June 9, 2023 [Reuters]- Having been surprised by Saudi Arabia announcing a unilateral 1 million barrels per day cut in oil output for July, oil refiners got more bad news when Saudi Aramco (2222.SE) informed Asian customers that prices for July-loading cargoes were going up.

Prior to the decision to increase the official selling prices (OSPs) for crude to be shipped in July, refiners in the top-importing region had been expecting prices to be lowered.

Saudi Arabia’s unexpected, solo cut in output came after the rest of the OPEC+ group decided at a meeting not to immediately add to their surprise 1.16 million bpd reduction in output announced after their April 2 meeting.

Justifying the Saudi decision, Energy Minister Prince Abdulaziz bin Salman stuck a somewhat contradictory theme, saying: “We don’t want people to try to predict what we do … This market needs stabilisation.”

After which, Aramco promptly increased OSPs.

The Saudis have in the past maintained that output decisions are taken by the energy ministry and are entirely separate from pricing decisions, which are made by state-owned Aramco based on market factors.

For this reason the political decision to cut output should have had no impact on the OSP decision. The fact that Aramco raised the OSPs when the market anticipated a cut was a major surprise and at odds with the market view of the current state of refining margins and fuel demand

The OSP for the benchmark Arab Light grade for July cargoes to Asia was increased by 45 cents a barrel from June’s level to $3.00 a barrel over the regional Oman/Dubai price marker.

Refiners surveyed by Reuters ahead of Monday’s announcement had expected the OSP for Arab Light to be cut by about $1.00 a barrel for July.

With the decision to increase the OSP, Saudi Arabia’s Asian customers are facing the prospect of margins shrinking even further, as well as uncertainty over the state of demand given rising fears of a global recession.

How they respond will be key to the path of crude oil prices in coming months.

The obvious path for Asian refiners to go down is to buy less Saudi oil, or crudes from other Middle East producers who tend to follow the Saudi lead on pricing.

Aramco sells the bulk of its crude under term contracts, but it is believed that these include provisions for either party to vary volumes up to a certain level.

This allows Aramco to reduce the volume supplied when the Saudis decide to cut output, as they just did.

But it also allows refiners to lower the amount of crude they buy from the kingdom if they are concerned about fuel demand, or indeed if they take the view Saudi crude is uncompetitive against competing grades.

LIMITED CHOICES

The problem for refiners in Asia is that there are limited alternatives to the crude supplied by the Saudis and other Middle East producers such as the United Arab Emirates, Iraq and Kuwait.

Russian, Iranian and Venezuelan crudes are all under some form of Western sanctions, meaning they can really only be bought by the big players in China and India.

U.S. crude and other grades from exporters in the Americas such as Brazil and Mexico can go some way to replacing barrels from the Middle East, but these have to be significantly cheaper in order to make the economics work, given the higher freight and insurance costs involved.

Ultimately, some refiners in Asia will face the choice of shrinking their profit margins even further, or reducing throughput in the hope of boosting retail fuel prices by creating scarcity.

There isn’t too much scope for margins to drop, with the profit per barrel of crude at a typical Singapore refinery ending at $4.45 on Monday.

This is a simple calculation of estimating profit by adding up the price of the various fuels produced and subtracting the cost of a barrel of regional benchmark Dubai crude.

As such it doesn’t include other items such as sustaining capital, taxes and operating costs, meaning that the low margin likely means many refiners are already operating at an overall loss.

This means refiners are likely to cut operating rates if they can’t secure crude cheaper than what is being offered by the Saudis.

The potential exception is refiners in China, the world’s biggest oil importer.

China has in the past trimmed imports and used up some of its ample stockpiles if refiners there take the view that oil prices are too high, or have risen too quickly.

It’s possible that Chinese refiners will continue to operate at high run rates in coming months, but keep imports largely steady.

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