When Opec first started cutting crude production back in October, one of the immediate effects on the market was a pullback in the supply of heavy sour crudes.
As we noted before, this is because Saudi Arabia, Opec’s largest and most proficient swing producer, is mainly a supplier of heavy sour crudes.
Heavy sour crudes, of course, are generally more suited towards the large-scale production of middle distillate and fuel oil products, rather than gasoline and light-ends. However, over the last few years many US refineries spent large sums of money converting themselves into more complex units capable of processing cheaper sour-heavy crudes just as efficiently. This meant that when a shortfall in the supply of heavy sour such crudes did materialise, refinery margins were hit, lifting prices of usually cheaper bottom-of-the-barrel products.
That effect can most visibly be seen in fuel oil, where spreads tightened from -$40 per barrel in July 2008 to -$1 per barrel from February onwards. Note the following chart from Merrill Lynch on Monday:
As Merrill Lynch observes, price differentials within residual fuels (mostly used as shipping fuel or for power generation) have also narrowed in Europe and in the United States. That is to say, the market isn’t even discounting the dirtiest of dirty fuels — something that’s counter-intuitive if you consider the strict environmental regulations in place that favour the use of lighter lower-sulphur blends in both shipping and power generation.
As they also note, this is particularly curious if you consider that usage of residual fuel oil in power generation has been falling due to its relatively high cost versus other fuels.
Which makes the Merrill Lynch analysts wonder:
Why is the heaviest, more polluting portion of the barrel not trading at a steep discount in this dire economic environment?
Conclusion: fuel oil cracks cannot be sustainable at such levels for much longer. Or as they state:
…we believe that rising middle distillate crack spreads could add some downward pressure on residual fuel oil cracks as we enter 2010. This is because as the price of distillates rises, refineries will have to increase crude runs, likely pushing up residual fuel oil production. In turn, more production with a relatively dire residual fuel demand environment should drive down crack spreads over the coming months. So far, the term structure of residual fuel has shifted up in terms of levels and has flattened in line with crude oil .
Related links:
The perils of a flat WTI curve and a cold winter – FT Alphaville
Crude inventories still a problem – FT Alphaville