In December 1997, when the Organization of Petroleum Exporting Countries decided to raise production quotas in spite of the Asian financial crisis, OPEC's critics once again asserted that the cartel was dying, if not dead. How could the organization get it so wrong, raising production when Asian growth was collapsing?
As it turns out, OPEC's blunder may have been the best thing for the organization. The ensuing price decline encouraged greater cooperation facilitated by frequent and constructive communication among Saudi Arabia, Venezuela, and OPEC outsider Mexico. Since then, OPEC has knit together no less than seven production accords, swinging an average volume of 1 million b/d on and off the market. As a result, one could argue that OPEC has begun a new era of activism.
The other important development of the last couple of years has been the significant shift in OPEC's price preference. A decade ago, OPEC's reference price was $18/bbl. The reference price rose to $21/bbl by the mid-1990s. The reference price is now a target price and is currently $25/bbl, although really the upper end of the $22-28/bbl price band. The move to $28/bbl from $18/bbl reflects an increase that has outstripped inflation.
Embodied in the new era of OPEC activism is the pursuit of higher prices. Indeed, the admitted objective of a higher overall price may be the glue that holds together the organization and ensures continued cooperation. Surprisingly, consuming-country governments have not reacted negatively to this higher price target.
Hitting its professed target for the OPEC basket in today's market, however, will take OPEC only halfway to the stated goal of market stability or an overall price level that meets the organization's revenue goals while keeping the consuming countries hooked on oil.
The OPEC basket is not a representative price benchmark for the oil market. On one hand, it represents a crude oil quality mix that is inferior to the light sweet benchmarks, West Texas Intermediate and Brent. On the other hand, it represents a crude oil quality mix superior to that sold by several member countries. It might seem appropriate to use a price benchmark somewhere between the premium prices of the Western consumer and the discount prices of many producers. In today's market, however, the growing distance between high and low-quality crude valuations makes the OPEC basket midpoint an inaccurate representation of the price mechanism in the global market.
Even if OPEC could consistently keep its basket price around $25/bbl, the medium sour crudes in the basket or the closest benchmark, Dubai, would be close to $23/bbl, and the heavy sours potentially under $20/bbl. As OPEC ministers have pointed out repeatedly, most of the members are selling crude at a level below the OPEC basket and certainly below the light, sweet benchmarks. Aspirations to higher revenues among the heavy, sour producers will only encourage the pursuit of a higher and higher price for the OPEC basket.
Meanwhile, in the US and in Europe, petroleum products are priced in relation to the local light, sweet benchmarks, WTI and Brent. These in turn can carry a $2-5/bbl premium to the OPEC basket price. So at one extreme, medium and heavy, sour crude producers are selling their crude at $20/bbl or less, while Western consumers are buying petroleum products at $30/bbl crude equivalent or much more. This is the bipolar market.
The heavier barrel?
For years, oil market analysts have pointed to the gradual trend towards a heavier, more-sour global crude oil barrel. Over the last decade, however, this trend has been slowed by developments such as the North Sea renaissance and the mid-1990s shift in the Saudi production slate.
In fact, as Fig. 1 shows, as a percent of total crude oil produced, the grades that fall into the categories medium, sweet; heavy, sweet; heavy, sour; and extra-heavy, sour have each remained at roughly 5%1. The medium sours, however, have fallen by close to 5%, while light sours have risen by a little under 5%. Light, sweet crudes have held ground at 25% of the total.
In sum, the global barrel has not become significantly heavier and more sour. In fact, from 1992 to 2001, total heavy crude has fallen to 53.5% from 57.5% of total production. By comparison, sour crudes have fallen by a little less than 3 percentage points, or to 56% from 59% of the total.
Now, as analysts focus on the growing reliance on Persian Gulf oil, they are once again forecasting an increasingly sour and heavy global barrel. Taking into account spare production capacity in Saudi Arabia and potential spare capacity in Iran, Iraq, Kuwait, and the UAE, this seems like a credible forecast. Even with new light, sweet crude from Kazakhstan and Africa, it seems unlikely that the balance will shift towards light, sweet production. At the very least, the global barrel will remain at its current quality. At the most, it will get a little heavier and more sour. All other things held constant, this should keep the sweet-sour price differential from contracting.
But the situation facing OPEC and the entire oil market is more profound than just a wide sweet-sour crude differential. It concerns petroleum product quality, geography, and refining investment, which have moved to center stage in the saga of how crude oil prices are made and influenced. The global crude oil market is increasingly divided into two different but linked poles, one whose price is shaped by marginal-quality economics and one whose price is shaped by cartel behavior.
Bipolar pricing
The first and more traditional pole is the heavy, sour, supply-dominated part of the market. OPEC's production decisions shape predominantly heavy, sour supplies. Asian refiners are the largest customers of the heavy, sour producers in the Persian Gulf, and they still produce a comparatively heavy, sour product slate. At this end of the market, the strongest price signals come from the crude oil supply side.
The other pole is the light, sweet, demand-dominated part of the market. Western refiners must produce an increasingly low-sulfur, high-tech slate of automotive fuels. Some refiners have made hefty investments to refine heavy, sour crude into light, sweet petroleum products. Other refiners, struggling for years with razor-thin profit margins, have been hesitant to make needed investments because of concerns over the rate of return on those investments.
With limits on upgrading and desulfurization capacity in a market of positive demand growth, there have been periods of very strong demand for the marginal barrel of light, sweet crude to make clean automotive fuels2. At this end of the market, the strongest price signals come from the petroleum product demand side.
The flip side of the growth in clean transportation fuels has been the decline of residual fuel oil. The 1980s are widely viewed as the decade during which the US abandoned fuel oil. Indeed, during the 1990s, fuel oil accounted for only 5% of US oil demand.
Europe followed a similar path but is only now finishing the process of marginalizing fuel oil as a power generation fuel. Indeed, demand for fuel oil has fallen by 400,000 b/d over the last 5 years and now accounts for only 8% of the European Union's entire oil demand.
Asia is following a similar trend but at a much slower rate. In Asia, fuel oil still comprises 19% of total oil demand. Moreover, transportation economics in Asia for alternatives such as LNG and pipeline natural gas will keep the move away from fuel oil on a slow path. As the relative value of fuel oil-especially high-sulfur fuel oil-falls, it only exacerbates the weakness of crude oils that yield a lot of fuel oil, contributing to the gap between these pricing regimes.
Even with the emergence of two different pricing regimes, the two poles of the global market maintain an arm's-length connection. OPEC production decisions do indirectly affect all crude oil benchmarks, including WTI and Brent. Likewise, petroleum product developments in the Atlantic Basin do indirectly affect Dubai and other sour crude prices.
The bipolarity of pricing is an historically unique result of the increasing quality isolation of the US and, to a lesser extent, the European light product markets. This isolation has happened at a time when the majority of spare capacity or potential growth in output is in the hands of OPEC and is predominantly sour.
The degree to which this is a new development can be seen in Fig. 2, which shows the shift in regional product market strength over the last couple of years. During the early 1990s, Singapore wholesale product prices were distinctly higher than those on the US Gulf Coast, in spite of the fact that WTI was $2-3/bbl higher than Dubai. By 1996-98, there was almost parity between Singapore and USGC light product prices, again in spite of the $1-2/bbl premium of WTI over Dubai. Since 1999, USGC product prices have consistently been above Singapore prices, encouraging the WTI-Dubai spread to widen to $3-4/bbl.
Marginal quality economics
The key to WTI's pricing is marginal-quality economics. Does the last barrel of supply correspond to the last barrel of demand in terms of quality? To simplify, the US market has growing demand for automotive fuels with decreasing levels of sulfur content. Refining investments have been made to take some heavy, sour crude and turn it into sweet, clean products. This represents a baseload of heavy, sour crude demand in the US.
The refineries that can handle heavy, sour crude represent a fixed and fully utilized volume. Any incremental (or unexpected) demand for sweet, clean products must come from incremental demand for light, sweet crude refined in the refineries that have not invested in sufficient upgrading or desulfurization capacity. If we also assume that the quality and volume of US crude is relatively fixed and spoken for, then the incremental demand for light, sweet crude must come from imports.
Crude import quality preferences and their impact on pricing can be seen in the specific price premium associated with quality. The best information on this comes from US import data that is organized by API gravity. As Fig. 3 shows, over the last 15 years, the quality premium (in terms of density) has ranged from $2.50 to $9/bbl as the relative supply and demand for different grades of crude oil have changed.
It is apparent that, beginning in 1997, the quality premiums began rising again. Moreover, they hit a recent high in 2000. The growing disconnect between pricing heavy and light crudes is reflected in price premiums for each grade of crude imported into the US. While the data organized by sulfur content are not as readily available, anecdotal evidence suggests a similar pattern across crudes with different sulfur content.
The situation in Europe is generally the same as in the US. There is growing demand for light, clean products; limits on refining investments to refine the heavy, sour crudes; and the need for incremental volumes of light, sweet crude. Moreover, the Auto-Oil II program will only tighten fuel specs over the next 10 years as more sulfur is removed from petroleum products.
The situation in Asia is heading in the same direction but at a much slower pace. Even though there are pockets of clean-fuel demand in countries such as Japan and Australia, the areas of fastest potential demand growth, such as China and India, are on fairly slow paths for improving fuel quality. Moreover, their economies are making the move to transportation fuels relatively slowly. Finally, most Asian refiners lag far behind their US and European counterparts in refinery upgrading and desulfurization.
So, refiners in the Atlantic Basin will increasingly seek out the incremental barrel of light, sweet crude imports. This means that WTI and, by extension, Brent, prices will have to maintain a fairly large premium to the heavier, more sour benchmarks. Moreover, from time to time, the Atlantic refiners will have to compete with Asian refiners for West African crudes. Finally, it also means that OPEC will have an increasingly difficult time shaping WTI and Brent prices with their production decisions. WTI and, to a lesser extent, Brent will have periods of distinct strength even when the global crude fundamentals are weak.
Implications for OPEC
The emergence of bipolar pricing in the global crude oil market complicates OPEC's objectives. How can OPEC pursue stable revenues for its predominantly heavy (or medium), sour crudes, and at the same time encourage stable prices in the demand dominated, clean products-driven market so that demand for transportation fuels does not falter? It will take time to pull the two poles back together to a point where OPEC can more directly impact the light, sweet market with its production decisions.
This time is needed for refinery investment. The link between these two pricing regimes is the refiner. After several years of low refining margins but tighter and tighter fuel specifications, the refining industry in the US and Europe has undertaken many steps to reduce costs and boost profits. The latest step has been dramatic consolidation, as stronger companies have scooped up weaker companies, hoping economies of scale will cut costs further.
Now, the bipolarity of pricing in the global market should work to the Western refiner's advantage, as the gap between the two pricing regimes pays for renewed investment through higher margins. In short, a refining boom has begun. If enough investment is made, however, the two markets will become increasingly reconnected, and the refining boom will gradually come to an end.
Time, however, is not on OPEC's side. Consumption is likely to take a hit, especially in the US, where high gasoline prices are getting enormous attention each summer as Phase II RFG (reformulated gasoline) prices spike. This is likely to go on for several more summers. The result will be higher mileage on cars, fewer sport utility vehicles sold, and greater interest in hybrid vehicles. Fuel cell cars are still at least a decade or two away.
Slower demand and more refining investment will gradually bring today's refining boom to an end, but it will take time. In the meantime, OPEC's ability to manage the oil market to keep prices stable enough to meet the twin objectives of ample revenues and ample demand will become (or remain) very difficult. The market will send signals from each pole, which may often conflict. Both OPEC and the consumer will be caught in the middle, deciphering which signals will move prices when. As a result, OPEC is destined to lurch from production agreement to production agreement, sometimes contributing to the price volatility it wants to avoid.
While OPEC awaits the needed refining boom, it is clear that some member countries will take more steps than others to optimize their positions in this market. Those with new light, sweet capacity, such as Algeria, and maybe Nigeria one day, are in a good position. Membership in OPEC affords them the price benefits of the group's general supply decisions while their light, sweet endowment allows them to benefit from price premiums dictated by the clean fuel movement in the west.
At the other extreme are countries such as Venezuela, Iran, and Iraq where the natural endowment is heavy and sour and investment in new capacity is hamstrung by mixed signals on foreign investment. Somewhere in between is Saudi Arabia, where there is some potential for more light, sweet crude production. Indeed, it would not be at all surprising to see another shift in the Saudi production slate within the next 5 years.
The other issue that is likely to come back on the table is vertical integration. At a time when refining investment is the most likely development to reconnect these two increasingly disparate pricing regimes, it may be in OPEC members' interest to invest in the downstream. In this way, member countries can participate in the short-term profits while hastening the day when their own sour crudes will not trade at such a discount to the light sweet benchmarks. When that day comes, OPEC's activism will be far more effective.
References
- The categories for quality are not exactly identical across every single region of the world, but generally for Fig. 1, the categories are as follows: Sweet is less than 0.8 wt % sulfur. Sour is everything else. Condensate is generally 60° gravity and higher. Light is 35-59°. Medium is 31-34°. Heavy is 21-30°. Extra-heavy is less than or equal to 20°.
- Obviously, upgrading and desulfurization capacity are not finite, but the lead time for such investments is long enough to prevent an immediate response to high product prices.
The author
Sarah Emerson is managing director with ESAI, Boston. She oversees all day-to-day operations at ESAI and directs its oil practice. Since joining ESAI in 1986, she has developed many of ESAI's unique analytical tools for analyzing global, regional, and national oil markets and forecasting oil prices. She has conducted industry studies on topics as varied as the transfer of pollution in energy trade, the evolution of gasoline markets, the prospects for the Russian oil industry, and the future of refining margins in the Middle East and Asia. Emerson received her BA from Cornell University and her MA from the Johns Hopkins University Nitze School of Advanced International Studies.
