OPEC’s spare capacity is not what it once was, a development that opens up a larger upside risk to oil prices.
A constant feature of the oil market is the prospect of unforeseen supply outages, whether from war, industrial accidents, sabotage, natural disasters or more mundane operational problems. These outages range from a mere nuisance to a major disruptive event, depending on size, scope and duration of the interruption.
OPEC has often stepped in with extra supplies when these events occur, offsetting the lost barrels. IEA member countries also have strategic petroleum reserves, which help cushion supply outages, although the U.S. is in the process of selling off its stockpile. In reality, Saudi Arabia is the main source of global spare capacity, one of the few sources of sizable capacity that can be ramped up or down on short notice.
Low levels of spare capacity typically correspond with periods of time when oil prices are high, while the reverse is also true. Between 2003 and 2008, OPEC spare capacity was at or below 2 million barrels per day (mb/d), a period that saw rising demand and a dramatic run up in prices. The financial crisis and collapse of oil prices forced OPEC to cut back, replenishing its spare capacity to over 4 mb/d.
The 2014-2016 oil bust was unique because OPEC decided not to take barrels off of the market, keeping output elevated (and spare capacity low) in the face of oversupply. Not coincidentally, oil prices crashed.
The OPEC/non-OPEC cuts at the start of 2017 restored some spare capacity back to 2 mb/d. But a year and a half on from those cuts, demand growth has soaked up some of the excess supply. The inventory surplus is all but gone and based on current trends, the supply deficit will continue to drain them. The market is tightening once again, and the buffer of spare capacity is low in historical terms at about 2 mb/d.
More importantly, the size of OPEC’s spare capacity has not changed all that much over time on an absolute basis even as the size of the market has grown. In 2006, oil demand was about 85 mb/d, with spare capacity at about 2 mb/d. Today, spare capacity is also at about 2 mb/d, but the oil market is now 15 mb/d larger than it was in 2006. That means OPEC’s spare capacity continues to shrink as a percentage of global supply over time, absent any upstream capacity additions. Related: Will U.S. Shale Offset Soaring Global Oil Demand?
As OPEC phases out its current production limits and steps up output, as is expected at some point in the next year or so, spare capacity will decline again. The EIA sees spare capacity falling to just 1.24 mb/d by the third quarter of 2019.
Thin spare capacity means that even minor supply disruptions can have outsized effects on oil prices while a major loss of supply could cause prices to spike. With Venezuelan output falling rapidly, and possible outages always looming in Iran, Libya and Nigeria, there are plenty of risks on the horizon.
Last week, Saudi oil minister Khalid al-Falih warned about the threat of low spare capacity. He said other nations must help because Saudi Arabia cannot no longer do it alone. "The kingdom cannot take on the burden single-handedly. We expect other countries to work with us to reciprocate the burden that the kingdom maintains on behalf of the industry,” he said.
He also noted that one justification for keeping the current cuts in place would be stimulate investment in new capacity, likely because Saudi Arabia cannot maintain 1.5-2.0 mb/d of spare capacity indefinitely.
Viewed one way, his comments appear to be an effort to move the goal posts on the current agreement, shifting focus from the five-year average for inventories as a basis for the OPEC/non-OPEC cuts, to some vaguer metric about the amount of new investment needed.
Yet, al-Falih’s concerns are not necessarily all that new. "If we extend our look to a couple of years, we have to worry about spare capacity [which is] declining as we go forward," he said back in February. "I am worried about being able to meet the supplies of production we need from 2020 and beyond." Related: Saudi Arabia’s $100 Oil Dilemma
A quick note on U.S. shale, which is often likened to a sort of “second spare capacity” because of the ability of shale drillers to bring new supply online rapidly. While the quick start-stop nature of shale does smooth out the magnitude of price swings, using the moniker of “spare capacity” for shale sort of misses the point. Shale drillers make individual decisions based on a firm’s own financial interests, not because of a broader market need. Moreover, shale drillers can’t and won’t ever act in unison. In this sense, U.S. shale never amounted to a second spare capacity, nor will shale be able to step in to offset some supply outage elsewhere in the world.
Nevertheless, it’s quite possible that U.S. shale grows so quickly that the market remains well-supplied for the next few years, as the IEA has previously predicted, keeping a lid on prices despite low levels of spare capacity. However, if U.S. shale slips up – and bottlenecks could slow growth – the market could find itself tight next year, perhaps even short on supply, while also suffering from low levels of spare capacity.
The flip side is that if OPEC holds onto its current production limits, which could preserve its spare capacity at about 2 mb/d, the oil market will tighten as demand exceeds output. Either way, absent a collapse of demand or aggressive growth from U.S. shale and other non-OPEC producers, the oil market is set to tighten.
By Nick Cunningham of Oilprice.com
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