The world is short on spare oil production capacity. This became clear a while ago despite attempts to ignore it on the part of some governments of large consumer countries. The problem has once again come into the spotlight amid the Ukraine crisis, which has prompted fears of disruption in Russian oil and gas exports.
“Spare capacity is falling and the [oil] market is having to reprice that lack of safety margin,” JP Morgan’s head of global energy strategy, Christyan Malek, told the Financial Times last week.
The spare capacity problem has been highlighted repeatedly, by OPEC, the International Energy Agency, and numerous analysts. The result of underinvestment, the decline in global capacity will take quite a while to reverse if it ever does, given the energy transition pressure that environmentalist groups, activist investors, and governments are putting on the energy industry. Forecasts that if Big Oil continues to explore for oil and gas, it might end up with some $500 billion in stranded assets are not helping matters, either.
Oil is currently trading at over $102 for Brent crude and over $98 for West Texas Intermediate. The latest spike came this weekend, after the United States, Canada, the EU, and the UK announced they would cut off several Russian banks from the international bank transfer settlement system SWIFT in response to the invasion of Ukraine. Given the size of Russia’s oil and gas exports, traders worried the latest punitive action from the West could result in oil and gas flow disruptions.
In the meantime, global spare capacity in oil has dropped to just 2.8 million bpd, according to JP Morgan data. That’s quite a bit lower than the 5 million bpd that is considered a comfortable spare capacity level, sufficient to cushion the market against any operational or, as is the case now, geopolitical disruptions. The level is so low, in fact, that, according to Malek, prices will continue higher even if the situation in Ukraine does not lead to disruptions in oil flows.
“The oil price is going up, and an oil supercycle is inevitable,” the analyst told the Financial Times. “There is nothing you can do.”
Disruptions, however, seem quite likely in the wake of the latest sanctions against Russia.
“The various banking sanctions make it highly difficult for Russian petroleum sales to occur now,” John Kilduff, partner at Again Capital, told CNBC this weekend. “Most banks will not provide basic financing, due to the risk of running afoul of sanctions.”
“Although the sanctions are still being crafted to avoid energy price shocks, we believe this aggressive-but-not-maximalist stance may not be sustainable, with disruptions to oil and gas shipments looking increasingly inevitable,” Evercore ISI wrote in a note, cited by CNBC.
Related: Oil Prices Retreat As Biden Leaves Energy Out Of Sanctions Package
Meanwhile, demand for oil continues to grow. According to the chief executive of Vitol, the commodity trading major, global oil demand is set to pass the 100-million –barrel-daily threshold this year for the first time. “Demand is going to surge in the second half,” Russell Hardy told Bloomberg earlier this month.
While demand is surging, Big Oil in Europe is being pressured to reduce its oil production, in the case of Shell with a court ruling, and in the United States, shale drillers cannot drill fast enough to keep up with demand growth. They are also suffering the fallout of the supply chain havoc wrought on the U.S. economy by the pandemic, so production recovery is going slower than it otherwise could have.
“Eventually we’re going to run out of spare capacity,” Vitol’s Hardy told Bloomberg last week. “That’s what the market is trying to work out – how worried to be about that scenario.”
Hardy was speaking before Russia sent troops to Ukraine. Now, the level of uncertainty about global oil supply is a lot higher, and prices may well follow. While the Western powers have tried to work around energy supplies in their sanction push against Moscow, Moscow itself may take the last step and turn off the taps.
While for now Russia has assured its energy clients there will be no disruptions to oil and gas flows, let’s not forget there were assurances it will not invade Ukraine until the country’s president mentioned Ukraine could once again become a nuclear power, which some in Russia believe acted as the final trigger for the invasion.
The FT quoted Bob McNally from Rapidan Energy Group, who said the chances of oil and gas flow disruption in Ukraine was limited, noting that Russia exports some 250,000 bpd of oil via its eastern neighbor and about a fifth of its gas exports to Europe. The lack of spare production capacity, however, made the point more or less moot.
“Until it’s clear that there will not be an interruption in oil supplies and in gas, I think you’re going to see upward pressure,” McNally said last week.
By Irina Slav for Oilprice.com
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In addition to this the global spare oil production capacity including OPEC+’s has been shrinking being undermined by underinvestment in oil and gas since 2019 and prompted by the pandemic and also incessant pressure by environmental activists on the oil industry to divest of its oil and gas assets abetted by the International Energy Agency.
Without global oil investment returning to pre-pandemic level of $542 bn annually for at least the next ten years, the global oil market can’t avoid rocketing oil and gas prices, a continuous shrinking of global oil production capacity and an impending supply shock.
The reason the United States and the European Union (EU) didn’t sanction Russian oil and gas exports is that the sanctions will harm the economies of those imposing them particularly that the United States is the world’s second largest importer of crude oil and the EU depends on Russian gas supplies for more than 40% of its needs and 30% of oil.
If, however, financial sanctions start to hurt the Russian economy, Russia could halt all its oil and gas exports to the EU thus plunging it in a deeper and more destructive energy crisis and inflicting considerable damage on the EU economies particularly Germany.
Moreover, the entire LNG exports of the United States, Qatar and Australia could hardly replace Russian piped gas supplies to the EU amounting to 200 billion cubic metres (bcm) and 15-16 million tons of LNG. The EU’s LNG import infrastructure is very limited. Furthermore, Russian piped gas is far cheaper than LNG. Russia can sell its entire gas and oil exports to China.
Dr Mamdouh G Salameh
International Oil Economist
Visiting Professor of Energy Economics at ESCP Europe Business School, London