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Nick Cunningham

Nick Cunningham

Nick Cunningham is a freelance writer on oil and gas, renewable energy, climate change, energy policy and geopolitics. He is based in Pittsburgh, PA.

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OPEC’s Spare Capacity Will Calm Oil Markets In 2017

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There is a wide variety of opinions on whether or not OPEC will deliver on its promised cuts of 1.2 million barrels per day, and a lot hangs in the balance. The difference between OPEC members complying with the deal and ignoring it altogether is a big one. It will go a long way in determining whether or not the oil price rally continues on its upward trajectory or begins to fizzle.

But while large cuts from OPEC are generally very bullish for oil prices, there is a side effect on the oil market from those reductions that could mute the price impact. Taking such a large volume of oil off the market does not make that production capacity go away. Indeed, moving 1.2 mb/d of capacity from active production into idled capacity will provide a substantial buffer to any unforeseen supply disruption.

That has always been the logic behind OPEC’s use of “spare capacity.” Saudi Arabia is pretty much the only country that has a large volume of oil capacity sitting on the sidelines, output that can be ramped up within a few weeks or months. The EIA defines spare capacity as output that can be turned on within 30 days and sustained for at least 90 days. Periods of low oil prices and low price volatility tend to correspond with periods of time in which Saudi Arabia has a large cushion of spare capacity. If the global oil market suffers from a surprise outage – say from a natural disaster like Hurricane Katrina or a man-made disaster like the war in Iraq – then there is capacity that can be called upon to plug any supply deficit.

Saudi Arabia has done this in the past, and because the oil markets are aware that such a capacity exists, volatility tends to be lower than it otherwise would be. When Saudi Arabia ratchets down production, which necessarily creates a larger buffer of spare capacity, volatility tends to soften. The opposite also tends to be true: when the market tightens, and Saudi Arabia ramps up production to meet demand, it does not always lead to lower prices. A smaller spare capacity can spook oil traders, especially when an outage occurs. In the period between 2003 and 2008, when OPEC was producing at elevated levels and running down spare capacity, it corresponded with the largest and longest bull run for oil in recent memory. OPEC’s spare capacity ran below 2 mb/d for most of that period. Related: The End Of The Oil And Gas Bankruptcy Wave

(Click to enlarge)

All of this is to say that the large cuts in production in 2017, assuming that they do occur, are not entirely bullish for oil prices. Saudi Arabia has promised to cut output from 10.6 mb/d down close to 10.0 mb/d. That will move a slice of active production into latent spare capacity. Add to that the smaller contributions from other OPEC and non-OPEC members, and the global spare capacity is set to grow for the first time in years (aside from a small uptick at the end of 2015). Related: Can U.S. Shale Add 1 Million Bpd In 2017?

More spare capacity will provide a bit of buffer to any potential outage in 2017, smoothing out the sharp edge of a hypothetical price spike. “If you’ve got OPEC full adherence for the first six months, the market should be relatively insulated from political risk because that cushion is available,” Alan Gelder, a vice president of Wood Mackenzie Ltd., told Bloomberg in an interview. Only a major outage in Saudi Arabia would be an unfixable problem for the oil market, he says. “[A]nything else should be able to be accommodated.”

That suggests that oil price volatility could be lower in 2017. Volatility is already at its lowest level in a year, which underscores the same argument: volatility plunged following the OPEC deal, as a greater level of certainty spread over the market (see chart: OVX is an index that tracks oil price volatility). And the resulting spare capacity that will result from the OPEC deal could lead to a sustained period of lower volatility. The “managed” market of OPEC has always been more stable than the “free” market in which OPEC jockeyed for market share.

(Click to enlarge)

Figure CBOE Crude Oil Volatility Index (^OVX)

The one other factor to keep an eye on is the near-record level of oil inventories, which will act as a second form of spare capacity – supply that can be called upon in a moment’s notice. That is another reason to believe that volatility will be less of a problem in 2017 than it was in 2016. The flip side of that is that the OPEC cuts will tighten the supply/demand balance, and will likely force drawdowns in inventories over the course of 2017. Once inventories come down to long-run averages, then there will be a smaller buffer for the global oil market. But, again, OPEC should have a little bit more capacity to work with to resolve any unexpected problem. After more than two years of volatility, we could be in for a smoother ride in 2017.

By Nick Cunningham of Oilprice.com

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