KUWAIT - The Crack Spread Factor.

The most important factor to the pricing of crude oil, with implications for the Middle East and the rest of the world, is a complex mathematical formula called the "crack spread". "crack" is the industry jargon verb defining the process in which crude oil is refined into products. It illustrates an ever-dynamic price relationship between crude oil and its products. As it rises, the crude's products are becoming comparatively more expensive than crude oil itself; but the crude later catches up with the pull of the crack spread. If the crack spread falls, the opposite happens.

This was the gist of a presentation made by APS Energy Group President Pierre Shammas to a seminar in Tokyo held on May 16 at the prestigious Institute of Energy Economics of Japan. The following are extracts from his presentation: "In other words, if the crack spread is rising, its products, especially gasoline, are leading crude oil up, not the other way around. I give you one example: Saudi Aramco, a trend-setter in the pricing of crude oils in the Middle East, is to raise the price of its heavier crude oils to Asian buyers for the third month in a row in June as refinery maintenance in Asia drives margins above US$10/barrel. Lighter, distillate-rich Arab Extra Light as well as naphtha-rich Arab Super Light should gain on the back of stronger gasoil prices and strong refinery economics.

"Saudi official selling prices (OSPs) are usually released around the fifth of each month before crude oil starts loading, and set the trend for Iranian, Kuwaiti and Iraqi prices, altogether impacting the price of more than 8 million b/d of crude oils sold to Asia.

"The more sour Saudi grades - Arab Heavy, Arab Medium and Arab Light - are likely to rise by an average of 30 cents/barrel in June, putting them at their highest level since April 2006 due in part to OPEC's production curbs imposed over the past six months. The grades have rallied in the past three months as healthy product demand has triggered a sharp rebound in crack spreads. The front-month fuel oil crack to Dubai swaps improved to a $10.07 discount in April, versus a $12.80 discount in March. The front-month gasoil crack to Dubai rose from a premium of $14.37/barrel to a $16.07 premium in April, the highest average since last August.

"Just like it happens every spring, the crack spread is rising, but this year has been rising earlier, faster and higher than previously. From being under $10 for most of the previous six months, it surged to almost $25. It pulled back a bit early, but by March 30, it was on the move again, closing at $18.37, up 12% on the day. Every time the price of crude rises and the Western popular media accuse OPEC of price gouging, the latter's defence is that it is not OPEC but the Western oil companies. The rising crack spread essentially proves their point.

"There is no real shortage of crude oil; actually, the world is awash in it. But there is no spare refining capacity... There has not been a new refinery opened in the US in 31 years; during that time, the actual number of refineries operating in the US dropped from 301 in 1981 to 149 in 2003. But this was less dramatic than it seemed. US refiners have consolidated many of their older and smaller refineries into fewer large-capacity plants. If more refinery construction had been allowed, it was argued, the refinery capacity crunch implied by rising crack spreads and rising pump prices would never have occurred.

"This argument might have more credence but for the fact that oil refining is a process and business which occurs all over the world... According to the Oil and Gas Journal, 96...countries have operating oil refineries within their borders; of the world's 10 largest-capacity oil refineries, only two, ExxonMobil's refineries in Baytown, Texas, and Baton Rouge, Louisiana, are in the US. The world's largest-capacity oil refinery, the Paraguana Refining Complex in Venezuela, ships almost all its products of 940,000 b/d to the US East Coast. The are 95 other countries where refineries are currently sited. Many of these countries are in the Third World; they are desperately poor, and local environmental movements, if they exist..., are at most nascent.

"However, the cost of building a new refinery - even in Africa - has risen sharply in recent years. So IOCs are having second-thoughts about such projects, waiting to see costs come down before putting their money into new capacity. This goes also for the upstream (E&P), where project costs have been shooting up to unprecedented levels.

"According to the EIA of the US Department of Energy, total world refinery capacity has only increased 1.5% from 2000 to 2005, from 81.53m to 82.8m b/d. This is in the face of surging world oil demand, particularly from the newly industrialising nations of China and India, not to mention the US, Europe, Japan and the rest of the OECD world.

"According to the Paris-based IEA, from 2003 to 2006, world oil demand increased by an average of 2.1% a year. Demand in 2005 was 83.7m of b/d, with refinery capacity then at 82.8m b/d, it means that the world was short of almost 1m b/d of fuel. At this point the US factor should be taken into account. Take out refining capacity shut down for repairs, maintenance, accidents and the unforeseen (in the immediate aftermath of Hurricane Katrina, nine US Gulf Coast refineries, representing 12% of US production, were shut; for many the shutdowns lasted many months) and you get the picture of markets for petroleum products which have much stronger tendencies to rise than to fall....

"'Maintenance' is the same reason that the oil companies annually, including this year, give for taking refinery capacity offline in spring, driving prices up, and setting the world's drivers up for the fuel price increase season which now lasts into early autumn. This yearly problem, and the tightness in the world's petroleum products markets in general, could be alleviated with new refinery construction; but this is not happening".

Shammas forecast that the front-month futures price of Brent will fluctuate mainly between $65-75/b. "But it could jump way above $75/barrel in the event of a major geo-political disaster in the Middle East, Nigeria or somewhere else.

"...Capacity expansions across the whole chain of the world energy business have become very expensive, with project costs having risen by 30% per annum in recent years. The high cost of projects is affecting the energy business worldwide, including petroleum production and refining capacities in the Middle East and elsewhere in the world.

"However, even at $90/barrel, Brent and other crude oils of similar quality is still cheap relative to its real cash value in 1980. This means that, relative to cash values in 1980, energy costs are not high. The global economy seems to be robust enough to absorb such a price for crude oil....

"Meanwhile, OECD oil inventories are heading for the steepest fall since 1996. Preliminary IEA data recently indicated a fall in OECD stocks of about 1m b/d during the first quarter of calendar 2007.

"The world's economy is growing 4.9% this year and another 4.9% in 2008, according to the IMF. This means a six-year growth period which has not been seen since the late 1960s and early 1970s. And oil prices are low also because the US dollar has been falling steadily since 2002.

"The fall in world oil stocks has been the work of OPEC. OPEC's ministerial conference in Vienna on March 15 decided to stick by its crude oil output target of 25.8m b/d. OPEC left its official quotas unchanged following decisions to cut production at its two previous meetings on Oct. 20 and Dec. 14 - with 1.2m b/d cut from Nov. 1 and another 500,000 b/d reduced from Feb. 1.

"World crude oil prices have switched between big gains and losses in recent months, mirroring heavy falls and rebounds to global stock markets caused by concern about a weaker US economy. But the economy in the rest of the world is strong enough to help the Americans catch up with the growth trend.

"Behind OPEC's March 15 decision to leave output unchanged until its next ministerial meeting in September lay a new calculation... OPEC had prevailed in its multi-year struggle to keep commercial oil inventories down in order to regain some control over turbulent petroleum markets and keep crude oil prices from falling to low levels reached in late 2006 and early 2007.

"OPEC wants to see commercial oil inventories in the main consuming markets being low and thus exercise its pricing power. This position has raised concerns in importing countries that world crude oil prices may rise again this summer as they did in the summer of 2006...

"OPEC contends that its strategy of keeping commercial oil stocks low poses little risk to the world economy. Its strategy will be tested in the coming months, as seasonal demand resumes its rise with the beginning of the summer driving season.

"Historically, WTI has had a premium over the price of Brent. But in recent months the trend has been reversed. On April 20, an important day to measure a trend, Brent closed the trading session in London at $66.41/barrel, while WTI at NYMEX was $62.80.

"The premium for Brent was caused by two factors: violence in Nigeria and a flood of excess crude oil at Cushing, Oklahoma, because some US oil refineries were still shut down for maintenance. Contributing to WTI's fall, relative to Brent, was a consultant's report that Iraqi oil reserves could be double than the 116 bn barrels reported for many years, and reports that China may take more serious steps to slow its economic growth....

"The background is important to know. Starting in 2004, OPEC had trouble stopping what seemed to be a runaway crude oil price boom. That was in large part because OPEC then lacked enough spare capacity to produce extra crude oil, prompting traders to bid up prices in the oil futures markets.

"Towards the end of 2004, OPEC's spare production capacity had dwindled to fewer than 1m b/d, leaving markets perilously stretched. Then, in the autumn of 2006, after an extended period of OPEC producing flat-out, crude oil prices began falling when oil supplies into commercial inventories were rising.

"On March 15, 2007, ahead of the OPEC production announcement, April Brent topped OPEC's unofficial $60/barrel target. In a statement after the Vienna meeting, OPEC focused on volatility in the oil market. It said: 'Although all indicators clearly show that the market remains well-supplied with crude oil...overall oil market volatility is likely to continue. In light of this volatility, the conference decided to continue closely monitoring market developments to ascertain that oil market stability is achieved and that global economic growth is sustained'.

"Ahead of the gathering, there had been suggestions from some ministers that OPEC would announce plans to hold an extraordinary meeting in June owing to the unsettled situation on global financial markets. But OPEC said its next meeting would be an ordinary one, in Vienna on Sept. 11. Following that, OPEC would meet in Abu Dhabi for an extraordinary conference on Dec. 5.

"In its monthly report, published also on March 15, OPEC noted that 'downside risks to the world economic outlook are coming to the fore'. It said world oil demand would grow 1.5% in 2007 from the 2006 level, matching its forecast in January and February. OPEC ministers on March 14 had said world oil demand could be hit should there be a long-term downturn in the stock markets which leads to slower US economic growth. Global equities were higher on March 15, but traders warned about a return to losses ahead.

"OPEC - excluding Iraq and new member Angola - is currently producing about 1m b/d above its official daily target of 25.8m b/d. Iraq is not included in the quota system because of disruption to its output. Angola will not have a quota before 2008. The world consumes about 85m b/d.

"OPEC's move to cut output in November and February came after light/sweet crude oil prices had tumbled to about $57. WTI went on to fall below $50 on NYMEX in mid-January, the lowest point for 19 months.

"OPEC's current President and UAE Energy Minister Muhammad bin Dha'en al-Hamili on March 15 told a press conference there were now around 100 projects costing about US$100 bn as further proof that OPEC members were continuing to invest in the petroleum sector - despite the very high costs of new projects.

"The OPEC head of research, Hassan Qabazard, said this will result in 38m b/d of crude oil production capacity for OPEC by 2010. But Hamili said OPEC was monitoring the recent weakness for the US dollar, a factor which could impact investment in the petroleum sector in the future. A more serious factor is the rising cost of projects....

"There have been calls for more oil supplies by the world's biggest consuming countries. But in its monthly report, OPEC acknowledged it may have to produce more by end-2007, having raised slightly its forecast of oil demand growth and said the demand for its own crude oil would average 30.4m b/d, up from previous estimates of 30.25m b/d.

"Before the OPEC meeting, Saudi Petroleum and Mineral Resources Minister Ali al-Na'imi had told the London-based Saudi daily ash-Sharq al-Awsat: 'Markets are comfortable, stocks are comfortable, so there is no need to change production.

"The omens suggest that OPEC will need to start increasing output in a few months to avoid choking the world economy. OPEC's ministers are likely to wait until oil inventory data are published in the coming months to confirm what the industry perceives - inventories are close to becoming so lean that the market is prone to a renewed price rise.

"It was petroleum products, mainly gasoline, which led WTI and Brent lower in recent months. But it will be mainly gasoline which will lead Brent and WTI prices up in the coming months. I expect US inventories of gasoline to be low in the coming months, which will push prices upwards....

"In classical economic theory, excessive price rises are self-defeating for companies. For one thing, they are supposed to tempt other competitors into the market, lured by the profit potential of those high prices, and eventually those high profits would be arbitraged, taken away by other companies, in the market. This does not happen in the petroleum products markets.

"The barriers of entry for a new competitor, the costs, time and complexity of setting up new refinery capacity and distribution networks are enormous, and so the oil business stays what it has been for many years, a comfortable little oligarchy, with only occasional new members, like LUKoil in Russia and China National Offshore Oil Corp in China. Both these now major players in the international oil markets solved the high initial barriers of entry problems by emerging out of former state-owned entities during the eras of communist economic management..."