The World Is Still Asleep On the Crude Quality Crisis: A Follow Up Note
By Anas Alhajji
When the world believe it’s awash in crude oil, it’s easy to overlook crude quality.
The “unsustainable” growth in tight-oil production expected in the coming years is blinding even major forecasting agencies such as the IEA and OPEC to two major problems that could ultimately trigger shortages. 1) Refiners have limited capacity in processing super light crude after years of investments on equipment to process heavy crude. 2) Super light isn’t the best or most cost-effective crude for making high-demand petroleum products such as diesel.
Shale plays – widely touted as key to meeting oil demand in the coming decades – produce light sweet and super light sweet crudes as well as condensates. This also doesn’t include the NGL. The products extracted are mostly natural gas, natural gas liquids (NGLs), gasoline and naphtha. So there’s a mismatch between the crude that can be pumped and the crude that can be processed.
The other more pronounced irony is that the promoters of shale like the midstream companies fail to understand the basics of refining: Naphtha cut from a Midland barrel in West Texas Light (WTL) is 41% while naphtha cut from Brent is 29%. For every 1 barrel of WTL processed, the naphtha cut is actually ~41.4% higher than Brent (41% vs. 29%).
So to set the record straight, here’s how crude quality is poised to affect the market:
- Crude quality will become more of an issue as shale production grows. It’s meaningless to argue that shale exports have always been able to find a home in the past as the IEA did in its most recent monthly report. This is about expected future growth and whether the market can handle a new influx of super light sweet grades.
- The biggest concern about crude quality is the mismatch between the fuels that can be produced profitably from shale oil and anticipated demand for heavier products such as diesel, an issue that is completely ignored by the IEA and OPEC forecasts. While shale can produce diesel, it comes with massive amounts of unneeded gasoline and naphtha. Refiners are in business to make money, not lose it, and this affects their bottom line more than their limited capacity to handle light crude.
- Crude quality is a critical factor in deciding whether to invest in shale companies and determining their valuation. Many shale companies – particularly those operating in the Permian – were hammered in recent weeks and lost billions of dollars in value. Why? Because of crude quality! By some sell-side estimations, the realized pricing on a boe basis for some Permian producers are in the low $40s and that’s not including any potential crude quality discounts in the future. Natural gas is sold at negative prices or flared. NGL prices have been halved. Whatever black liquid is left isn’t enough to generate positive cash flow at current prices and doesn’t justify additional investment. Without that capital injection, shale is NOT going to deliver the amounts of crude expected by the IEA and OPEC in the coming years, especially given its high decline rates.
- Crude quality may be partially to blame for refiners’ struggles to increase utilization rates in recent weeks. As refiners change slates, it’s possible that the abundance of light crude and the dearth of heavy crude is causing technical problems at refineries. Blending has its own limitations, which will also limit shale growth in the coming years. Worth noting that weather-related problems curtailed gasoline production in recent months, making some people think, wrongly, the US was able to produce heavier products from shale.
- Additional evidence of crude-quality issues is overwhelming: Heavier crudes are being sold at a premium to light crudes. U.S. shale exports are displacing other countries’ light crudes. Producers such as Nigeria are unable to market their light crude. Existing excess refining capacity is in countries which don’t receive U.S. shale oil exports, such as Russia, but the extra processing ability doesn’t translate into additional demand for oil, let alone U.S. light oil.
- The crude-quality issues will be exacerbated by IMO 2020, next year’s mandatory switch to low-sulfur fuels by vessels operating in international waters. Refineries need heavier crudes to produce the required fuel. So those positing that shale will benefit from the rule are missing the point. The irony is, blending with light sweet crude to produce the required fuel might lead to gasoline shortages, or at least, will reduce US gasoline exports.
- Finally, US sanctions, especially on Venezuela, who is major producer of heavy crude, and the need for more pipelines to bring heavy crude to the US is exacerbating the crude quality issues.
Crude-quality issues are hitting all segments of the oil market and heading to one conclusion: Slower shale-production growth and shortages of heavier crudes. In this case, it is possible that we might end up in energy oil shortages while we are awash in oil!