Light/heavy crude oil spreads tightened sharply over the past several weeks in favour of heavy crudes. Brent has been trading just $1.50/b above Dubai, less than half the premium three months ago, and LLS only $5/b above heavy Mexican Maya compared with a $14/b premium in early October. Many factors were influencing this unusual development of heavy sour crudes trading at a very narrow spread to light sweet grades, or even in some cases at a premium. Predominantly, this has been driven by strong fuel oil price gains due to improving demand, as well as increased supply of light sweet crude which has dampened prices for these grades, along with concerns about a possible tightening in heavy sour supplies. Since December, fuel oil crack spreads in Asia, which usually sell at a discount, have jumped into positive territory amid strong demand from refiners, utilities, and the bunker market. Fuel oil crack spreads to Dubai crude – which show the product’s profitability relative to heavy sour Mideast crude – shot up to the highest level on record and have sustained positive values since mid-January. Cracks have surged and even flipped into positive territory several times during this period, a development not seen since 2003. Unusually strong demand has boosted crack spreads higher, particularly in China, where independent “teapot” refineries buy fuel oil in order to upgrade it into higher-quality products.
The Asian market is also facing a shortage of ‘on-specification’ bunker fuel. The recent introduction of legislation reducing sulphur content of marine bunker fuel from 4.5% to 3.5% is likely to limit ‘on-spec’ supply and arbitrage barrels will be needed to meet bunker demand, a development that has helped push prices higher. Demand has also been strong in Japan and South Korea. Japan’s demand for fuel oil spiked after most of the country’s nuclear power plants were shut following the Fukushima nuclear disaster in March 2011. This development has pushed Japanese fuel oil stocks below their five-year average. In Europe, high sulfur fuel oil cracks have also been strong and are currently traded at levels not seen in a decade. This could be attributed to lower refinery runs, as well as a decline in Russian fuel oil exports. Moreover, the closure of Petroplus has also reduced the availability of fuel oil in the region.
The demand for heavy sour grades has also been strong in recent weeks, not just because of healthy refining margins, but also due to increased demand, particularly for Urals from European and Chinese buyers, who see this crude as a suitable alternative to some rival Middle East barrels. European refiners in particular have been intensively searching for alternatives grades. Depending on the degree of refinery complexity, individual refiners in these countries may have a specific need for relatively heavy sour crude.
In the Atlantic Basin, more light sweet barrels have become available due to the faster-than expected return of Libyan crude production and the closure of some refineries in Europe and the US. The European market for light sweet crude has come under strong pressure, as reflected in the growing contango and downward-shifting contract for difference (CFD) curves. The gap between Dated Brent and 2nd and 3rd month Brent has widened to over $1/b for the first time since the disruption in Libyan production last year. This is no coincidence as the return of Libyan crude production has weighed heavily on European sweet grades. The shutdown of over 650 tb/d of refinery capacity on the US Atlantic Coast has also cut demand for light grades and boosted availability of Nigerian crude. The Petroplus outages have been a further factor weighing on these grades.
Sales of light sweet North Sea crude to the US have also taken a hit from rising US shale production. The rapid growth in light sweet production, mainly associated with the recovery in Libyan output, coupled with concerns about a possibly tight sour market due to geopolitical factors, colder weather over the remainder of winter and continued high demand for fuel oil, may put further pressure on the light sweet/heavy sour spread. As result, the spread between light sweet and heavy sour crude is likely to remain narrow for at least some time.