Differences across grades of crude oil can tell us a lot about why oil prices have become so high.
Not all the black gooey stuff that comes out of the ground is the same. Crude oil produced by different fields differs importantly in viscosity and sulfur content. The more viscous crudes (as measured by a lower API gravity) are called “heavier,” and those with higher sulfur content are called “sour” (as opposed to low-sulfur “sweet” crude). The heavier and more sour the crude, the more difficult and expensive it is to turn into usable refined products. The price of oil you usually hear quoted (such as the recent highs of $67 a barrel) is the price of a light, sweet grade like West Texas Intermediate.
The graph at the right shows the price differential (in dollars per barrel) for European Brent (a relatively light, sweet crude) over Mexican Maya (a heavier sour). The price premium for light sweets had typically been about $5 a barrel up until last summer, when it began rising quickly, now standing at triple its earlier value. To put the size of the current price spread in perspective, if the price of light, sweet crude had only risen as much (in dollars per barrel) as the heavy sour, the increase in the price of light, sweet crude during the last year would have been a third smaller than what we actually observed.
One factor contributing to the dramatic increase in the price spread is a decrease in the supply of light, sweet crude. The higher quality crude supplies of course get used up first, so the world is now increasingly reliant on a lower quality product. The graph at the left reveals that every year over the last five years, the average API gravity of non-OPEC oil production has decreased (produced crude is increasingly “heavy”) and the sulfur content has increased (crude is increasingly “sour”).Vital Trivia used data from OPEC’s August Oil Market Report to calculate that global production of light, sweet crude actually declined between 2000 and 2004– peak oil has already passed, at least as far as light, sweet crude is concerned.
While supply of light, sweet crude has gone down, the demand has gone up. In January 2004, the U.S. EPA’s Tier 2 low-sulfur gasoline regulations began to be implemented. This rule was announced by President Clinton on December 21, 1999, though the announcement gave the nation’s refineries four years to develop plans to cope with the changes that have only recently begun to be implemented. A study by Deutsche Bank noted regulations to reduce fuel sulfur content also being implemented by Europe, Singapore, Philipines, Australia, China, and India. Harry Chernoff mentioned Japan and Canada as well, and noted that the easiest way to meet these standards is to start with a lighter, sweeter crude:
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.
The third critical ingredient is
refining capacity. British Petroleum reported that global refinery capacity increased by 1.8 million barrels a day between 2001 and 2004, while global crude production was up 5.3 mbd. Moreover, not enough of this capacity is able to process the increasingly heavy and sour crude supplies. Chernoff again:
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 retire 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.
Although the change in the price spread is pretty dramatic, the explanation is quite simple: (1) supply is down, (2) demand is up, and (3) the capital investments necessary to cope with facts (1) and (2) were not made. Government regulation in response to environmental concerns appears to have played an important role in both (2) and (3).