FSO Editorials

ALL HAT, NO CATTLE
by Elliott H. Gue
Editor, The Energy Letter
March 30, 2007

"Water, water every where, And all the boards did shrink; Water, water every where, Nor a drop to drink." --Samuel Taylor Coleridge, The Rime of the Ancient Mariner

Iran isn't an energy-independent country.

I'm well aware that Iran produces more than 4 million barrels of oil per day, the fourth-highest production in the world. And with the near-constant reporting about Iranian crude reserves during the past six months, I find it difficult to believe that anyone could be unaware that Iran has 132 billion barrels in proven reserves--or, at least, they claim to.

But what's often ignored is that we don't consume crude oil. You don't fill your car's tank with crude, nor is it used to power jet aircrafts, cruise ships or railway locomotives. Crude oil, in its natural state, often isn't even that flammable; one of the first uses of crude oil was as an alternative to whale blubber in oil lamps.

The real global source of energy is refined products: gasoline (petrol), diesel and jet fuel. Crude oil is nothing more than a raw material--the feedstock used to produce these refined products.

Here's where Iran's energy equation doesn't add up. Last week, the Iranian parliament set a date for the introduction of gasoline rationing; it also announced a roughly 25 percent hike in gasoline prices. That's because the country is literally running out of gas.

The problem is twofold. First, as I've highlighted before, the Iranian government has elected the self-destructive practice of subsidizing petrol by pegging the price at 9 cents a liter (34.6 cents per gallon) for the past three years, despite the rapid rise in gasoline prices almost everywhere else around the world.

As with any good, artificially low price, it leads to excess demand and waste encouragement. Because gasoline is so cheap, consumers will use more petrol and won't take steps to conserve.

Second is the far-more-obstinate problem of refining capacity. Refiners literally convert raw crude oil into these usable refined products such as gasoline. They're the key middlemen between crude oil and actual, usable products. This crucial step in the crude oil supply chain is often ignored by the financial media.

Assuming the refineries are working properly, the total throughput of Iranian refineries is less than 1.5 million barrels of crude oil per day. And that's a big assumption; as I've stressed before, Iran has massively underinvested in the upkeep of its energy infrastructure. If refinery accidents and shut-ins are relatively common in countries like the US and the UK, you can imagine the potential if a country isn't investing sufficient cash in maintenance.

At any rate, Iran's refining capacity is no better than 38 percent of its oil production; the country can't even refine half the oil it produces. Nor, for that matter, can Iran even refine close to what it consumes.

The bottom line: Iran actually imports some 40 percent of the oil consumed domestically. Somewhat akin to Coleridge's ancient mariner, Iran is surrounded by crude oil but totally incapable of using that oil domestically.

Importing all that petrol is expensive. Iran's parliament is sensibly concerned with its domestic subsidy program and wants to limit the annual subsidy to $2.5 billion. My guess: A 25 percent price hike isn't going to fix that problem or curb Iran's dependence on foreign refining capacity.

And this isn't a problem just for Iran. When you factor the refining capacity into the global energy puzzle, the picture changes dramatically. Take Venezuelan President Hugo Chavez, for example.

As part of Chavez's "Socialist Revolution," he's implicitly and/or explicitly threatened to cut off US oil supplies; Venezuela exports roughly 1.5 million barrels of oil per day to the US, including both raw crude and oil products. That puts Venezuela behind only Canada and Mexico as a source of petroleum for the American market. In the context of the current tight global crude market, this would seem to be a significant potential problem.

Chavez has, of course, followed up this rhetoric with stunts like offering subsidized heating oil to poor in the US and even getting Joe Kennedy to front that effort. He's also talked with China and the left-leaning mayor of London about ways for Venezuela to divert more of its oil to these countries and away from the US.

But it's important to understand the myriad issues with Chavez's plan. First, much of Venezuela's crude is heavy and/or sour crude. To explain, every day in the newspaper and all over the Internet we hear of crude trading at $60 or $58 per barrel as if it were just one commodity with one price. Typically, the price we hear about will be the New York Mercantile Exchange (NYMEX) futures price, which is based on the price of light, sweet crude oil.

You'll also hear talk of Brent crude, a standard for oil sourced from the North Sea of the UK and Norway. The name comes from the Brent oilfield, located northeast of Scotland's Shetland Islands.

But these are just common types of crude and certainly don't represent the current trading price of every grade of crude on Earth.

Oils are typically described based on two basic properties--specific gravity and sulphur content. Without delving into too much detail, specific gravity measures the density of a substance compared to the density of pure water. According to the standard scientific definition, the specific gravity of water is 1; if a substance has a specific gravity less than 1, it's less dense than water and will float.

To put this into context, 1 gallon (3.79 liters) of gasoline typically weighs a little more than 6 pounds (2.73 kilograms). In comparison, a gallon of fresh water weights closer to 8.3 pounds (3.77 kilograms); that means the specific gravity of gasoline is roughly 0.72 (6.0 divided by 8.3). Gasoline is less dense than water.

In the petroleum business, however, the standard scientific measure of specific gravity is altered by a standard formula to yield API gravity. (API stands for American Petroleum Institute.) API gravity moves opposite to standard specific gravity; in other words, the higher the API gravity, the "lighter" or less dense the crude oil.

Crude oils are graded by API gravity. For example, crude oils with an API gravity of more than 31.1 degrees are considered light crude oils. When you hear the term light, sweet crude on the news, that's exactly what they're talking about.

Crude oils with an API gravity of less than 21.5 degrees are, as you may have already guessed, called heavy crude oils. And crudes with a grade between these two levels are typically termed medium crude oils.

Brent crude typically has an API gravity around 38 to 39, so it's considered a light crude. The NYMEX crude oil futures contract also calls for crude with "not less than 37 degrees API gravity nor more than 42 degrees API gravity." Therefore, this futures contract is also based on light crude oil.

This measure isn't meaningless from a refiner´┐Żs standpoint. Specifically, light crude oils are simpler to refine than heavy crude oils. That's because your typical barrel of light crude oil will tend to yield a higher quantity of useful products such as gasoline per-barrel refined.

Refining light crude into gasoline is a less-complex process than refining heavy crude. Using some more-complex processes, the gasoline yield of heavy crude oils can be increased tremendously. But not all refineries can handle heavy crude economically. That is why light crudes typically trade at a premium valuation to heavy crudes.

The second key terms to understand are sweet and sour. These terms have absolutely nothing to do with taste; rather, both terms refer to the sulphur content of the crude oil. Sweet crudes are relatively low in sulphur, while sour crudes have a higher naturally occurring sulphur content.

The bottom line about all of this is that the most-commonly quoted type of crude oil is light, sweet crude. This is also one of the most-expensive, highest-quality types of crude oil on the planet.

Standard Maya crude has an API gravity of 22 degrees and a sulphur content of 3.3 percent; it's a heavy, sour crude. The current price of Maya crude is about $45 per barrel, a whopping $11 discount to West Texas Intermediate (WTI) and closer to $14 discount to Brent. The chart below shows the difference in price between WTI crude and Maya crude over the past several years.


Source: Bloomberg

Here's the problem for Venezuela: The country has no alternative market to the US for much of its crude. One useful measure in this regard is a refinery's complexity index. Refineries that are able to run heavier, more-sour feedstocks are said to be more complex than refineries that can only run light, sweet crude.

There are a few different ways to measure this, but one of the simplest is to compare a refinery's conversion capacity to its total throughput capacity. Without delving into too much detail, suffice it to say that conversion capacity is what allows a refiner to process heavy, sour crudes.

Venezuela has total refining capacity of about 1.28 million barrels of crude oil per day. The country's total conversion capacity is less than 40 percent of that amount; my crude measure of complexity stands at 38 percent. Venezuela is woefully incapable of refining even a small part of its crude domestically, so it must export that oil to countries where it can be refined.

Of course, the Venezuelan government-owned oil company, doing business as Citgo in the US, owns refineries abroad--mainly in the US mainland and in the US Virgin Islands (St. Croix). Citgo either owns outright or holds a large stake in another 1.1 million barrels per day worth of refining capacity located in the US.

The complexity index for its US-based refineries stands at 83 percent. Obviously, these refineries were set up with the express purpose of handling Venezuelan heavy crude oil imports into the US market. And, as a whole, US refineries are among the most complex in the world; it's a logical importer of Venezuela's crude.

How about those other potential markets? China has total refining capacity of about 6.25 million barrels per day. But the complexity index for these refineries is only 15.5 percent; China can't adequately refine heavy crudes, so the vast majority of Venezuelan oil exports would be useless to China.

Chavez's threats ring hollow when you consider these facts. Chavez needs every ounce of oil revenue he can get to stay in power. Without his oil-funded social programs and "21st century" socialist spending, he'd likely be out of power in a matter of weeks. The fact is he's just as dependent on the US as the US is on Venezuela, perhaps even more so.

Elliott H. Gue is editor of The Energy Letter.

© 2007 Elliott H. Gue

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