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If it's oil, even sour is sweet

"Light, sweet" crude oil is what everyone wants, but rising demand has brought in more "heavy, sour." But not all refiners can process it.

Like bartenders putting cheap alcohol into their cocktails, some U.S. refiners are reaping huge profits these days by relying on lower-quality crude oil to make everything from gasoline to diesel.

The difference is that, unlike martinis mixed with barnyard booze, these finished fuels, after a little extra work, are the same quality as those made with top-shelf ingredients and therefore fetch the same high price from consumers.

The world's premium oil is described as light, sweet crude, and most refiners prefer it because it is low in sulfur, easy to process and yields the most volume per barrel of the transportation fuels in greatest demand. This preference has been magnified by environmental laws that require the industry to produce cleaner-burning fuels.

But as the world's oil thirst swells to more than 84-million barrels a day and producers struggle to keep up, the extra supply being brought onto the market, primarily by Saudi Arabia, is the heavy, sour variety. Trouble is, not all refiners have the equipment needed to process it.

As a result, the already high price of light, sweet crude has been magnified, with each barrel selling for more than $50 on futures markets. By contrast, there is a relative abundance of medium to heavy crudes that sell for much less, and that puts refiners who can process it in a very good position.

Depending on the precise chemical composition, lower-quality oil is selling at discounts ranging from $7 to $17 per barrel compared with light, sweet crude. A year ago, heavy, sour crudes, whether from Mexico, Venezuela or Canada, were discounted by about half that much.

"The sweet-sour spreads have never been this good," said Gene Edwards, senior vice president of supply and trading at Valero Energy Corp., based in San Antonio, Texas, the nation's largest independent refiner and the leading processor of sour crude.

The gap has narrowed somewhat after the Saudis reined in production this year to comply with reduced output targets set by the Organization of Petroleum Exporting Countries, or OPEC. And analysts think today's sharp price disparity is likely to narrow further over time, as more sour crude refining capacity is added and as Saudi Arabia or some other producer taps new fields that produce lighter crude to meet rising global demand.

However, assuming the global demand for oil remains strong, the discounts are not likely to return to historical norms any time soon.

"The same trends are likely to be in place for the next three to five years," Edwards said.

Despite the extra costs associated with processing lower-quality crude, the profit margins of independent refiners able to handle it are up sharply. For example, Valero reported net income in 2004 of $1.8-billion, nearly three times what it made the year before, while Premcor Inc.'s profits tripled to $478-million. Valero's shares have more than doubled in the past year, while Premcor's are up nearly as much. Shares of Frontier Oil Corp. also have soared.

Valero attributed its stellar fourth-quarter results to its "superior leverage to sour crude discounts," which were $10 per barrel cheaper, on average, than the price of West Texas Intermediate, the light, sweet oil that futures prices are pegged to on the New York Mercantile Exchange.

More than half the oil used by Valero - some 1.3-million barrels a day - was sour during the fourth quarter, including Mexican Maya, which accounted for nearly one of every five barrels and averaged $16.75 per barrel cheaper than WTI, according to the company. The company also processes heavy, sour crude from the Gulf of Mexico known as Mars, which has become the U.S. benchmark.

In the past two years, Valero has significantly expanded it ability to process heavy, sour crude, by acquiring a 315,000-barrel-a-day refinery in Aruba and a 185,000-barrel-a-day refinery in Louisiana. In late 2003, the company also completed the expansion of its heavy, sour processing capacity at a refinery in Texas by 45,000 barrels per day.

Fadel Gheit, senior oil analyst at Oppenheimer & Co. in New York, said the decision in recent years by Valero and others to expand their heavy, sour refining capacity has proved to be "brilliant."

While the spread between sweet and sour is likely to narrow, "going forward, the differential is still going to be much higher than it was in the past," Gheit said.

Premcor, a small, independent refiner based in Old Greenwich, Conn., also is betting its future on the profit potential inherent in lower-quality crudes. In November, for example, Premcor announced it was pursuing a 50-50 joint venture with Canadian oil producer EnCana Corp., whereby Premcor's refinery in Lima, Ohio, would be modified to process about 200,000 barrels a day of heavy oil supplied by EnCana.

In a similar move, Canada's Suncor Energy is spending $300-million to upgrade a refinery it owns in Denver, where it intends to process increasing volumes of heavy crude produced from its oil sands operations.

Refining analyst Aaron Brady at Cambridge Energy Research Associates said these types of deals could become more common as Canada and other nations ramp up production of heavy, sour crudes.

"That stuff is all looking for a home," he said.

But as more "homes," or refineries, are built to handle sour crude, the profit margins will dwindle, said Cal Hodge, a former Valero executive who runs a Houston-based consultancy specializing in clean fuel issues.

"Just watch for history to repeat itself," Hodge said.

[Last modified March 11, 2005, 19:15:02]