Houston: "We have a problem."

[dan_s]

Shale oil may be too light for U.S. refiners to handle. Notes below from Morgan Stanley. If you'd like to see the full report, send an email to dmsteffens@comcast.net

As US production surges ahead, it is rapidly getting lighter
too. In technical terms, all growth is due to oil with API
gravity above 40. At the same time, the average API gravity of
oil processed by US refiners is just ~32. In this note we discuss
the possible consequences of this mismatch.

The ever lighter US barrel: Fracking creates cracks and fissures though which
only relatively small hydrocarbon molecules can flow. As a result, oil from shale
formations is very 'light' and this is driving all of US production growth. At the
same time, US refiners tend to process heavier grades. This mismatch is already
there but set to grow in the future. How this will impact oil markets is a complex
question with several uncertainties. We have two hypotheses but also identify
four 'known unknowns'. Our best guess: sharply rising exports of light oil,
persistent WTI-Brent spreads and pressure on heavy-light differentials for now.

#1 - Light crudes now appear to be crowding out heavier grades: Over the last
few years, the average gravity of available crude in the US was relatively stable.
Production became lighter but imports become heavier, offsetting each other.
Recently, however, this seems to be changing.

#2 - Storage seems to be getting lighter: The average API gravity of crude
available in the US seems well above the gravity of refinery intake. This would
imply that refiners are taking heavier barrels out of storage than are being put in.

#3 - What capacity do refiners have to process light crude? Besides the two
hypotheses above, there are also four genuine uncertainties. For example, US
refineries have been designed to process mostly heavy barrels. Their
configuration is sub-optimal for light shale crude. How much can they take?

#4 - What is US export capacity? In the end, US light crudes may be best
processed overseas, which would imply sharply growing exports. Exports of light
grades are already rising fast, and with shale growing >1 mb/d y/y, this is set to
continue. For historical reasons however, most infrastructure was for imports,
not exports.

#5 - Who will buy it? Seaborne trade of oil with API gravity >40 is just 6 mb/d.
Adding an incremental ~1 mb/d per year to this may be challenging. China, India,
Japan, Korea and Singapore have all imported meaningful amounts of US crude
in recent months but none of the light crudes produced by shale.

#6 - What will it do to middle distillate yields? Middle distillates like diesel and
jet fuel are likely to be the key long-term drivers of oil demand growth. However,
as crude gets light beyond a certain point, it starts to yield less middle distillate –
another uncertain headwind.

For context, the weighted average API gravity of all crudes produced globally is ~37, and 80% falls below 40. Important benchmarks like Brent and WTI have API gravity of 38 and 41 respectively, which makes both of them light crudes. When it comes to US shale however, oil tends to be even lighter than that. The average API gravity in the Permian Midland basin is ~41. This increases as you go west: the Permian Delaware has average API gravity of ~45. The Bakken and Eagle Ford are ~44 and ~43 respectively.