Oil Fundamentals: Crude Oil Grades and Refining Process

First of all, I would like to give credit to Liying Zhao (Options Engineer at HyperVolatility) for helping me to conceptualize this article and to gather the necessary information to develop it. There will be other articles describing the physical side of the crude oil market so this is simply “the first gear of a more complex apparatus”.

The present analysis is not a quantitative research on the oil market and its aim is to list the most important aspects to consider before investing or trading the black gold. Consequently, the focus will primarily be on the petroleum physical market and on how the oil industry works. The HyperVolatility team spends a great deal of time analyzing and trading commodity markets, hence, crude oil positions have always had a considerable weight in our portfolio. Also, the great attention towards commodity markets generated by the credit crunch and the consistently high volume on crude oil futures and options are some of the reasons that convinced us to put together a general guideline for those who choose to venture into energy markets and in particular fossil fuels.

First of all, it is worth mentioning that there are almost 250 different types of crude oils in the world but the ones that are mentioned the most are primarily 2: the American West Texas Intermediate and the European Brent Blend (which is now the global benchmark).It is not unusual to hear financial journalists talking about other crude oils like the Nigerian Bonny, the Arab Light (Saudi) or the Dubai (UAE); nevertheless, the spotlight is almost exclusively on WTI and Brent. The reason these markets, particularly the Brent, have so much media coverage is due to their importance when pricing other crude oils worldwide. Again, the Brent is the nowadays global benchmark (although the WTI used to have this role) so every oil producer or buyer will have to know its price; the question is why?

Why all other crude oils have to be priced according to Brent price fluctuations?

The answer to this question is API gravity, sulphur content and export.

As we previously mentioned there are many types of crude oils in the world but the chemical composition of each crude grade differs slightly. Crude oil is a fossil fuel and it is made of hydrocarbons (molecules of hydrogen and carbon atoms) but what makes the real difference, in terms of commercial value, is the weight of the hydrocarbons. The rule is simple: the lighter, the better. In order to determine how heavy or light petroleum liquids are the American Petroleum Institute introduced a standardized scale called API gravity. The API gravity system is a standardized way to compare and rank the “lightness or heaviness” of diverse crude oils. The system is very simple: the API gravity coefficient measures how heavy or light petroleum liquids are with respect to water. Crude oils with an API gravity greater than 10 are considered to be light (so they float on water) while oils with API lower than 10 are classified as heavy (so they sink when mixed with water). Crude oils with high API values (10 and higher) are lighter and produce greater quantity of marketable product, hence, they are more commercially desirable. This concept can be better understood by looking at the following chart (source: The International Crude Oil Market Report):

Grade of Crude Oil

The graph displays the distribution of different crude oils according to API gravity (X axis) and sulphur content (Y axis). It is easy to notice that WTI and Brent are both located in the right – hand side of the chart and they are very close to the X axis. The reason these oils are situated in this area is because their API gravity is very high (which means they are light types of oil) and their sulphur content is lower than 0.5% which means they are sweet (the word “sweet” in technical jargon means that there is a low level of impurity).

Let’s summarize what has been stated so far:

1) API gravity measures the lightness / heaviness of crude oils

2) API higher than 10 means that the crude oil is light and more profitable in terms of commercial value

3) API lower than 10 means that the crude oil is heavy and produces a minor quantity of commercial product after refining

4) Sulphur content measures the degree of pureness of crude oil, the level of impurity that each crude oil type contains

5) Sulphur content higher than 0.5% indicates a high level of impurity (sour crude oil) that has to be removed

6) Sulphur content lower than 0.5% implies a low level of impurity (sweet crude oil). This condition is preferred because less work is needed and the refining process is faster

7) All the crude oils ranked at the bottom of the right hand side of the chart are considered to be the most attractive under a commercial point of view

The aforementioned bullet points explain fairly well why the Brent is one of the best crude oils in the world but why is it better than the WTI?

The answer is straightforward: the European Brent is exported while the West Texas Intermediate remains within the US.  Consequently, the WTI has a “minor impact” on international markets (in reality, a part of the Alaskan oil output is exported to Japan and South Korea but the quantity is so small to be irrelevant in terms of international impact).

There are other chemical and physical aspects that need to be mentioned when talking about crude oil and one of these is certainly viscosity. Viscosity is the “ability” of a specific crude oil or refined product to flow.

Why is this factor important?

The degree of viscosity is very important to determine how crude oil will be stored or transported which means that the cost of carry will be primarily influenced by this variable. Crude oils can be classified according to their viscosity coefficient:

1) Paraffinic crude oils have low viscosity but they are easily flammable. Most of the engines lubricating oils are made of paraffinic crude oil. Paraffinic oils have a high API gravity and therefore tend to be light types of crude oil

2) Naphthenic (or Asphaltic) crude oils have a high viscosity coefficient but they are not easily flammable. This is the case of bitumen. Naphthenic oils have low API gravity and therefore tend to be heavy types of crude oil

This classification is very useful because it helps us understand a bit better how the refining process works. Let’s combine all the information together:

– Light and sweet crude oils (Brent, WTI, Bonny) have high API gravity, low sulphur content, low viscosity, high flammability and therefore are paraffinic oils. Light and sweet crude oils, once refined, tend to produce high quantity of gasoline

– Heavy and sour oils (Venezuelan BCF, Russian Urals crude, etc) have low API gravity, high sulphur content, high viscosity, low flammability and therefore are naphthenic oils. Heavy and sour crude oils, once refined, tend to be used as bitumen feedstock

The refining process aims to separate petroleum liquids in different chemical components which will be subsequently treated and combined with solvents to generate new oil derivatives.

How does the process work?

The crude oil is essentially pumped into a furnace and here the raw petroleum releases gases and liquids which are subsequently channeled in a tower to start the fractional distillation process. The point of directing the oil in this tower is to separate or fractionate different chemical components using heat. Specifically, each chemical component will have a specific boiling point and by increasing the temperature every constituent will start vaporizing as soon as its own boiling point will be reached. This process is gradual so the crude oil will fractionate into different gases at different temperatures but it is also continuous, which means that new raw petroleum liquid will be injected into the distillation tower at regular intervals to replace the fluid that has been already fractioned. The refining process usually produces a standardized set of oil derivatives such as gasoline, jet fuel, diesel fuel and asphalt. Nevertheless, other products (methane, propane, kerosene, etc) are often distillated. Oil derivatives have a wide range of applications; here we list some of them:

1) Methane also knows as natural gas, can be used for heating

2) Ethane is usually employed as a feedstock for other production processes (like the one followed to produce plastic)

3) Propane can be used for both cooking and heating

4) Gasoline is primarily used as fuel for vehicles

5) Naphtha is another feedstock and it is generally reused in the petrochemical industry

6) Kerosene (known as paraffin in UK, Ireland, South Asia and South Africa) is predominantly employed to produce Jet fuel oil

7) Gas oils are used to distillate diesel engine fuels or for home heating

8) Fuel oils are reused to power refineries or power stations. Alternatively, they are often utilized as a fuel for ships but in this case they are referred to as bunker fuel or bunker fuel oil

Now, this information is surely very important to anyone who is seriously thinking to invest or trade oil markets. Oil fundamentals are sometimes overlooked but a sound understanding of the dynamics underlying the fossil fuel industry is essential to fully comprehend market movements. As we anticipated at the beginning of this article, this is only the first part of a broader project.

If you are interested in trading crude oil you may want to read some HyperVolatility researches dealing with this topic:

“The Oil Arbitrage: Brent vs WTI”

“The Pricing of Commodity Options”

Commodity Volatility Indices: OVX and GVZ

“Commodities and Currencies: Inter – Market Analysis”

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