Juneau, Alaska

(907) 699-6788 ed.king@kingecon.com

Alaska Might Be Benefiting from Oil Sanctions

Alaska North Slope (ANS) oil has been selling at a premium to Brent for nearly a year, and we are seeing millions of dollars of added benefit as a result. The mostly likely cause is oil sanctions on Iran and Venezuela.

Let’s explore the situation.

Refinery Inputs

Each refinery is designed to manage a certain type of crude oil, which varies on two basic dimensions: the specific gravity and the sulfur content of the oil.

The specific gravity is a measure of how “heavy” the hydrocarbon molecules are. The sulfur content measures how “sour” the blend is (a crude is considered “sour” when it has a sulfur content greater than 0.7%). Refineries operate most profitably when they refine a crude closest to the type it is designed to handle.

Alaska produces a crude oil that is of medium weight and is a little sour. It’s gravity measure comes in at 32.1 API with a sulfur content of 0.96%.

The primary consumers of Alaska’s crude oil are the refineries located along the US West Coast. They are mostly in Long Beach, California, with a few in the Bay Area, and a handful in the Puget Sound.

These refiners currently look to purchase crudes with around 29 API and 1.3% sulfur content. See the graphs below generated from EIA data.

This means that ANS is almost exactly what these refineries are looking for (after all, they’ve been designed to handle Alaskan Crude for 40 years).

When we look at how much those refineries are paying for ANS compared to other oil blends (which is called the “price differential”), we can see how the value of those crudes are changing.

That is, when the general value of oil changes, all crude oil blends move together. But, when two blends see their differentials move, it implies that the value of one crude has become more or less valuable than the other.

ANS to WTI Crude

Prior to 2011, ANS sold at an average discount of $1.74 to WTI. Then, the shale revolution flooded the Gulf Coast market. With more oil being produced than could be efficiently used, midcontinent oil went on a fire sale.

Suddenly ANS (whose market was mostly unaffected) became significantly more valuable than those midcontinent crudes that had no outlet to the global markets.

That differential narrowed over the next 6 years as transportation systems adjusted to the new production landscape.

But, in 2017, something changed again. Suddenly, ANS became increasingly more valuable than the light-sweet crude coming from those shale plays.

By the way, this differential is expected to narrow again over the next year as new pipelines open.

ANS to Brent Crude

Alaska North Slope crude typically follows Brent more closely than WTI. That’s because both crudes are put on to oil tankers and shipped to coastal refineries over the ocean. Meanwhile, WTI is mostly delivered by pipeline around the US, east of the Rockies.

But, the ANS to Brent differential has changed in the last few years.

In 2016, ANS regularly sold at a discount of $2 to Brent. That differential narrowed to an average discount of just $0.35 during the next two years. And then, beginning in November of 2018, the differential flipped. ANS began selling at a premium to Brent. And it has continued to sell at a premium ever since.

It isn’t completely unheard of for ANS to sell at a premium to Brent, but it is unusual for it to persist for this long. It’s not as though the differential flips every summer or that there is some other cyclical explanation either. Something must have changed.

Possible Explanation

One explanation, that seems to make sense, is that the global market for heavier crudes is out of balance. This is partly due to the tremendous increase in light-sweet crude oil production pushing down on the price of oil across the spectrum. This results in a crowding out of heavier crude oil production that is more expensive to get out of the ground (like Alberta oil sands).

But, another reason is that the oil being disrupted by sanctions on Venezuela and Iran are of the medium/heavy-sour variety. This implies that the oil West Coast refineries are built to handle is in short supply. When something is undersupplied, it puts upward pressure on the price of that good.

The timing of this argument also lines up. The Iran sanctions were put in place last summer, around the time the differential began to really shift. When the waivers for those sanctions expired and Venezuelan sanctions were implemented, the ANS-Brent and ANS-WTI differentials appear to have widened.

Financial Impact

It’s unclear exactly where oil prices would be without those sanctions, or how the differential would look right now. It’s also unclear where the differential will head next (it has traded at a $2.17 premium so far in July, with a high of $3.25 and a low of $0.90).

But, if we just assign a $3 bump (going from -$2 to +$1) in the relative price of oil during the last 12 months, that adds up to $550 million of additional value. Of that, the State treasury probably received an extra $100 million or so of financial gain.

What to Expect

Even with the oil sanctions in place, the market is currently oversupplied with oil. OPEC has extended their commitment to reduce production, but does not appear willing to cut deeper.

On top of that, the risk of a global economic recession appears to be increasing, putting downward pressure on oil demand forecasts. Combined, the short-term outlook for oil prices is more bearish than bullish until something happens to rebalance the market.

This means that if the oil sanctions are lifted, we should expect even more oil flowing into a crowded market place. The result would be a reduction in oil prices across the board, likely down to the mid-$50’s for Brent.

But, we would also expect to see the ANS-Brent differential flip back, wiping out the temporary premium we are currently getting, on top of the general price reduction.

Moral of the Story

So, the moral of the story is to proceed with caution. ANS is already trading at a few dollars more than it “should” be. And, current market conditions suggest that we shouldn’t expect oil prices to go much higher, without a serious disruption in the global supply chain (which is certainly possible).

But, don’t extrapolate the current conditions too far into the future. Oil markets change quickly and constantly. Trying to see the future while our view is obstructed by the present is like trying to plot a course from behind a mountain. It’s better to rely on information collected from a much higher vantage point to understand the general lay of the land.

And, if something crazy does send oil prices through the roof over the next few months, don’t spend the windfall. We will need it when gravity takes over and sends prices crashing back to Earth.

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