Saudi Arabia, a producer of medium to heavy crude oil, should account for 40 per cent of the pledged cut, reducing output from 10.63 million b/d in November to 10.05 million b/d by 2Q17.

Crude oil light-heavy spreads have widened over the past couple of years following Saudi’s decision to engage in a market share war with the US shale industry.

The US shale oil industry lost 990 thousand b/d of production between 2Q15 and 4Q16, suggesting that the global crude slate turned more heavy throughout that period.

Over the past 25 years, Saudi deliberately cut its crude production in 1999, 2002 and 2009. In each of these three episodes, the share of light crude production has increased at the expense of medium grade output. The historical pattern to sell more profitable (light) grades should be no different or even more pronounced this time around as the kingdom needs to maximize its revenues in this low price environment.

Saudi crude exports to the US have already decreased significantly in December, against the seasonal patterns.

Output in Libya, the main producer of light-sweet crude in the region has seen a remarkable rebound from 280 thousand b/d in August 2016 to almost 700 thousand b/d this month. Bank of America Merrill Lynch expects crude output to reach 900 thousand b/d by the end of the year as Libya, together with Nigeria is exempt from the OPEC deal. However, this number could be reached much earlier.

Growing light crude oil supplies combined with fewer medium to heavy barrels will mechanically lead to a structural narrowing in the light-heavy crude spreads around the globe. In fact, the Brent-Dubai spread already narrowed since 2Q16 on strong buying interest of Middle Eastern crudes from Asian refiners and has recently reached the lowest level since October 2015.

Brent-Dubai forward spreads are currently trading at a premium to spot spreads but this trend should reverse in the coming weeks.

“As we highlighted early last year, crude oil light-heavy spreads have widened over the past couple of years following Saudi’s decision to engage in a market share war with the US shale industry. Surging OPEC output has increased the availability of medium to heavy crude grades while US light sweet production was forced to shut down on unsustainable economics. Now the tables are turning. On November 30, OPEC agreed to cut output and some non-OPEC nations followed suit on December 10, setting the stage for another shift in global crude oil gravity. Saudi Arabia, a producer of medium to heavy crude oil, should account for 40 per cent of the pledged cut, reducing output from 10.63 million b/d in November 2016 to 10.05 million b/d by 2Q17,” said the report.

“The key question is whether Saudi will cut output evenly among its three main crude grades or favor some over others. The historical pattern to sell more profitable (light) grades should be even more pronounced this time around as the kingdom needs to maximize revenues in this low price environment. Elsewhere, whether it is Libya, the US, Russia or even Canada, the share of light oil relative to medium oil supplies is poised to increase in the coming months. For US refiners, the average crude slate is set to return to the patterns seen during the shale oil boom and become lighter. In fact, given the narrowing light-heavy spreads, and potential tax reform on imports and exports from the new administration, US refiners may be encouraged to import less crude, process a lighter crude slate and export more gasoline to meet growing EM demand.

“In our view, such a shift in the global crude quality is not fully reflected in the market at the moment. Brent-Dubai forward spreads are currently trading at a premium to spot spreads but this trend should reverse in the coming weeks. Similarly in the US, the LLS-Mars spread has more room to tighten in our view, especially in 4Q17, when demand for distillate products picks up seasonally. Naturally, our view implies that OPEC complies with its pledged curtailments, and that WTI crude oil prices increase to the mid to high $50’s, allowing US light-sweet production to rebound gradually.”

Source: CPI Financial – BofA Merrill Lynch