London, 3 March 2011

While the rest of the world should be able to handle the loss of Libya's light sweet oil, it poses severe problems for Europe's already troubled refining sector, which relies on high quality crudes to make any money at all. Loss of Libya's oil production has exposed the escalating problem for European refiners trapped between increasingly stringent standards for transportation fuels and their own lack of investment in upgrading and especially desulphurisation capacity as a result of poor profitability.

Libya's light sweet oils are particularly prized by refiners because they yield a high proportion of valuable products (gasoline and diesel), while minimising the need for expensive processes to break up larger, less valuable molecules (coking, catalytic cracking and hydrocracking) and remove sulphur (hydrotreating and hydrodesulphurisation).

But the key constraint in the market at the moment is sulphur content rather than the density of crude oil.

SULPHUR NOT GRAVITY

Extra barrels from Saudi Arabia can largely substitute for lost Libyan output in terms of density. Saudi Arab Light is only modestly heavier than Libyan grades. Most refiners should have no difficulty cracking the slightly higher proportion of heavy molecules -- especially since the world is oversupplied with gasoline and marginal demand is for heavier diesel fuels, which require less upgrading.

Sulphur is more of a challenge. Saudi Arab Light (1.8 percent sulphur by volume) contains over six times as much sulphur as Libyan crude (0.1-0.4 percent). The loss of Libya's sweet crudes is not easily replaced.

Disruptions have triggered a scramble for other lowsulphur sweet crudes such as Nigeria's Bonny Light (0.14 percent) and Qua Iboe (0.12 percent) and Angola's Cabinda (0.12 percent) and Kuito (0.68 percent) -- though Angolan crudes such as Kuito present their own problems because of high acidity.

Desulphurisation is a particular problem for European refineries. Western Europe has some of the most stringent standards for transportation fuels, requiring very low levels of sulphur in gasoline and highway diesel. But the region's refiners have been plagued by excess capacity and aging facilities, hampering profitability and discouraging investment.

Rather than invest in expensive upgrading and desulphurisation units that would allow them to process a wider slate of crude oils to exacting product specifications -- like India's giant newly built Jamnagar refinery -- European refiners have continued to rely on buying high-quality crude oils that require less processing, leaving them more vulnerable to a disruption in this segment of the market.

European refiners are increasingly trapped. They have lost their ability to dump excess gasoline output into export markets such as the United States. Product standards are still tightening for example in marine diesel.

At the same time, competitors in the United States and Asia are investing heavily, enabling them to process poorer quality (therefore cheaper) crudes. So while Midwest refiners in the United States enjoy bumper margins (based on cheap landlocked Canadian and Bakken crude), and modern refineries such as Jamnagar are extremely profitable (processing heavier, sourer crudes), refining margins in Europe have shrunk close to zero or turned negative as refiners are hit by the soaring relative cost of light sweet oils.

OUT OF STEP WITH DEMAND

Loss of Libyan crude has exposed deeper structural problems in European refining that are blocking investment. In a note published in November 2010, the European Commission said EU refining capacity is out of step with evolving demand. EU refineries produce too much gasoline, for which demand is shrinking, and not enough middle distillates such as diesel, for which demand is growing rapidly.

Between 1990 and 2008, demand for middle distillates rose 35 percent, and demand for jet fuel/kerosene and diesel increased 82 percent, while demand for gasoline fell 26 percent. But while EU supply of middle distillates rose 28 percent, gasoline production fell only 4 percent.

http://register.consilium.europa.eu/pdf/en/10/st16/st16302-ad03.en10.pdf

As a result, the EU has become increasingly reliant on imports to meet its middle distillate requirements, while European refiners struggle to sell surplus gasoline profitably on world markets.

"So far the U.S. has served as a convenient outlet for excess EU gasoline, but it is widely predicted to reduce its consumption going forward," according to the Commission.

The EU could continue to export gasoline to markets in Africa and the Middle East, but "future gasoline deficits in both these regions are likely to be well short of EU gasoline export levels.

"In order to contain or reduce these trade, the EU refining industry would have to invest significantly in additional refinery conversion capacity to produce more middle distillates, and it would have to reduce gasoline-focused refinery capacity".

Meanwhile, European refiners are struggling to make a profit. To make money at all, they rely on high-quality crudes from the North Sea, Libya and West Africa, which are either in decline or vulnerable to unrest, trade at a premium and leave them at a cost disadvantage compared with competitors in North America, the Middle East and Asia.

Poor margins, lack of investment and inadequate desulphurisation capacity have left European refineries unusually exposed to Libya's production problem, while competitors in other regions should experience fewer difficulties.

Ends --

By John Kemp, Reuters market analyst – for Commodities Now.

The views expressed here are his own.