As heavy oil price soars, refiners face reckoning

NEW YORK/HOUSTON (Reuters) - Heavy, sour crude -- normally counted on as a cheap alternative to light, sweet oil -- is surging in value and punishing U.S. refiners that spent billions of dollars on machinery to process tarry oil.

Any rebound may depend on OPEC restoring output of heavy-sour oil it has cut since late 2008, but analysts say that could take many months.

The largest U.S. refiner, Valero Energy Corp (VLO.N), said Tuesday it expects a 50 cent per share loss in the second quarter, in part due to smaller-than-normal discounts for heavy-sour crude affecting its margins.

"The differentials are far from normal levels but it could take a balancing of supply and demand, perhaps in 2010, to see a return to normal," said Jason Gammel of Macquarie Research Equities in New York.

Heavy, sour oil requires expensive extra processing to convert into products like gasoline and diesel. San Antonio, Texas-based Valero and other companies have made major investments in equipment like cokers in recent years to do that.

After OPEC agreed to reduce output by 4.2 million barrels a day since September to boost prices, its members cut mostly heavy-sour oil, which is usually less valuable.

That has hurt refiners, which sought more of the cheaper crude to cut costs during an economic downturn.

"When margins are weak, refiners seek the cheapest source of crude their equipment will permit," said Carl Holland of Energy Trading Solutions in Connecticut. "This means high sulfur, heavier gravity crudes."

Light, sweet crude is trading near seven-month highs of $70 a barrel, but heavy-sour crude now costs almost as much, despite its added processing costs.

Heavy-sour Mars from the U.S. offshore patch has historically dealt for about $5 a barrel less than West Texas Intermediate futures. It now trades at $1.70 below WTI.

Mars even surged to a rare premium to WTI earlier this year, when a storage glut in Oklahoma -- the delivery point for light-sweet oil futures -- cut WTI prices sharply.

'DARK AGES OF REFINING'

The more narrow spreads are just one source of gloom for big U.S. refiners, which have seen margins plunge along with fuel demand during the recession.

Credit Suisse expects more downward earnings revisions. "The Dark Ages of refining are upon us," the bank said in a report on Thursday. "The U.S. refining industry needs less capital, not more."

U.S. refinery crack spreads -- the difference between the cost of light, sweet crude oil and wholesale price of petroleum products -- have narrowed to around $11 a barrel, versus about $20 a barrel in June of 2008.

U.S. refiners able to process Mexico's heavy-sour Maya crude last year, when that crude was $16 a barrel cheaper than WTI, enjoyed an extra $13 per barrel in profits, one industry source estimated.

Maya's discount to WTI has narrowed to an average $4.50 a barrel this year.

Valero has been most aggressive in converting its refineries, but others including Shell (RDSa.L), Marathon (MRO.N), Total (TOTF.PA) and ConocoPhillips (COP.N) are still planning almost $30 billion in additional U.S. refinery upgrades that include new or larger coker units. Now, several delays have been announced.

"The trend is still to build higher-complexity refineries, but those looking for a fast payback on the big deep conversion investments made in 2006-2007 will have to wait significantly longer," said Mark Sadeghian of Fitch Ratings.

More expensive sour could be a boon for refiners like Sunoco (SUN.N), which hasn't invested much to run sludgier crudes.

Differentials may return to more typical levels as OPEC pumps more, said Tim Evans, of Citi Futures in New York. OPEC countries have already reduced compliance with output cuts, "but we may see a formal rollback of quotas when OPEC meets in December," he said.

Producers like Mexico, with a cash-strapped oil industry, have also cut heavy-crude export levels. Maya exports peaked in 2004 at almost 1.8 million barrels a day, but slid to 1.1 million bpd in April.

As deep-conversion refineries become more popular, the U.S. is importing more heavy-sour oil. In March, heavier crudes -- with API gravity below 25 -- accounted for 46 percent of U.S. imports, up from an average 37 percent last year, and 23 percent 10 years ago.

(Additional reporting by Robert Campbell in Mexico City; Editing by Jeffrey Jones and David Gregorio)