal barrel can be refined by the marginal worldwide refining capacity into the marginal products at the benchmark marginal prices.  The answer to that question is no both on the crude side and the products side.  With respect to crudes, first principles economics says that as heavy, sour crudes flood a market that is not equipped to refine them, the spreads between crude grades should widen.  In fact, this is exactly what has happened.  As of October, 2004, the spread between WTI and Mexican Maya (heavy, sour) has widened to more than $13/bbl. versus $9/bbl. in the first half of 2004, $6-7/bbl. last fall, and less than $5/bbl. at this time two years ago.  At $13/bbl. less than WTI, the price of Mexican Maya is closer to the politicians’ “correct” price of $30/bbl. than to the “artificial” price above $50/bbl.  Other spreads between light, sweet crudes and heavy, sour crudes show similar patterns.  Mars (a medium, sour Gulf of Mexico crude) now trades at a discount exceeding $8/bbl. versus $4-5/bbl. in the first half of 2004, $3-4/bbl. last fall, and $2-3/bbl. two years ago. 

In short, the problem isn’t that the price of oil is “too high.”  The problem is that for several reasons the benchmarks used to determine “too high” are no longer appropriate.  The new market dynamics are relatively high product prices (for any level of crude prices), relatively large discounts for heavy, sour crudes (to the extent world product demand is not price elastic), and relatively high prices for the old benchmark crudes (to the extent worldwide refining capacity remains oriented towards light, sweet crudes).  Not only must the world perception of “high” crude and products prices change but the world benchmarks need to change.  In recognition of this fundamental shift in the oil industry, some organizations (e.g., Platt’s) have been exploring the possibility of changing the world benchmarks to crude grades like Mars but change is slow in coming.  Change is likely to be even slower in coming on the issue of consumer attitudes towards permanently higher crude and product prices.

This transition in marginal supply and marginal demand creates opportunities for companies positioned on the correct side of the supply / demand spectrum.  The most successful companies will fall into two groups: producers of light, sweet crudes and refiners of heavy, sour crudes.  Investors looking for companies whose production is skewed towards premium crudes should keep in mind that most of the fields in the U.S. and the North Sea that produce crudes literally deliverable against the NYMEX light, sweet crude contract (e.g., West Texas Intermediate, Brent, Forties, Oseberg) are old and expensive to operate.  Better opportunities are likely in existing and emerging light, sweet fields in higher-risk parts of the world, including West Africa (e.g., Nigeria, Gabon) and certain fields in the South China Sea and around the Caspian Sea.  Some of these crudes, e.g., Nigerian Bonny Light, are also deliverable against the NYMEX contract and others are likely to achieve that status once production reaches internationally meaningful levels.

On the refinery side, the refiners who stand to benefit are those who can process heavy, sour crudes into light, sweet products.  Independent refiners best positioned in this area are Valero, Tesoro, and Premcor, all of which are heavily leveraged to sour crudes compared, for example, to Sun, which refines only sweet crudes.  Among integrated major oil companies, refining capabilities are across-the board.  ConocoPhillips has the highest exposure to refining in general but since refining typically represents no more than 20-35% of the majors’ net income, differences in crude processing capability are of relatively little significance.

The bottom line is that the markets are working.  It’s just that the media, the public, the politicians, and most energy analysts have been looking at the wrong benchmarks.  Many of the individuals in these groups could save themselves a great deal of aggravation by recognizing the fundamental and permanent (or soon-to-be permanent) changes in the crude and products markets instead of berating OPEC and others about some obsolete notion of a fair price for oil.

SOURCE Pathfinder Capital Advisors, LLC
CONTACT: (704) 344-0216 or inquiries@pathfindercap.com

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