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Why Libya Is Important to Oil Prices

As most investors are well aware, oil prices have surged as turmoil in Libya has risen. Increased violence in that North African nation has knocked out at least half the country's production of 1.6 million barrels a day of oil.

Lower output from Libya's oil fields comes at an inconvenient time for global economies.

The world's thirst for oil is especially strong right now in diesel and other distillates. According to JPMorgan, these distillates will account for more than half the world's demand growth in oil this year. An important fact to keep in mind is the fact that it takes more of heavier oils to produce diesel than it does light crude oil from Libya.

In addition, environmental regulations globally are clamping down on fuels with high sulfur content to combat air pollution. For example, Europe this year limited sulfur content in fuels for some machinery and on inland waterways. And in 2012, Europe will expand the restrictions to trains too.

Similar trends are taking place in the United States. The US Department of Energy just sold 2 million barrels of high-sulfur heating oil from a strategic reserve. It will soon be bidding for the same amount of low-sulfur oil this summer, further stoking demand for sweet crudes, such as come from Libya.

Libya's Oil

Stock markets rallied earlier this week as Saudi Arabia announced that it would make up for any shortfall in Libyan oil production. But the solution is not that easy people who bought stocks on that news really don't understand the oil market.

Yes, it's true that Libya produces only 1.6 million of the globe's 87 million barrels of oil a day. However, it produces some of the most coveted and highest quality light, sweet crude oil on the planet. Its crude is easily refined into gasoline and diesel. It is also lower in sulfur, making it cleaner to burn.

Libya's crude oil stream includes Es Sider, whose light density and low sulfur content makes it desirable. Even more desirable is the oil from the huge El Sharara oil field in Libya run by Spain's Repsol. This oil is a mere 0.07 per cent sulfur!

Saudi Arabia is the de facto custodian of OPEC's 4.7 billion barrels a day of effective spare capacity. However, Saudi crude oil overall is not of the same quality as Libya's.

Most of the country's production is classified as medium crude oil. Arab Light, the leading Saudi oil by volume, is a relatively high 1.8 per cent sulfur and heavier. This makes it more difficult to refine into light products such as diesel and other fuels.

The Future for Oil Prices

The take away for investors is that the Saudis have adequate spare supplies to replace Libya's lost production. But the quality of the oil is mostly inferior. You can't just substitute one barrel of Saudi oil for one barrel of Libyan oil. For example, it takes three barrels of Saudi oil to make as much diesel as Libyan oil.

This means oil companies will have to do more than just replace lost production barrel for barrel. Ideally, they will also need to find new sources of light, sweet crude oil.

Other regions of the globe producing high-quality crude oil include Nigeria, Angola, Algeria, the North Sea and the region surrounding the Caspian Sea. Most of these regions aren't exactly politically stable either.

One definite trend that will continue for the foreseeable future is that the bidding for high grades of crude oil by oil companies will further raise prices for the kinds of high-quality crudes that underpin benchmark oil futures contracts. It most likely will also reduce fuel output from refineries unable to afford the higher prices.

As mentioned earlier, this is happening at precisely the time when demand for low-sulfur oil is increasing. This has raised fears of a repeat of 2008, when oil prices moved above $145 a barrel.

Two factors though may prevent oil from reaching those lofty levels, at least for now.

The first is that since 2008 refiners have invested hugely in turning barrels of heavy oil into light products. Global refinery distillation capacity is also up 3.3 million barrels per day since 2008 to 92.5 million barrels a day.

Oil inventories in developed countries are also higher than levels were in December 2007. In the United States, the 727 million barrel strategic oil reserve contains 293 million barrels that are low in sulfur.

However, due to the spreading unrest in North Africa and the Middle East, oil prices will not move back to $75 a barrel anytime soon. The turmoil is particularly unsettling in Bahrain, because of its proximity to Saudi Arabia and the presence of a major US Naval base there.

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