* S. Korea, Singapore blend cheap fuel oil with condensate as feedstock
* Fuel oil-condensate blend cuts residue yield, boosts high-value products output
* Japan's TonenGeneral processing more, Cosmo considers buying fuel oil
By Florence Tan and Jane Xie
SINGAPORE, Dec 23 (Reuters) - Asian refiners are increasingly replacing costlier crude oil with a low-value oil product to produce higher value fuels, in an attempt to control costs and stem a decline in profitability.
They are buying fuel oil, a cheap residue of the crude refining process, and blending it with condensate, a super light oil, for processing at their plants. By doing that, the refiners are able to cut input costs, curtail output of the loss-making residue and produce more high-quality oil products.
The shift toward cheaper feedstock may dent Asia's crude oil demand and cap price gains, especially as Japan, which usually pays the highest spot premiums for crude imports, gears up to increase the use of the alternative raw material.
South Korean refiners have already increased imports of straight-run fuel oil (SRFO), which enables easier blending and processing, and demand from China and Singapore has remained robust. Japan's import demand will grow as the closure of another two crude distillation units (CDUs) by March will tighten domestic supply.
"It should be a long-term trend, as long as crude prices remain expensive and fuel oil is relatively cheap," said a South Korean trader, referring to the use of fuel oil as feedstock.
Oil refiners face weak margins for turning crude into products over the next five years as capacity additions are forecast to outpace demand growth.
Refiners say profit margins are lagging the rise in Middle East crude prices, forcing them to look for alternatives.
The official selling price of Abu Dhabi's flagship Murban crude has averaged $6 above Dubai quotes between September and November, hitting the highest since May 2008. But the $18 profit from making a barrel of gasoil - one of the most profitable oil products - is a far cry from the $40 seen in 2008.
Russian SRFO, commonly known as M100, blended with Qatari deodorised field condensate could be $2 a barrel cheaper than Murban, traders estimated. Costs could be lowered further if Iranian fuel oil and condensate were used, a trader said.
By processing the blend at their plants, refiners can reduce output of fuel oil and increase the yield of more valuable products such as naphtha and gasoil.
Fuel oil makes up almost half of the output when refiners process Middle East crude. Refiners stand to lose $9.63 this year for producing each barrel of the residue fuel with Dubai crude versus $5.67 in 2012, Reuters data showed.
The wide price gap is helping to draw more users.
Japanese refiner TonenGeneral Sekiyu KK has recently bought more SRFO and is also considering another alternative feedstock - vacuum gas oil, a source familiar with the matter said.
Domestic rival Cosmo Oil too is considering buying SRFO as raw material, for the first time, another source said.
Forecasts of weak refining margins may encourage refiners to continue processing more of the fuel oil-condensate blend as long as the residue's price gap with crude stays wide.
Asia's average monthly imports of SRFO, at 350,000-450,000 tonnes, however, are small compared with the 70-80 million tonnes of crude it buys, according to Thomson Reuters Oil Analytics.
Top SRFO suppliers Russia and Iran will be two key wild cards in ensuring the price gap remains for refiners to continue processing straight-run fuel oil.
Russia is expected to keep SRFO exports steady as new conversion units will come online only from 2015, energy consultancy JBC Asia's managing director Richard Gorry said.
And any increase in Iranian oil exports following continued progress of talks with world powers to end Tehran's decades-old nuclear dispute may weigh on prices.
Traders and refiners are also watching China's demand for the product. Beijing has allowed two more independent refiners, often called teapots, to import crude next year.
That will mean teapots, which typically process fuel oil to produce more expensive fuels, could start using crude oil in their facilities.
China's SRFO imports were largely steady at about 1.1 million tonnes in the first 10 months this year, despite rising crude imports by its largest independent refiner, ChemChina, suggesting strong demand for the fuel.
"We expect the crude import quota for independent refiners to have a meaningful effect only in the second half of 2014," JBC's Gorry said, citing logistical and regulatory hurdles faced by new importers that could keep China's SRFO demand steady. (Additional reporting by James Topham in Tokyo; Editing by Muralikumar Anantharaman)