Tight distillate markets continue to support high oil prices. But surplus fuel oil is now competing with crude as a feedstock for upgrading units.
Supply and demand balances no longer provide a sufficiently detailed picture of what is going on in the world oil market. Overall, the current balance suggests an oversupplied market. Oil demand growth is slowing and global stocks are rising, prompting Saudi Arabia to cut output. Yet oil prices continue to rise, defying apparently bearish fundamentals.
But the global balance is too blunt an instrument. There are now two markets for oil — a market for non-substitutable oil, mainly transport fuels, and a market for substitutable oil, mainly burning fuels. With the global economy still growing strongly this year, demand for non-substitutable oil remains robust. Consumption of gasoline, diesel and jet fuel was up sharply in the first half of this year, despite rising oil prices. At the same time, demand for substitutable oil fell away as high oil prices encouraged industry and power generators to switch to cheaper fuels where possible, cutting the use of residual fuel oil, naphtha and propane.
The market for non-substitutable oil is tight. Refiners are struggling to make enough low-sulphur transport fuel to meet growing demand. A heavier sourer crude slate has cut the yield of sweet distillate products and upgrading capacity is fully utilised, so crack spreads are at record levels. Consumers are prepared to pay high prices for gasoline and diesel as the booming economy needs transport fuels. Unlike in previous oil price shocks — when labour and capital were also in short supply — the economy is more resilient and inflation has not taken off.
By contrast, the market for substitutable oil is slack. Falling fuel oil demand and the heavier crude slate has left refiners with unwanted residue on their hands. With refinery upgrading capacity fully utilised, heavy crudes must now compete with surplus fuel oil as a feedstock for crackers and cokers, creating the impression that the oil market is oversupplied. As a result, heavy crude producers must either cut their prices to compete with surplus fuel oil or cut production — as Saudi Arabia did from April onwards.
The problem for Opec — and Saudi Arabia in particular — is that the market-clearing price for substitutable oil is now much lower than the market-clearing price for non-substitutable oil. As long as there are no easy alternatives to oil as a transport fuel, consumers will pay high prices for gasoline, diesel and jet fuel. But the price of substitutable oil is capped by the price of competing fuels, especially coal and natural gas. It is much more profitable to cut output of heavy crude and earn a higher price on each barrel sold, than to cut prices in order to compete in a lower value market for substitutable oil.
Unless Opec changes its behaviour and takes concerted action to drive down the price of crude by competing in the substitutable market, high oil prices look set to persist — at least until the market for non-substitutable oil becomes less tight. Record crack spreads already provide huge incentives for refiners to find ways of boosting their yield of low-sulphur distillates, and the crude slate is showing signs of getting lighter. But demand for oil as a transport fuel — especially from developing countries such as China and India — shows little sign of slackening, unless the global economy slows abruptly, which may yet happen if the price of oil goes too high.