Crude oil: Variants and pricing dynamics

At a time when many commodity-led economies, especially in the emerging markets are still reeling under the unpleasant realities of the prolonged drop in crude oil prices, it’s a useful exercise to gain some basic awareness of how the market for crude oil and other primary energy commodities work. This is the first in a series of articles that aims to provide interested readers with a basic understanding of energy market concepts, terms, principles and market realities from a commercial, economic and financial viewpoint.

This introduction will focus on the physical origins of crude oil and key forces that affect price and quantities observed in global markets.

The word petroleum was coined from a combination of two Greek words: “petr” (which means rock) and “oleum” (which means oil). Therefore, petroleum (or crude oil) means oil from the rock (or from beneath rocks). It belongs in the family of hydrocarbons which occur in three basic forms. Hydrocarbon that occurs in liquid state (with varying degrees of thickness or viscosity) is referred to as crude oil. When it occurs in gaseous form, it is called natural gas (which includes methane, propane, and butane). When hydrocarbons occur in solid state, it is called coal.

Conventionally, deposits of crude oil are found mostly in coastal, swampy areas or some hundred of meters away from the coastal areas into the ocean. In its raw form, crude oil comes in different grades but for the retail end-user, it is delivered as fuel products in the form of gasoline (known in Nigeria as premium motor spirit), diesel, kerosene and jet fuel and other by-products.

In some market jurisdictions, jet fuel (popularly known as Jet A-1 or Jet A) can be substituted for domestic-use kerosene (in which case, it is called dual-purpose kerosene or DPK). However, aircraft engines that run on DPK do require more frequent servicing than those that run exclusively on aviation fuel (or Jet A-1/Jet A/Jet B). Other by-products of crude oil include non-fuel outputs such as lubricants, bitumen and other residual products in the plastics and petrochemicals industry.

The oil industry value chain consists of activities that are involved in finding, discovering, developing, producing and moving crude oil into refineries. It also includes the refining process itself as well as marketing and distribution activities involved in getting refined products to the final consumers. These stages can be categorized as upstream (exploration, development and production), mid-stream (crude oil transportation and refining) and downstream (marketing and distribution of refined products).

Depending on the region and physical environment from which it is extracted, crude oil differs in grade based on two important qualities: viscosity (or thickness) and the sulphur content. Crude oil grades with high viscosity are described as heavy crude while those with low viscosity are described as light crude. Viscosity is measure by the API (American Petroleum Institute) gravity index. In the same vein, crude oil grades with low sulphur content are described as ‘sweet’ while those with higher sulphur content are described as ‘sour’. Hence, ‘light sweet’ crude which Nigeria produces is a grade that combines low-sulphur content with low viscosity.

In crude oil pricing, crude oil variant that has a higher viscosity (heavy crude) than a market benchmark or reference crude (e.g. the Brent crude) will attract a price discount while those with lower viscosity (light crude) will attract a premium. The price is also adjusted upward (for lower sulphur content) or downward for (higher sulphur content). Traditionally, refineries found it easier and cheaper to process light-sweet crude variants than the heavy/sour grades. This explains why until recently, Nigeria’s main crude oil variant (the Bonny light/sweet crude) was in high demand and commanded a premium. Conversely, heavier crudes such as the variants from Qatar, Venezuela and Chad sold at a discount due to lower demand.

Higher grade crude can be processed to produce a higher volume of high-value outputs (e.g. gasoline and diesel). The yield is measured by the ‘crack spread’ which specifies the volume and breakdown of (both high-value items + low-value items) output that one can expect from x barrels of crude oil.

In recent years, especially with the advent of shale oil (and oil from other unconventional sources), many refineries in the developed world have been retro-fitted to enable them handle ‘tougher’ variants of crude inputs in an efficient manner. It’s important to note however that because refiners usually source crude from various sources, the practice is to blend available stocks of crude to meet certain specifications ahead of actual processing. Finally, the enhanced processing capacity of many refineries has resulted in a significant drop in demand for what used to be premium crude. For example, Nigeria’s crude oil export to the US was on the decline since 2005 and actually hit a bottom in 2015 when zero shipment was recorded in at least one month.

David Adeoye