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July 28, 2017

A Crude Primer: Would a Barrel of Oil by Any Other Name Smell as Sweet?

July 28, 2017
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When people talk about a barrel of crude oil, there is a tendency to lump all of it into one large category. The reality is that there are different flows of crude oil from all over the world that have various, distinct qualities. There are two main qualities used in the classification process. The first is API gravity and the second is the sulfur content.

API gravity is a measure of the density of oil on a “light to heavy” scale. Generally, “light crude” has an API gravity greater than 38° and “heavy crude” has an API gravity of less than 22°. Water by comparison has an API gravity of 10°. Some heavy crude is dense enough to sink in water.

The sulfur scale ranges from “sweet to sour”. If oil has a sulfur content of less than 0.5 percent it is considered “sweet,” and if it is above 0.5 percent it is considered “sour.” Oil that is heavy or sour requires a more complex, more intensive, and more expensive refining process.

How Does Oil Get to Market?

Oil markets can most simply be understood as composed of three stages: upstream, midstream, and downstream. The upstream phase is the exploration for and production of oil, which occurs when a company drills an oil well. Once the oil is extracted from the ground, the oil is typically sold to a transporting company. Transporting the oil is the midstream stage and can consist of multiple transactions between a number of companies. The third stage is the refining stage, in which oil is turned into useful products.

How is Oil Priced?

Oil is produced in over 90 countries around the world. The price for a barrel of oil in a given location is determined by a number of factors. The characteristics of the oil as described above constitute one factor. In general, refiners are willing to pay a higher price for light sweet crude because it is cheaper to refine light sweet oil into useful products. However, a much more important factor is the geographical location of the oil supply, and access to diverse markets that have demand for the oil.

Consider two barrels of light sweet crude oil produced in different regions: Barrel #1 is produced in a sparsely populated area with no infrastructure in place to transport and process the oil. Barrel #2 is produced close to an oil refinery hub like the Gulf Coast in the US. Which do you think would fetch the higher price?

The answer, of course, is Barrel #2. Though the first barrel may be of identical quality, without the infrastructure—railways, pipelines, etc.—in place to easily transport it, midstream companies would not pay a premium for it because their transportation costs would be so much higher.

The “true” value of oil in a market is ultimately determined by companies/traders who enter into contracts with each other to buy and sell it. These oil traders are constantly negotiating—with buyers trying to get a lower price and sellers trying to get a higher price. As contracts are entered, the prices are reported and the public can see what the market says oil is worth. This price is called a “benchmark.”

Different Markets

There are several unique oil markets in the US alone and hundreds of others around the world. The distinctions in these markets are created by factors like the type of refineries in the region, the type of oil that can be affordably transported to the region, and the types of refined fuels that are in the highest demand in the region.

For example, the US Gulf Coast is a large market for heavy sour crude. This is mostly due to the fact that a high percentage of oil refined in the Gulf Coast has historically been from Mexico and Venezuela—both of which produce mostly heavy sour crude. As a result, a majority of the refinery capacity is designated for medium to heavy sour crude. The US East Coast, on the other hand, is not as good of a market for heavy crude because most of the refineries in that part of the country are not built to refine heavy sour crude. Within each unique market there are benchmark prices that determine what the value of a barrel of oil should be for any given transaction.

Why Are WTI and Brent Predominant?

WTI is the benchmark that refers to a blend of US oil flows that tend to be high quality light sweet oil varieties that are priced in Cushing, Oklahoma. Brent is the benchmark that refers to oil originating in the North Sea. Why have they become so distinguished?

According to the Energy Information Agency, widely used benchmarks have four main qualities:

(S)table and ample production; a transparent, free-flowing market located in a geopolitically and financially stable region to encourage market interactions; adequate storage to encourage market development; and/or delivery points at locations suitable for trade with other market hubs, enabling arbitrage (profit opportunities) so that prices reflect global supply and demand.

WTI and Brent pass each of these four tests.

Let’s take a closer look at WTI, to explain what this means. Cushing is located in a region that is relatively close to very stable and ample production. Oil flows from the Bakken play in North Dakota, the Permian Basin of West Texas and New Mexico, the Scoop and Stack plays in Oklahoma, and several other US oil fields all flow through Cushing. The stable-and-ample requirement is covered easily.

With the US export ban now in the past, WTI has no problem meeting the threshold for EIA’s second requirement. The US market is very transparent, with all production and distribution data collected and reported by multiple state, federal, and private groups. Also, the oil industry in the US is privately run and suffers from relatively little government intervention.[1]

The Oklahoma hub also easily meets the third demand. Cushing is home to the largest crude oil storage facilities in the world with more than 80 million barrels of storage space. The fourth demand goes along with the third. The large storage capacity can be efficiently and affordably distributed to a number of other markets/hubs. Cushing oil supplies can be distributed to refineries in the Gulf Coast, the Midwest, and the East Coast through pipelines and railcars.

WTI vs. Brent

At different times WTI and Brent have each been considered a better indicator of global oil prices. Each has advantages and disadvantages. WTI flows mostly through pipelines into Cushing. This enables a higher volume of contracts for batches of various sizes. Due to the storage facilities and pipeline capacity, oil traders can respond quickly to demand in various markets and can supply to downstream companies in whatever size batch they demand.

Brent, on the other hand, is a waterborne supply and is transported by tankerload. Tanker ships carry enormous quantities of oil, so the contracts involving Brent tend to be bigger contracts. This results in a lower number of contracts. But the global financial markets are ever-shifting, and oil prices can change drastically in a short amount of time due to market sentiment, geopolitical conflicts, or even weather events. Creating a continuous price based on Brent can be difficult due to the lower volume of contracts that cannot react in real time as easily as WTI.

The advantage of Brent is actually the same as its disadvantage. As mentioned, it is a waterborne supply which means that companies can affordably access markets around the world. Transporting large shipments of oil on ship tankers is the cheapest way to transport oil. So unlike WTI, which has to travel through pipelines and railcars in landlocked areas, companies that produce Brent crude oil can cheaply access whatever market is paying the highest price for their oil. This exposure to many major markets, gives an accurate picture of what markets around the world are willing to pay.

Conclusion

The next time you hear a market analyst on Fox Business Channel discussing oil prices, you’ll have a little more insight into the topic if you remember these basics: “light” versus “heavy” refers to API gravity, “sweet” versus “sour” refers to sulfur content, and WTI and Brent are geographic benchmarks that give us a glimpse of the prices buyers and sellers are circling around on the open market.


[1] In 1975 the US passed the Energy Policy Regulation Act, which among other things put a ban on exporting oil from the US. This would seem to limit the ability of companies to use WTI as a reliable benchmark since it was cut off from global markets. The main reason that WTI remained a reliable benchmark is because the US market for oil is so large. So since WTI was the price point for crude oil produced in the largest market in the world, it remained an accurate indicator of the value of oil. This is not to say that the export ban did not negatively affect WTI’s influence, because it certainly did. This was most clearly seen from 2009-2015, the peak years of the ongoing shale boom in the US, during which time WTI traded at a substantial discount to Brent. This differential was due to the excess US light sweet production that was forced to sit in storage because there was simply not enough demand for it in US refineries, and the export ban restricted companies from sending their oil to markets that had space for their oil. In the decades prior to the shale boom, many US refineries updated their facilities to process heavier sour crude. In 2015 the export ban was lifted, which likely means that WTI and Brent will ultimately trade at very similar prices moving forward.

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