Despite the renewed commitment of the US and its allies to a long struggle against terrorism, punctuated by this week's air strikes on Syria, the near-term price of Brent crude oil remains stubbornly below $100 per barrel. Global economic growth is hardly robust, yet without soaring shale oil production in the US, oil prices would surely be much higher as I argued this summer. However, I don't think that paints a complete picture of why Brent looks so weak today.
Since the onset of the "Arab Spring" in early 2011, the only other period of sustained sub-$100 Brent pricing coincided with a spell in mid-2012 when it appeared the financial crisis in the European Union might lead to at least a partial break-up of the EU. Weak demand, or the prospect of it, can have as big an impact on oil prices as the curtailment of a significant producer's output. Today's soft oil market surely reflects lower demand in the EU and slower growth in China, as noted in recent estimates from the International Energy Agency. The big story, though, is still US shale oil and OPEC's response to it.
The numbers for shale, or light tight oil (LTO) as it's often called, are impressive, especially to those accustomed to watching the gradual ebb and flow of different oil sources over long periods. In the 12 months ending in June 2014, US oil production grew by 1.3 million barrels per day (MBD), not far short of Libya's pre-revolution exports. Since January 2011, the US added 3 MBD, or about what the UK produced at its peak in 1999.
In fact, since 2010 incremental US LTO production has exceeded the net decline of the entire North Sea (Denmark, Norway and UK) by around 2 MBD, contributing to a significant expansion of Atlantic Basin light sweet crude supply. And just as the current debate about whether to allow US oil to be exported hinges on crude oil quality as much as quantity, the impact of LTO on Brent is likely about more than just volume. It's the same reason the return of a few hundred thousand barrels per day of Libyan (light, sweet) oil is seen as a serious drag on the Brent price.
The New York Mercantile Exchange defines light sweet crude as having sulfur content below 0.42% and an API gravity between 37 and 42 degrees. That's less dense than light olive oil. Brent is similar. Much of the LTO produced from US shale formations fits those specifications, and what doesn't is typically even lighter and lower in sulfur.
The current "contango" in Brent pricing, in which contracts for later delivery sell for more than those for delivery in the next month or two, is a clear sign of a market that is physically over-supplied: more oil than refineries want to process, with some of it going into storage. However we also see indications that the historical premium assigned to lighter, sweeter crude versus heavier, higher-sulfur crude is under pressure.
One example of this is the gap or "differential" between Louisiana Light Sweet, which wasn't caught up in the delivery problems that plagued West Texas Intermediate for the last several years, and Mars blend, a sour crude mix from platforms in the Gulf of Mexico. From 2007-13 LLS averaged around $4.50 per barrel higher than Mars, while for the first half of this year it was only $2.75 higher and today stands at around $3.40 over Mars.
While OPEC's reported Reference Basket price has been falling in tandem with Brent, its discount to Brent has also narrowed by about $1 per barrel recently, compared with the average for 2007-13. Considering that its components include light sweet crudes from Algeria, Libya and Nigeria that sell into some of the same Atlantic Basin markets as Brent, that looks significant.
A narrowing of the sweet/sour "spread" of only a dollar or so per barrel isn't earth-shattering when it only represents around 1% of the value of the oil in question. However, it might just be the camel's nose under the tent. Further expansion of US LTO output, defensive output cuts by OPEC sour crude producers like Saudi Arabia, and the continued displacement of light sweet crudes formerly imported into the US could all increase the pressure on Brent's premium value. The possibility of US crude oil exports beyond the few cargoes of condensate allowed under current rules adds a wild card to an already strong hand.
It's ironic that for decades the global oil industry planned and invested, anticipating the gradual disappearance of light sweet crude. There were enough periods when that seemed to be occurring to justify the construction of billions of dollars of hardware to convert lower-value heavy and/or sour crudes into high-value products. While there's still a lot of such oil in the market, a prolonged period of narrow discounts versus light sweet crude would frustrate most refiners and reward those who bet against conventional wisdom and kept their facilities simpler.