Thursday, May 04, 2006

Sweet and Sour

No, I’m not referring to the menu item found in your local Chinese restaurant – here, “sweet” and “sour” are descriptors of different grades of crude oil. Given oil prices near $75/barrel, and my confessed interest in the energy sector, I thought it’s appropriate to write about some basic elements of the oil market that the individual investor may find informative. In this post, I will discuss different grades of crude oil and how that difference is translated into profits at oil refineries.

Different grades of crude
First of all, it’s important to know that not all crude oil are created equal. They can actually have different compositions and properties depending on their place of origin. The term “sweet” refers to a class of crude oil with a low sulfur content, usually less than 0.5%. The opposite is, of course, “sour” crude. The sulfur content is important as sulfur oxides from the combustion of fossil fuels are the direct causes of acid rain. Sweet crude can be refined more easily into pricier end products such as gasoline as opposed to, say, heating oil. Conversely, sour crude requires more refining to meet current environmental standards. The other common descriptor for crude is “light” and its opposite, “heavy”. They refer to the density (specific gravity) and viscosity (a function of the wax content) of the crude oil and determine how easily it flows. (Source: Wikipedia and related pages. Also see here for more on different grades of crude.)

The headline quote for the price of oil traded on Nymex is for a light sweet crude. It should be clear from the above discussion that light sweet crude enjoys a premium over heavy and sour grades of crude. For the same reason, the loss of Nigerian oil, which is a very high grade of crude, have put a great deal of upward pressure on both oil and gasoline prices. Recently, it has been noted (e.g. by Don Coxe and Matt Simmons) that the extra capacity coming out of Saudi Arabia are of the heavier variety. This could be a circumstantial evidence that “peak oil” for Saudi, and by inference, the world, is close at hand.

We sometimes hear from the media that the lack of refining capacity is partially responsible for high oil prices. Thoughtful readers may have questioned those statements since at first glance, the logic seemed backwards: refining capacity should impact gasoline prices just as oil supply should impact oil prices, but since refineries are “down stream” from oil supplies, how does refining capacity affect oil prices? The answer lies in the fact that when refining capacity is tight, whether in an absolute sense or in the lack of ability to process heavy, sour crude, the demand for light sweet crude that provides a better mixture of end products, rises, thus pushing up the headline oil price.

The recent increase in gasoline prices was attributed to the loss of refining capacity due to retooling to accommodate ethanol blends. The shoulder season after high winter heating oil demand and before the onset of the summer driving season is traditionally a time to build up gasoline stocks. It does not bode well to have such high gasoline prices already at this time of the year. The possibility of a gasoline price spike due to another devastating hurricane season is one of my three main worries for the US stock market in the second half of this year (the other two are continued weakness in housing and protectionist rhetoric in the election season).

Crack spread
Crack spread is a rough estimate for the difference or spread between the end refinery products and crude oil. Cracking refers generally to a chemical process that fractionates a large molecule into smaller ones, of which the oil distillation process is an example. The crack spread option traded on the Nymex is also known as the 3-2-1 crack spread, meaning that 3 barrels of crude is assumed to produce 2 barrels of gasoline and 1 barrel of heating oil. For example, if the current prices are $70/barrel (1 barrel = 42 gal) for oil, $2.00/gal for gasoline and $1.94/gal for heating oil, then the crack spread is equal to $2.00 x 42 X 2/3 + $1.94 x 42 x 1/3 -$70 = $13.16 per barrel. (See also this calculator at Nymex). In the wake of Katrina, the crack spread was as high as $40.

The crack spread is closely related to the bottom lines of the Valero’s and Tesoro’s of the world. As the composition of world crude supply continues shifting towards lower grades, oil refiners with the right kind of refining capacities have already benefited handsomely. The following comparison chart between three refiners and OIH (oil services holders) and XLE (energy SPDR) demonstrates how richly rewarded the investors in the refiners have been. Given the forecast of more frequent hurricanes in the Gulf of Mexico and diminishing world-wide supply of light sweet crude that trend may well continue. However, please don’t take this as a recommendation to buy them now. The group is quite extended and oil prices likely have just seen a double top at $75. As usual, readers are urged to do their own research.