Oil prices recovered modestly in European session after the sharp selloff yesterday. While Saudi Arabia, the US and the IEA pledged to replace Libya's oil supplies, the risk remains there as the grades of oil produced by the countries differ. The spread between WTI and Brent has stayed above 14 as European oil markets are more affected by oil output disruption. In our opinion, while a risk premium should be attached to Brent crude for some time, the price should stay below 120 if the unrest in the MENA region does not spread to other oil producers, especially Saudi Arabia.

Oil supply disruption may be supportive for oil fundamentals in a sense that the ample spare capacity held by the OPEC can be utilized. Libya's oil output takes up around 25% of OPEC's spare capacity of 4.65M bpd and if production in Algeria, another African country thought to be at risk, is also affected, more than half of the cartel's total spare capacity will be in use.

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However, output replacement is not any easy job. The chart below shows different grades of crude oil according to sulphur content (sour vs sweet) and density (heavy vs light), The lighter and sweeter the crude, the higher the price it can be sold, because refiners can produce higher yield of high quality refined products from it. Oil produced in Libya is of similar quality to Brent crude but is lighter and sweeter than Saudi's. Therefore, the quality criterion is challenging even though Saudi can meet the quantity part.

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There's no consensus so far on how much of Libya's production is affected. While the IEA estimated that 30-50% of the country's 1.2M bpd output is affected, Italy's ENI said that 75% of the country's output is cut. Disruption in oil output is more influential to Europe, rather than the US. According to the DOE/EIA, Libya had estimated net exports of 1.50M bpd in 2009 with the vast majority of Libyan oil exports are sold to European countries like Italy (0.43M bpd), Germany (0.18M bpd), France (0.13M bpd), and Spain (0.12M bpd). Exports to the US have increased since sanctions against Libya were lifted in 2004. In 2009, the US imported crude oil of 0.08M bpd, up from +0.056M bpd in 2005.

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