Among the reasons for decline in prices, Barclays notes that despite a lower call on OPEC, Saudi Arabia has maintained elevated production levels, and other OPEC producers have raised output
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All crude oil contains some impurities. When the total sulfide level in the oil is 1 % the oil is called "sour." Sour crude oil contains the impurities hydrogen sulfide (H2S) and carbon dioxide, or mercaptans.
The impurities will need to be removed before this lower quality crude can be refined into gasoline, thereby increasing the cost of processing. This result in a higher-priced gasoline than one made from sweet crude oil. Sour oil is toxic and corrosive, with high levels of hydrogen sulfide. The oil has the smell of rotten eggs, and at high concentrations the inhalation of hydrogen sulfide is fatal.
The name given to barrels of crude oil that meet certain content requirements, such as low levels of sulfur and hydrogen.
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Sweet crude future contracts are the most popular oil contracts traded on commodity markets. This type of oil is much easier to refine than sour crude.
Crude oil produced by different fields differs importantly in viscosity and sulfur content. The more viscous crudes (as measured by a lower API gravity) are called "heavier," and those with higher sulfur content are called "sour" (as opposed to low-sulfur "sweet" crude). The heavier and more sour the crude, the more difficult and expensive it is to turn into usable refined products.
One factor contributing to the dramatic increase in the price spread is a decrease in the supply of light, sweet crude. The higher quality crude supplies of course get used up first, so the world is now increasingly reliant on a lower quality product.
While supply of light, sweet crude has gone down, the demand has gone up. In January 2004, the U.S. EPA's Tier 2 low-sulfur gasoline regulations began to be implemented.
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.
The third critical ingredient is refining capacity. British Petroleum reported that global refinery capacity increased by 1.8 million barrels a day between 2001 and 2004, while global crude production was up 5.3 mbd. Moreover, not enough of this capacity is able to process the increasingly heavy and sour crude supplies. Chernoff again:
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.
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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.
Although the change in the price spread is pretty dramatic, the explanation is quite simple: (1) supply is down, (2) demand is up, and (3) the capital investments necessary to cope with facts (1) and (2) were not made. Government regulation in response to environmental concerns appears to have played an important role in both (2) and (3).