Kate Mackenzie Will a product squeeze see crude oil prices keep rising?

The irony of crude prices breaking well above $85 can’t have been lost on the energy ministers who met in Cancun last week to discuss new measures for tackling oil price volatility. The big question is whether prices will remain at that level, and push even higher – something that could dampen nascent economic growth in much of the world.

As most reports have noted, the latest rise followed reports of improved global manufacturing data, particularly in China. Some analysts caution this is not sustainable, given that relatively substantial amounts of crude oil remain in storage, which should continue to dampen physical demand for oil.

But is there a fundamentals angle to this rise; and what would it mean if so? One long-time oil watcher says it could mean the high crude prices are not only sustainable, but will keep rising. OECD demand is widely thought to have peaked and it’s well known that any growth is coming almost exclusively from emerging markets, particularly China.

And here, economist and analyst Philip K Verleger identifies a possible trend towards growing demand for diesel fuel, especially low-sulfur and ultra-low-sulfur diesel (which are popular in China), relative to other refined products such as gasoline. The rising crack spread for gasoil, he says, seems to confirm this. Verleger points out that changes in gasoil prices are an excellent predictor for Brent (itself a light sweet blend), from which about 60 per cent of the world’s crude oil is priced:

So what would the fundamental factors be behind the recent rise in gasoil prices relative to gasoline? Verleger says there are two likely:

First, demand for heavy crudes, used principally in the marine sector, remains depressed as world trade is only slowly recovering to pre-recession levels. Second, gasoline demand is down, making it less economic to run crackers and less economic to process heavier crude. Under these circumstances, distillate rich sweet crude should again be in greater demand.

The relative growth in gasoil prices is in part exacerbated by shut-ins of refining capacity, which in itself is partly due to the rebalancing that went on to cope with last year’s distillate glut. This has now potentially revived the muted gasoline to gasoil demand effect – last seen in 2008.

Verleger has argued before that a similar product squeeze caused the 2008 run-up in crude oil prices; the refining industry simply did not have enough capacity to turn heavier grades into the low-sulfur products that were in demand.

Considering aggregate crude oil supply, he says, overlooks the problems caused by demand for certain refined products, particularly when light sweet crude is less and less abundant — with the shortfall being increasingly made up by heavier grades, which require more intensive refining facilities.

Related links:

China, setting the world’s oil prices - FT Energy Source
High oil prices, not so disconnected after all? - FT Energy Source