Shifting global crude trade patterns expected to create quality disparity

Robert A. Hermes
Purvin & Gertz Inc.
Houston

Adapted from a paper presented at Oracle Corp. Energy Executive Forum, Houston, Sept. 30, 1997.

Advances in exploration and production technologies and the globalization of the petroleum industry are creating new major crude sources in areas that were formerly off limits for reasons of geography, politics, or technology.

These emerging crude oil supply centers are, in turn, shifting worldwide trade patterns and changing the quality of crude oil in the major reining centers.

These changes will have trickle-down effects for refiners around the world, adding complications to an industry already challenged by low margins and tightening regulation.

The most significant new developments that will affect world crude supply and trading patterns in the coming years are:

• Latin American, especially Venezuelan, initiatives.
• Canadian heavy oil and synthetic crude oil projects.
• Deepwater Gulf of Mexico discoveries.
• Caspian Sea developments.
• North Sea production profile.

Each of these developments is described here, followed by an analysis of the consequences.

Latin America

Latin American production will be the source of the most significant changes.

Production will ramp up rapidly. Between now and 2005, another 4.2 million b/d of production will enter the market (see chart [52,908 bytes]).

These projections are relatively firm through 2005. After that, they become rather speculative, depending on future events.

The opening of Venezuela to foreign participation is by far the most significant development in terms of volume, crude oil quality, and geopolitics. Production of the extra-heavy Orinoco oil is expected to exceed 1 million b/d, based on projects currently under way.

This material will enter the market as partially upgraded synthetic crude oil. Even allowing for some slippage in schedules, Venezuelan production is likely to exceed 5 million b/d by 2005.

The increases in production from Venezuela, combined with increases from Colombia and Mexico, are expected to put another 3.5 million b/d into the Caribbean market by 2005.

Canada

Canada is also geared up to expand production (see chart [40,025 bytes]).

Production of the traditional crude oils from Canada-the light sour and light sweet varieties-will not increase much. Western Canadian production of light crude oil will decline somewhat, but fields off the East Coast will more than offset this decline.

The big increase in production will come from the heavy crude oil reserves in western Canada. These reserves will be produced both as diluted heavy crude oils and as synthetic crude oils, with varying degrees of upgrading.

By 2005, another 700,000 b/d will be coming from the heavy oil fields. Most of it will be destined for the U.S. Midwest, which is only about a 3.2 million b/d market. This supply will replace declining U.S. supplies of light crude oil.

Gulf of Mexico

The Gulf of Mexico is experiencing a tremendous ramp-up in production, adding more than 1 million b/d by 2005.

The sweet crudes from this region are largely traditional shallow-water production. Production of these crudes will increase only slightly.

However, a major surge of new deepwater production is coming on stream. At this stage of development, it is difficult to project how big this surge will be or how long it will last.

Purvin & Gertz projects that it will build up through about 2007, at which time it will level off, then begin a slow decline.

If one compares it to other developing regions, such as the North Sea, it could be argued that the production level will go higher and last longer.

Another significant factor is that it is predominately medium-grade sour crude oil, similar to Arab medium in quality. So it is very different from the traditional production of the Gulf Coast.

Western Europe

Western Europe production comes mainly from the Norwegian and U.K. sectors of the North Sea. It has continually confounded everyone's predictions of a decline since the early 1980s. Instead, it has continued to increase.

Now, almost everyone agrees that this increase in production will continue well into the next century. Beyond that, production probably depends primarily on the speed of development of the more difficult Norwegian pros- pects.

Quality is not expected to change significantly.

Caspian area

The Caspian Sea holds some of the largest oil reserves in the world. Nobody knows exactly how much is there, but estimates place it potentially among the giant producing areas of the world.

The former Soviet Union never emphasized developing this oil, for both technical and political reasons.

The smaller republics, composed of different ethnic groups, represented the frontier of the FSU, and substantial reserves remained to be exploited within Russia. As a consequence, development of these fields was never emphasized, even though the potential of the region has been known for over 100 years.

Western companies are also having difficulties in getting deals together with the governments in this area. Probably even more significant, they are having difficulty getting transportation agreements to move the oil to market because it has to cross various independent states. Each country tries to extract 100% of the economic benefit from crossing its territory.

Some progress is being made, but many difficulties remain. Nevertheless, Purvin & Gertz expects by 2005 to see about 1 million b/d of additional oil from this area (see chart [50,821 bytes]). It, by and large, will be a lighter, higher-quality crude oil.

OPEC

With all this new production, what is left for OPEC?

Until recently, the balance has looked reasonably stable because of the fast-growing markets in Asia. With only the slow rates of growth in the Organization for Economic Cooperation & Development countries, a flood of new production would cause severe supply/demand problems. Nevertheless, price pressure will exist over the next several years as this new production comes on stream (see chart [72,322 bytes]).

The balance looks fairly comfortable both on the upside and downside-that is, it appears that the capacity will be there to deliver the supplies needed by the market. At the same time, the utilization level will be high enough to prevent too many problems.

This comfortable balance is prem- ised on Asian demand recovering from the current crisis and then continuing to grow.

Purvin & Gertz does not believe that the very high Asian growth rates of the last few years will return. However, even significantly lower growth rates still add substantially to demand.

Global crude movements

One of the interesting consequences of these regional production outlooks is how they affect global crude oil flow patterns.

Oil is found based on geology, and on the terms and conditions that the host governments offer. However, the need for oil depends on the economies of consuming countries-how fast they are growing and how dependent their economies are on oil.

What has happened is that most of the demand growth has been in Asia, but most of the new supplies are in the Atlantic Basin, resulting in a mismatch between where the oil is being found and where it is being consumed. This mismatch will change both trading and pricing patterns.

Traditionally, the Persian Gulf has been the "equalization point" for world oil supplies because it served all the major markets: Asia, Europe, and the U.S. As the important new supplies come on stream, global flow patterns will change, such that certain flows will decrease over time while others increase (see map [105,904 bytes]) Taking into account some reasonable assumptions, Middle East flows to the Americas and Europe will gradually decline, while African production will increasingly be diverted towards Asia to supply the market there. In addition, oil flows from Latin America and Canada to the U.S. will increase.

The changes in flows cause significant price implications. If the equalization point becomes West Africa-that is, it is the swing supply between east and west movements-this then implies that Middle East crudes will be priced out of the U.S. market.

Until the past 2-3 years, only minimal supplies of African crude were shipped to Asia. In 1997, however, that increased rapidly to almost 1 million b/d. African exports to Asia will quickly ramp up to more than 2 million b/d (see chart [36,767 bytes]).

Total African exports are expected to increase gradually. The deepwater technology that is being so successfully applied in the Gulf of Mexico is also applicable to West Africa. In fact, several major fields have recently been discovered off Angola.

For Middle East exports, this means an increasing amount will be sent to Asia and a decreasing amount to the U.S.

Although much has been said about U.S. dependence on Middle East oil, the U.S. is actually a relatively small consumer of Middle East oil. Much more Middle East oil is exported to western Europe and the Asia/Pacific region-to Japan in particular.

The U.S. imports only about 1.5 million b/d of Middle East crude, compared with U.S. refinery runs of about 14 million b/d. Virtually all of the U.S. Middle East imports come from Saudi Arabia.

U.S. crude balance

Considering only the economics of moving oil in the most prudent manner possible to minimize transportation cost, most of the Middle East crude oil would be backed out of the U.S. In addition, most European supplies would be eliminated.

These changes would compensate for the surge of crude oil coming from Latin America. Even though U.S. imports overall are projected to rise by about 2 million b/d by 2005, U.S. imports of Latin American crude are expected to increase by 2.7 million b/d during that period.

What will happen in practice, however, when these additional supplies become available, is difficult to predict. Obviously, geopolitics will play a role-particularly the relationship between Saudi Arabia and the U.S.

Many arguments could be made explaining why the traditional relationship between these countries will continue. If Saudi Arabia is to maintain its share of the U.S. market, Latin American crude oil will have to be shipped to Asia or Europe. This movement would go against traditional flow patterns, which will cause some price pressures.

Another interesting development will take place on the U.S. West Coast.

Although Alaskan production has also been rather stubborn in following decline predictions, it finally seems to have peaked and begun its decline. With Alaskan production decreasing and West Coast demand increasing, non-U.S. imports into California will rise substantially.

Most of these will come from Latin America. Mexico is the most logical source because of its export facilities on the Pacific Coast. However, the higher-sulfur Mexican crude oil is not a very good quality match to the traditional crude slate of California refineries.

Crude quality changes

Quality changes are as important as volume changes. Heavy crude oil production is a pretty small part of world production, but it is projected to increase by about 2.3 million b/d by 2005. Almost all of that will be from the Western Hemisphere (see chart [52,477 bytes]), although a little will come from the Middle East.

Much of this additional heavy oil will have been processed to some degree or blended with lighter oils for transportation in pipeline or marine systems.

A very large increase in heavy oil production is expected in Canada. One of the refineries in Edmonton is switching from synthetic crude oil to heavy crude oil, which will free up even more supply.

By 2005, exports of synthetic crude oil will about double to 450,000 b/d.

Refineries can typically run small incremental volumes of this crude oil, but large volumes cause imbalances in the process configuration. It is typically a "bottomless" crude oil. The distillate fractions have been partially upgraded, but the yields and properties of the fractions are quite different from conventional oils.

In addition, heavy oil projects in Venezuela are also producing partially upgraded oil, ranging from very little upgrading to extensive processing that produces sweet crude oils.

Downstream consequences

The common result of these changes in crude oil supply is a major change in the crude slates of refineries in all parts of the U.S. These changes, combined with continuing pressure on the environmental front, will require significant capital expenditures in refining. Expenditures will be needed mainly in bottom-of-the-barrel processing and hydrocracking.

Refinery margins are just now showing some improvement from the conversion capacity overbuilding in the early 1990s. Capital expenditures in refining are at a low point in the normal cyclical pattern.

Producers of heavy oil and synthetic crude oils could have problems marketing the oil through traditional channels. As a result, many of the projects will be integrated with U.S. refineries so that a secure market is ensured.

Of the Venezuelan heavy oil projects, only the one backed by European firms Total SA, Statoil, and Norsk Hydro AS (OGJ, Dec. 1, 1997, Newsletter) is not integrated with U.S. refining capacity. However, much of the Canadian production is not integrated.

Except for projects that are integrated with the upstream, refineries do not appear to be willing to make speculative investments to handle the anticipated changes in crude oil availability.

In order to ensure markets for their products, producers are likely to have to assume the risk of refinery investment, either in supply arrangements with refineries or by making further investments in synthetic crude upgrading plants.

The Author