U.S. shale is surging, threatening to take even more market share away from OPEC. But the prospect of U.S. oil edging out barrels from the Middle East is not nearly as simple as it might seem.

Oil coming from the major shale plays in the U.S. is light and sweet, while a lot of oil coming from OPEC is medium or heavy, and often sour. A lot of refining capacity along the U.S. Gulf Coast, built up over years and decades, is equipped to handle heavier forms of oil. Before the shale revolution, refiners made their investments in downstream assets assuming the oil they would be using would come from places like Saudi Arabia and Venezuela.

Lighter shale oil is perfectly fine for making gasoline, but not the best for making diesel and jet fuel. Medium and heavy oil is needed for that.

But refiners have a tidal wave of light sweet oil on their hands, perhaps too much. The U.S. refining industry could max out its ability to swallow up light sweet oil from the shale patch, as the FT reports, particularly as U.S. shale drillers are expected to add upwards of 4 million barrels per day (mb/d) over the next five years.

Meanwhile, heavy crude production has waned as of late, with sharp declines in output in Venezuela and Mexico in the past few years. Shipments from Canada face a bottleneck because of fixed pipeline capacity. The result has been a somewhat tighter market for heavy oil, which refiners want to process into jet fuel and diesel.

In the years ahead, demand for gasoline could start to slow down as vehicles become more efficient and EVs start to gain more market share. Meanwhile, diesel demand has grown much faster, and will likely jump in 2020 as new regulations on dirty fuels from the International Maritime Organization take effect. That could force the shipping industry to switch from residual fuels to diesel, perhaps adding as much as 2 mb/d of demand for diesel, the FT reports.

In other words, volumes of lighter oil suited for gasoline production are soaring while production of medium and heavy oil used for diesel is flatter, even as diesel demand is poised to grow quickly. And refining capacity capable of handling light oil might not be up to the task. Related: Is Another Oil Price War Looming?

That could present some problems for refiners, some analysts say. “The dirty secret of U.S. shale oil is not many people want it,” Bill Barnes of Pisgah Partners, an energy project development consultancy, told the FT. “It’s wrong to say the U.S. can add 1m-plus barrels a day of production capacity a year and it will immediately find a home in the world’s refining system.”

Just because shale production is skyrocketing does not mean that refiners want the oil. Franco Magnani, the head of trading at Eni, told the FT that the company won’t rush out and by shale oil because its refineries were not made for that type of oil. “It could be a top-up in certain situations but not really a base diet [for Eni’s refineries],” Magnani told the FT. “[Shale’s] very light so either you have a refinery that’s geared towards that but maybe then it’s too light even for that. Or you use it only in very specific situations.”

Not everyone agrees, noting that in a 100-mb/d oil market, adding 1 or 2 mb/d of light oil is manageable. The problem with that notion is that only a fraction of the global refining industry can handle digest additional barrels of light oil. After excluding the U.S. refining system, which is reaching its limits, the market for light oil is closer to 15 mb/d, the FT reports.

The result could be that shale producers might have to accept discounts for their product in the next few years if refiners balk at purchasing every additional barrel of light oil.

According to a recent study from Wood Mackenzie, roughly three-quarters of the additional oil expected to come from U.S. shale will have to go overseas because U.S. refiners will be maxed out on light oil. Related: How Will OPEC React To Soaring Shale Production?

Others agree. “There will still be a sizable surplus of lightweight crude,” Rob Smith, director of IHS Markit’s oil markets and downstream group, told Reuters. He predicts U.S. shale will add 4 mb/d of new supply by 2023, a volume that cannot be taken up by existing refineries along the Gulf Coast. WoodMac estimates that refiners will only be able to take up about 1 mb/d of extra 4 mb/d through 2023. The rest will have to be exported.

The flip side is that the shortage of light oil refining capacity might spark new investment in new facilities. ExxonMobil just announced plans to double its light oil refining capacity along the Gulf Coast, an investment specifically made because of the surplus of light oil in Texas. The expansion would take place at Exxon’s Beaumont and Baytown refineries in Texas and Louisiana. “It’s really a full Gulf Coast upgrade,” Senior Vice President Jack Williams told Wall Street analysts last week, according to Reuters. “We know this is going to be a long-term resource,” he said.

Ultimately, a surplus of light oil could be a problem for shale drillers. Sharper discounts could challenge the economics of adding new supply, perhaps throwing up obstacles to growth. That could challenge the industry’s ability to meet the aggressive expectations that so many forecasters have laid out.

By Nick Cunningham of Oilprice.com

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