In the spring of 1971, the Texas Railroad Commission announced, for the first time, that it would allow 100% production. In other words, producers in Texas were free to produce at capacity. On that date, the marginal price of crude oil was no longer set in Texas. In mid 2004, OPEC announced, for the first time, that it would allow 100% production. The OPEC quota still stood but the valves were open. On that date, the marginal price of oil was no longer set by OPEC.

Now that we have passed the point where prices could be set by fiat, energy analysts and politicians are at a loss for words. The widespread belief is that even with surging demand from the U.S. and China, oil prices “should” be around $30/bbl. and that the difference between this price and current prices around $50/bbl. represents fears of terrorism, actual or potential disruptions in Iraq, Venezuela, and Nigeria, the possible bankruptcy of Yukos, speculation on the NYMEX, and so on. What these analysts and politicians are missing is that the marginal price of oil is much closer to $30/bbl. than $50/bbl. It is just that the marginal barrel of oil is no longer what they think it is and the benchmarks used to determine whether prices are “too high” are no longer appropriate.

The most widely used crude oil price benchmarks in the world are West Texas Intermediate (WTI), used primarily in the U.S; Brent, used primarily in Europe; and the OPEC market basket, used around the world. (Other benchmarks, like Dubai, are used in Asia.) WTI is very light and very sweet. This makes it ideal for producing products like low-sulfur gasoline and low-sulfur diesel. Brent is not as light or as sweet as WTI but it is still a high-grade crude. The OPEC basket is slightly heavier and sourer than Brent. As a result of these gravity and sulfur differences, WTI typically trades at a dollar or two premium to Brent and another dollar or two premium to the OPEC basket. The OPEC basket typically trades in OPEC’s official price range, currently $22-28/bbl. In recent months, however, WTI has traded at $20-25/bbl. above the OPEC price range and even the OPEC basket has traded as much as $15-20/bbl. above the OPEC price range. Something is obviously wrong here.

The Changing Dynamics of the World Oil Markets
In fact, four trends unrelated to terrorism, disruptions, bankruptcies, or speculation are changing world oil markets. All of these trends are highly significant and some are permanent. The trends are towards: 1) increasingly heavy, sour crude production, 2) increasingly stringent sulfur standards in the major consuming regions, 3) increasingly mismatched marginal refining capacity for both the marginal crudes and the marginal products, and 4) less short-run price elasticity of demand throughout the world.

Crude Supply
While WTI, Brent, and the OPEC basket are benchmark grades and important contributors to world supply, none comes close to representing the marginal barrel any longer. Barring a worldwide recession and a collapse in demand, the marginal barrel will now forever be heavier and sourer than these grades. Wishful thinkers hoping that Saudi Arabia can open its valves a little further will be disappointed to know that the incremental production offered by the Saudis is relatively heavy and relatively sour. Although there is considerable disagreement within the industry over the date Hubbert’s Peak will be reached, there is no disagreement that the worldwide peak in production for the lightest, sweetest grades has long passed.

Sulfur Standards
Sulfur standards for gasoline and diesel have been growing tighter in the major consuming regions over the past few years. This trend will continue. Gasoline sulfur standards were tightened in the U.S. and Japan this year, will be tightened next year in the U.S., Europe, and Canada, and will be tightened the following year in Europe and Japan. The trend in diesel sulfur standards is similar. These increasingly stringent standards would reduce the yield of gasoline and diesel per barrel of crude even if the quality of the crude inputs were not declining. Starting with heavier, sourer crudes means even lower yields of gasoline and diesel.

Refining Capacity
The marginal refining capacity in the world cannot process heavy, sour crudes at all, let alone process these crudes into light, sweet products. Converting existing refining capacity to process heavy, sour crudes to produce light, sweet products is expensive and time-consuming. In the U.S., the conversion (for the refiners who are converting) is a multi-year, multi-billion-dollar project. Some refiners have elected to produce light, sweet products only from light, sweet crudes. Others have elected to retire refining capacity. In parts of the world that supply markets with only higher sulfur products or that have dropped out of the market to supply low-sulfur products, little or no conversion will take place and the demand will continue for the diminishing fraction of light, sweet crudes.

Real Prices and Price Elasticity
Crude and refined product prices, while high in nominal terms, are far from historic peaks in real terms. Also, crude and refined product costs in the developed world represent a much smaller fraction of economic output than in the 1970s and 1980s. This combination of relatively modest real price levels per barrel, especially in regions with strong currencies versus the dollar, and relatively large improvements in GDP per barrel mitigates the economic stress of “high” oil prices in much of the world. At the same time, rapid and accelerating GDP growth in countries like China and India is generating increased demand from countries that had previously been only minor factors in world oil markets. While it is true that these countries use much less oil per capita than the developed countries it is also true that they use more oil per unit of GDP than the developed countries. In short, absent a worldwide recession, demand for oil and refined products will continue to increase.

Figure 1 shows one of the crucial aspects of the real price issue. It shows the price of WTI indexed to December 2000 expressed in dollars, euros, and yen. Although the price of WTI in dollars has risen sharply over the past three years, the price in euros had been more-or-less flat until the summer of 2004. During the summer of 2004, the euro-adjusted price rise was only about half as large as the dollar increase. The yen-adjusted price rise has also lagged the dollar price rise over the past year, though by a lesser amount than the euro. Trends during the recent (autumn 2004) decline in oil prices are the same. Considering the weakness of the dollar versus most major currencies during the past 2-3 years, the clear inference is that a large percentage of the rise in the price of WTI has been due to dollar weakness, not oil strength. Although not discussed in the present paper, the weakness of the dollar has potentially enormous implications for the long-term pricing structure of the major oil exporting countries. It is no secret that discussions are taking place among these countries about changing oil pricing (regardless of the crude benchmark) from a dollar-based price to a market-basket price based on the dollar, euro, and yen.

Benchmark Definitions Revisited
Combining the factors outlined above, we have a situation where 1) the marginal crude supply is increasingly heavy, sour; 2) the marginal product demand (in the major consuming regions) is increasingly light, sweet; 3) the marginal refining capacity is neither qualified to handle the inputs nor produce the outputs, and 4) the marginal prices of the products are thus far insufficient to induce any meaningful demand response anywhere in the world. As we would expect from this combination of factors, refining margins have widened to historically high levels on the output side (i.e., crack spreads) and discounts for heavy, sour crude have widened to historically high levels on the input side (i.e., crude spreads).

For example, Figure 2 shows that as the price of crude oil has risen over the past two years in all grades (e.g., light, sweet WTI; medium, sour Mars; and heavy, sour Maya) the spread between WTI and Maya has widened to around $15/bbl. versus $9/bbl. in the first half of 2004, $6-7/bbl. last fall, and around $5-6/bbl. at this time two years ago. At $15/bbl. less than WTI, the price of Maya is very close to the politicians’ “correct” price of $30/bbl. Other crude spreads show similar patterns. Mars now trades at a discount to WTI around $9/bbl. versus $4-5/bbl. in the first half of 2004, $3-4/bbl. last fall, and $2-3/bbl. two years ago.

Whether OPEC literally produces the marginal barrel of oil is not the question any longer. The question is whether the marginal barrel can be refined by the marginal worldwide refining capacity into the marginal products at the benchmark marginal prices. The answer is no both on the crude side and the products side. In short, the issue isn’t that the price of oil is “too high.” The issue is that for several reasons the benchmark crude definitions used to determine “too high” are no longer appropriate. In recognition of this fundamental shift in the oil industry, some organizations (e.g., Platt’s) have been exploring the possibility of changing the world benchmarks to heavier, more sour crude grades (e.g., Mars) but change is slow in coming.

The issue of benchmark pricing by a currency basket, rather than a single currency, is separate from the definition of benchmark crudes but no less significant. As the dollar continues to decline, crude prices that are “too high” in dollars are not necessarily too high in euros or any of the other currencies that have appreciated significantly versus the dollar in the past few years. This is a topic for another day.

Who Benefits?
This transition in marginal supply and marginal demand creates opportunities for companies positioned on the correct side of the supply / demand spectrum. The most successful companies will fall into two groups: producers of light, sweet crudes and refiners of heavy, sour crudes. Investors looking for companies whose production is skewed towards premium crudes should keep in mind that most of the fields in the U.S. and the North Sea that produce crudes literally deliverable against the NYMEX light, sweet crude contract (e.g., West Texas Intermediate, Brent, Forties, Oseberg) are old and expensive to operate. Better opportunities are likely in existing and emerging light, sweet fields in higher-risk parts of the world, including West Africa (e.g., Nigeria, Gabon) and certain fields in the South China Sea and around the Caspian Sea. Some of these crudes, e.g., Nigerian Bonny Light, are also deliverable against the NYMEX contract and others are likely to achieve that status once production reaches internationally meaningful levels.

On the refinery side, the refiners who stand to benefit are those who can process heavy, sour crudes into light, sweet products. Independent refiners best positioned in this area are Valero, Tesoro, and Premcor, all of which are heavily leveraged to sour crudes compared, for example, to Sun, which refines only sweet crudes. Among integrated major oil companies, refining capabilities are across-the board. ConocoPhillips has the highest exposure to refining in general but since refining typically represents no more than 20-35% of the majors’ net income, differences in crude processing capability are of relatively little significance.

A Final Comment
The bottom line is that the markets are working. It’s just that the media, the public, the politicians, and most energy analysts have been looking at the wrong crude benchmarks (and potentially the wrong currency benchmarks). Many individuals in these groups could save themselves a great deal of aggravation by recognizing the fundamental and permanent (or soon-to-be permanent) changes in the crude and products markets instead of berating OPEC and others about some obsolete notion of a fair price for oil.

Harry Chernoff is with Pathfinder Capital Advisors, LLC (, a privately-owned investment bank and investment advisor primarily in the energy area. Prior to joining Pathfinder, Mr. Chernoff spent 24 years as an economist covering a wide variety of energy issues at Science Applications International Corp. Mr. Chernoff has a B.A. in economics from The College of William & Mary and an M.B.A. from Marymount University.