Since 2012 most of the growth of global oil production has been concentrated in light crude from the US, surpassing that of heavier grades by 1.7 million b/d as of November 2018, and by 2.6 million b/d as of January 2019.
In 2018 the imbalance between light, sweet and heavier sour crude supplies had been aggravated by production cuts, both voluntary and involuntary, as well as the strongest growth of US shale production ever recorded. The announcement of the reinstatement of oil sanctions against Iran and the continued deterioration of Venezuela’s crude oil output led to loses in the medium and heavy sour category.
Now, the deficit in medium and heavy sour crudes is being intensified by the continuous rise in US light, sweet crude production, a new round of production cuts from the Organization of Petroleum Exporting Countries, and outages or curbed production from Iran, Venezuela, and Canada. This year, more geopolitical uncertainties are unfolding amid the expiration of the US oil waivers in May and a fresh round of US sanctions targeting Venezuela’s oil sector.
The Brent-Dubai (BD) spread dipped from around $3.20/bbl in May 2018 to 30¢/bbl in January. Similarly, the WTI-Dubai spread collapsed well into negative territory around -$7/bbl on average.
Considering that the global medium and heavy production is expected to fall further in 2019 due to the sanctions on Iran and Venezuela, as well as the OPEC+ output cuts, the sweet-sour imbalance will likely get worse.
A VARX analysis
Bassam Fattouh and Andreas Economou, economists from the Oxford Institute for Energy Studies, employed a VARX model (a standard VAR model with exogenous variables) to quantify the impact of various oil risks on the trajectory of the sweet and sour crude spreads in 2019.
Under a baseline case, light, sweet production is assumed to increase by 900,000 b/d on a year ago, and medium and heavy sour production will decline by 1.1 million b/d on a year ago, with most of the declines observed in the first half of the year. The baseline forecast predicts that the narrowing of the BD spread will persist throughout the first half of the year before gradually widening in the second half.
Under an Iranian sanctions case, considering a loss of 590,000 b/d of Iranian production between May and December, the spread will move into negative territory. And the Dubai benchmark is expected to trade at around $1/bbl premium to Brent, before the spread narrows again but only marginally.
Under a Venezuela crisis case and a Saudi Arabia deeper-cuts case, the BD spread will slide well into the negative territory in the first half of the year, before narrowing and turning positive in the second half.
Under the final case that combines the preceding forecast scenarios into one extreme scenario, the BD spread will move even deeper into the negative territory in the first half of the year. The net negative impact on the spread in this case exceeds $2/bbl, meaning that the Dubai benchmark could trade at $2/bbl premium over Brent.
IMO effect?
A conventional wisdom was that the BD spread would widen as IMO rules take effect and the shipping industry shifts towards consuming cleaner fuels. This should increase demand for light sweet crudes while lowering demand for sour crudes.
However, whether the price differential impact of such policy adjustments will overwhelm the price impact of supply losses of medium sour crudes is yet to be seen.
“What our results show is that IMO 2020 is only one of the many factors impacting spreads and supply factors are as important (if not more important) in determining movements in price differentials. In other words, the widening of the sweet-sour spreads may still occur as we enter 2020, but this is far from a forgone conclusion,” Fattouh and Economou said.
“By cutting output, OPEC+ is tightening an already very tight medium [and] heavy sour market with potential implications on refining margins and eventually on global oil demand if complex refining margins weaken significantly. The key question facing OPEC+ producers is whether they should or can take any measures to resolve this quality imbalance or should they just leave it to the market mechanisms to resolve it,” they said.
