The above is this columnists own definition of conditions necessary for inter-regional trade of base stocks and other oil products. It is a definition that few in the base oil market would quibble with, but one would probably find different opinions about the range of transactions that qualify as arbitrage. Your columnist argues for a loose interpretation that takes in most inter-regional shipments, for such an interpretation gives a better grasp of changes occurring in the market today.

Traditionally, most base oils have not traveled far from the refineries that produced them, ending up at lubricant plants within the same country or region. Those that did get sold to other regions tended to follow regular routes – from Europe to the Middle East and India, for example, or from the United States to Central and South America, from Europe to West Africa and so on.

From time to time, developments have triggered aberrations in these patterns. For example, prices for API Group I oils in the U.S. sometimes rise due to temporary plant shutdowns. Occasionally, such increases would coincide with drops in European prices caused by gluts. And in some instances such events would be accompanied by Europe-to-North America freight rates favorable enough to allow sales prices that were acceptable to buyers while still profitable for sellers.

At such times, shipments would start to flow westward across the Atlantic – perhaps for a few weeks, sometimes for months. Eventually, however, one or more of the requirements for such business would end. Europes surplus would shrink, the supply problems in the U.S. would resolve, or freight rates would rise – any of which would be enough to halt the Europe-to-U.S. Shipments.

Most anyone in the industry would agree that the opportunity created by such events is an arbitrage. But what about the more common shipments from Europe to the Middle East? Some in the industry would call those normal trading patterns, as distinct from arbitrage – in other words, not arbitrage.

This columnist disagrees and calls common trading patterns the result of arbitrage, too. Some might argue that they do not fit the definition, since patterns can prevail for years, sometimes decades. But a looser interpretation of temporary is all that is necessary to bring them under the definitions umbrella. The point is, no pattern is etched in stone; it only prevails so long as a price differential and transportation costs allow the seller to make his margin.

Why does the vocabulary matter? Certainly trades will occur no matter what we call them. But a clearer recognition of why they occur makes it easier for us to see deals that could occur, and this is increasingly important because the number of potential trading opportunities is rising.

In the latter half of 2010 traders and buyers in West Africa started to look for new sources for base oils, due in part to lack of availabilities and high prices from traditional sources such as Europe, the U.S. and Brazil. Among the options that these traders and buyers considered were cargoes from Indonesia, Thailand and Singapore, all affected by the opening in recent years of new plants along the Pacific Rim. While no such deals are known to have been completed, the mere fact that they were considered encourages others to explore more adventurous potential deals.

Last year one major oil company sent Group II base oil from Singapore to the U.S. Gulf of Mexico coast. Doing so required much forethought, but demand in that area of the Far East had all but collapsed due to oversupply. The old way of dealing with this type of situation would have been to slash prices and dump the material in the local market. But an intracompany arbitrage existed to export the material to a market that demanded oils of that quality yet could not fulfill requirements in the short or medium term.

Freight cost is an important element of any arbitrage as it can create opportunities which otherwise could not have been realized. Vessels calling at a convenient discharge port or load port may offer attractive rates to fill space that would otherwise be deadweight.

Since the late 1990s, Group II oils have flowed from South Korean refineries to Europe and the U.S. Presently, this trade continues in spite of the fact that the U.S. has become a huge producer of Group II and has even begun exporting some of that material to the European arena. The notion of arbitrage continues to exist between Korea and the U.S., while at the same time a new arbitrage is opened between U.S and Europe for the same type of material. Far East supplies are stored by sellers in Europe, creating the potential for a reversible arb – Group II flowing from Europe to the U.S. should the right conditions arise – in addition to the cross arb. All of this adds to the growing complexity of globalized supply.

The market is likely to reach an entirely new level of complexity with the development of a new regional hub for Group III production. Group III is currently produced in state-of-the-art plants in Korea, Malaysia, and Indonesia. Although there are some older plants making this material within Europe, increasing demand there has created an arbitrage allowing integration of Far East Group IIIs into the European market on a large scale.

But this arb may not last forever. Looming over the market are scheduled openings of Group III plants in the Middle East. These sources will serve markets in that region but will also target Europe, the U.S and Africa to capitalize on their large production capacities.

Will the new suppliers supplant Far Eastern producers that now supply Europe and the U.S.? Will the Far Eastern producers hold on to existing customers? Regional surpluses and deficits are no longer enough to answer such questions. The outcome depends on arbitrage. Which routes will allow the best margins for sellers and the best deals for buyers? The most likely result is an ongoing state of flux, with some volumes being supplied under long term contracts and others being placed through spot sales whose patterns continually change.

It is worth mentioning the role that finished lubricant approvals play in base oil trade. Lube blenders seek approvals certifying that their engine oils and other products meet specifications set by original equipment manufacturers and industry bodies. These approvals require often expensive testing and apply to specific formulations, including specific base stocks or base stock blends.

Interchange rules allow some flexibility, but blenders are not completely free to switch base stocks unless they want to incur the expense of additional testing. Thus approvals can cause blenders to throw aside economic criteria in the name of technological consistency. The solution is to view approvals as creating a type of technical arbitrage that then fits neatly into the overall theory. This also allows one to recognize the possibility that a blender will switch base stocks – despite the cost of additional testing – if the economics become attractive enough.

The base oil market is becoming increasingly complex as demand grows for more highly refined fluids. At the same time, base oil trading, like many industries, is becoming more and more global. As a result, a greater number of potential arbitrage opportunities have come into play, and the number will continue to increase. Those who keep an eye on these opportunities will have a clearer understanding of what is happening in the market today – and what is likely to happen in the future.