Like bartenders putting cheap alcohol into their cocktails, some U.S. refiners are reaping huge profits these days by relying on lower-quality crude oil to make everything from gasoline to diesel.

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Like bartenders putting cheap alcohol into their cocktails, some U.S. refiners are reaping huge profits these days by relying on lower-quality crude oil to make everything from gasoline to diesel.

The difference is that, unlike martinis mixed with barnyard booze, these finished fuels, after a little extra work, are the same quality as those made with top-shelf ingredients and therefore fetch the same high price from consumers.
The world’s premium oil is described as light, sweet crude and most refiners prefer it because it is low in sulfur, easy to process and yields the most volume per barrel of the transportation fuels in greatest demand. This preference has been magnified by environmental laws that require the industry to produce cleaner burning fuels.

But as the world’s oil thirst swells to more than 84 million barrels a day and producers struggle to keep up, the extra supply being brought onto the market, primarily by Saudi Arabia, is the heavy, sour variety. Trouble is, not all refiners have the equipment needed to process it.

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As a result, the already high price of light, sweet crude has been magnified, with each barrel selling for more than $50 on futures markets. By contrast, there is a relative abundance of medium to heavy crudes that sell for much less and that puts refiners who can process it in a very good position.

Depending on the precise chemical composition, lower-quality oil is selling at discounts ranging from $7 to $17 per barrel, when compared to light, sweet crude. A year ago, heavy, sour crudes, whether from Mexico, Venezuela or Canada, were discounted by about half that much.

“The sweet-sour spreads have never been this good,” said Gene Edwards, senior vice president of supply and trading at San Antonio-based Valero Energy, the nation’s largest independent refiner and the leading processor of sour crude.

The gap has narrowed somewhat after the Saudis reined in production earlier this year to comply with reduced output targets set by the Organization of Petroleum Exporting Countries. And analysts say today’s sharp price disparity is likely to narrow further over time, as more sour-crude-refining capacity is added and as Saudi Arabia or some other producer taps new fields that produce lighter crude to meet rising global demand.

However, assuming the global demand for oil remains strong, the discounts are not likely to return to historical norms anytime soon.

“The same trends are likely to be in place for the next three to five years,” Edwards said.

Despite the extra costs associated with processing lower-quality crude, the profit margins of independent refiners able to handle it are up sharply. For example, Valero reported net income in 2004 of $1.8 billion, nearly three times its results the year before, while Premcor’s profits tripled to $478 million. Valero’s shares have more than doubled in the past year, while Premcor’s are up slightly less than that. Shares of Frontier Oil have also soared.

Valero attributed its stellar fourth-quarter results to its “superior leverage to sour-crude discounts,” which were $10 per barrel cheaper, on average, than the price of West Texas Intermediate, the light, sweet oil that futures prices are pegged to on the New York Mercantile Exchange.

More than half the oil used by Valero — some 1.3 million barrels a day — was sour during the fourth quarter, including Mexican Maya, which accounted for nearly 1 out of every five barrels and averaged $16.75 per barrel cheaper than WTI, according to the company. The company also processes heavy, sour crude from the Gulf of Mexico known as Mars, which has become the U.S. benchmark.

In the past two years, Valero has significantly expanded it ability to process heavy, sour crude, by acquiring a 315,000 barrel a day refinery in Aruba and a 185,000 barrel a day refinery in Louisiana. The company also completed in late 2003 the expansion of its heavy, sour-processing capacity at a refinery in Texas by 45,000 barrels per day.

Fadel Gheit, senior oil analyst at Oppenheimer in New York, said the decision in recent years by Valero and others to expand their heavy, sour refining capacity has proven to be “brilliant.”

Premcor, a small independent refiner based in Old Greenwich, Conn., is also betting its future on the profit potential inherent in lower-quality crudes. In November, for example, Premcor announced that it was pursuing a 50-50 joint venture with Canadian oil producer EnCana Corp., whereby Premcor’s refinery in Lima, Ohio, would be modified to process about 200,000 barrels a day of heavy oil supplied by EnCana.

In a similar move, Canada’s Suncor Energy is spending $300 million to upgrade a refinery it owns in Denver, where it intends to process increasing volumes of heavy crude produced from its oil sands operations.

Refining analyst Aaron Brady at Cambridge Energy Research Associates said these types of deals could become more common as Canada and other nations ramp up production of heavy, sour crudes.

“That stuff is all looking for a home,” he said.

But as more “homes,” or refineries, are built to handle sour crude, the profit margins will dwindle, said Cal Hodge, a former Valero executive who runs a Houston-based consultancy specializing in clean fuel issues.

“Just watch for history to repeat itself,” Hodge said.