Political upheaval in Libya is causing much more turmoil in world stock markets than the popular overthrow of the government in Egypt–even though Egypt is a much larger country with much more influence in Middle East politics. The obvious difference between the two is that Libya is an oil producer and Egypt is not. But when we look at the amount of oil Libya brings to the surface every day, it’s pretty small–1.6 million barrels, or less than 2% of the world’s daily usage. How can that be so important?
The answer is that a lot depends on two factors: the kind of oil Libya has (light, sweet crude) and the ability of the world’s processing capacity to turn different types of oil into usable products.
Wikipedia has a chart that diagrams the structure of a typical oil refinery. It’s complicated. Luckily, six years as an oil analyst taught me that you don’t need to know all the ins and outs. The Cliffnotes version:
1. The primary refining process consists in putting the crude oil in a big metal cylinder and boiling it. Heat causes the crude to break up into three parts:
—the lightest molecules, basically gasoline, that rise to the top of the tube
—medium-weight molecules, jet fuel, diesel fuel, home heating oil, naphtha, that settle in the middle
—the heaviest, industrial boiler fuel or “residual” oil, tar, asphalt and other junk, at the bottom.
The top two parts, or “fractions,” contain most of the value. The third might be hard to give away.
2. An increasing proportion of the oil available for refining is what industry jargon calls “sour” instead of “sweet. “ That is, it contains sulfur, a corrosive element and a pollutant. So most refineries have expensive desulfurization machinery that remove the sulfur from refined products.
3. An increasing proportion of the available oil is also “heavy” instead of “light.” That is, it’s rich in bigger molecules and contains few small ones. Therefore, the primary heating process yields large amounts of the junky stuff at the bottom of the column and very little of the more valuable gasoline and middle distillates.
As a result, most modern refineries also have (again, very expensive) machinery to “crack,” or break up, the large molecules at the bottom of the distilling column into smaller-molecule, more valuable output, like diesel or gasoline.
That’s all you need to know. Light, sweet crude: boil it and you’re done. Heavy, sour crude: spend billions on a “back end” to your refinery so you can make it into stuff people will buy. Why do this? …heavy, sour crude is a lot cheaper.
world refinery capacity: a mixed bag
Building, or even upgrading, a refinery is a pain in the neck. It’s a multi-billion dollar, several year project. It requires educated guesses about what kinds of crude oil, sweet or sour, light or heavy, will be available on the market when the refinery is finished, as well as whether there will be more or less demand from competing refineries for the kinds of crude your plant is optimized for. In addition, in most developed countries, it may be next to impossible to get local government permission for any kind of building. Do you want a refinery in your back yard?
As a result of all this, there’s still a substantial amount of refining capacity, particularly in Europe, where the owners have opted to do nothing. So these plants can’t process anything else except the lightest, sweetest crude.
why Libya matters
That’s where Libya comes in. Yes, Libya is only a small factor in the world oil market (the country may have huge reserves, but that’s irrelevant if they’re not being developed). And it has a reputation as an unreliable supplier. But the 1.6 million barrels it churns out is all easy/cheap to refine light, sweet crude that’s rich in the gasoline and diesel fuel that the US and Europe consume.
There may be lots of “extra” crude oil available on the market. But that’s predominantly heavier and sulfur-laden. These are only substitutes if the refineries that have contracted for Libyan crude can process these lower grade oils as well. The frantic bidding we’re seeing in the market for similar light sweet crude argues that they can’t.
The refiners affected are in a no-win situation. They can scramble to get the crude they need, so they can produce fuel for their retail outlets, in which case they get blamed for higher prices. Or they can simply shut down until Libyan crude is available again, in which case they’d take the political heat for supply shortages.
In the short term, then, the mismatch between the capabilities of the world’s oil refining plants and the “slate” of crudes available to refiners will translate into higher retail prices. Because of the unusually pure nature of Libyan crude, withdrawal of even that country’s small contribution to world crude production can cause this.
stock market effects
I don’t have any idea how the Libyan situation will play out politically. My guess is that virtually none of the “experts” talking or writing about Libya do either. The least favorable outcome for the world ex Libya would be a years-long cessation of that country’s oil production–sort of a mini-Iraq. World refined products prices might be, say, 5% higher than they would otherwise be. Consumers in the US, where taxes on gasoline are very low by world standards, would be disproportionately hurt.
Even in this case, though, I think there are much more powerful currents affecting the US economy–like the pace of recovery, mobile broadband, internet-enabled erosion of brick-and-mortar retailing. Yes, the US would be hurt, yet again, by Washington’s failure to have a coherent energy policy. But we deliberately haven’t had one for thirty-five years, so that’s not real news. And somewhat higher oil prices could get lost in the welter of other, structural things going on.
To my mind, the current downdraft in world stock markets has very little to do with Libya. It has more to do with how high the markets have gone in the past six months.
The S&P 500, for example, has been steadily rising since September and is up by 28% since then. Time for a correction?
Looking at the market from another perspective, the S&P was up more than 7% year to date as of mid-day last Friday. Assume we could have closed out the month that way. If 7% were an average two-month return on stocks, then the yearly return would be 42%–or 4x what history tells us is the norm for stocks. In year one of a bull market, this might be possible. But approaching year three? …no way.
To my mind, Libya is more a trigger than a cause for investors to take profits after this run. If it hadn’t been Libya, it would have been something else.
One interesting characteristic of world equities over the past few months has been–until this week–the unwillingness of stocks to go down. I’ve been reading this as being the result of an asset allocation shift to equities and away from cash and bonds. If so, it will be important to watch for how deep this correction is and how long it goes on. Continuation of flows into stocks would argue that the correction will be shallow and brief. Looking at the charts, the first line of defense for the S&P is around 1300.
In short, I’m reading this downdraft as a natural part of the two-steps- forward, one-step-back character of equity markets.
Most investors simply don’t look at prices during a period like this. That’s ok with me. I’ve always found these times to be good for upgrading your portfolio. Stocks that have done poorly over the past year probably won’t go down much in a correction (after all, they didn’t go up), while strong-performing stocks can be hurt badly as nervous investors “lock in” profits. So you may be able to switch to better companies at a 10%-20% cheaper price than you would have been able to last week. The fewer investors doing this, the better bargains for those who are.