Both Saudi Arabia and Russia recently increased their oil production levels, an indication that they are getting a head start on higher output even as possible changes to the OPEC/non-OPEC agreement remain up in the air.
There is growing discord from within OPEC, with Iraq joining a group of those opposed to higher output levels. Iraq’s oil minister said that the objective of the cuts has not yet been achieved, and that Iraq “rejects unilateral decisions made by some producers which do not consult with the rest.” Those comments come after Venezuela and Iran formerly requested solidarity against U.S. sanctions, and lobbed angry statements at Saudi Arabia for seeming to comply with U.S. requests for higher oil production.
The solidifying opposition among a solid portion of OPEC against higher output comes even as Saudi Arabia ratcheted up production by somewhere between 85,000 and 161,000 bpd in May, likely taking output back above 10 million barrels per day (mb/d). Russia also boosted production by more than 50,000 bpd in early June. Because the top two oil producers are already starting to increase output, and they are pretty much the only ones in favor of increasing production, the OPEC meeting is shaping up to be highly contentious.
The oil market is assuming some level of increase at the upcoming meeting, which is why prices have fallen back from recent highs and have remain subdued. But higher OPEC production does not necessarily mean a well-supplied market, nor does it mean that price stability will stick around.
There is one major factor that the market seems to be overlooking. Any increase in production will come at the expense of the already limited spare capacity. Saudi Arabia holds the bulk of global spare capacity, which can be defined as a volume of oil that can be called upon at short notice and then sustained for a period of time. Deploying that surplus, while adding supplies to the market, will cut into the buffer.
According to Reuters and data from U.S. bank Jeffries, if Saudi Arabia and Russia hike production, global spare capacity would shrink from the current 3 percent of global demand down to just 2 percent. That margin would be the lowest in more than three decades. “You would essentially be taking 3.2 million barrels per day (bpd) of spare capacity down to approximately 2 million bpd,” Jefferies analyst Jason Gammel said, according to Reuters.
Some other analysts say the cushion could be even smaller. The EIA said that OPEC’s spare capacity was only at 1.91 mb/d in the first quarter of 2018, a figure that is assumed to decline over the next year and a half. If Saudi Arabia ramps up output to, say, 10.5 mb/d, as it was before the onset of the agreement at the start of 2017, that would shrink the size of spare capacity siting on the sidelines by a significant 500,000 bpd or so.
The Saudis are well aware of the problem. Saudi oil minister Khalid al-Falih said as much last month in an interview with Reuters. “We are concerned about tight spare capacity nowadays,” he said.
Up until recently, the massive volume of oil sitting in inventories has acted as a form of spare capacity. That surplus has been well above average levels since 2014, and it has taken an extended period of time to use up that excess. But, we have arrived at that point – the OPEC/non-OPEC production cuts have eliminated the inventory surplus, and inventories could draw down for the rest of this year if the OPEC+ coalition doesn’t increase production.
That is why Saudi Arabia and Russia are on the verge of adding supply back into the market. But with the inventory surplus gone, spare capacity now moves front and center. Higher production will directly cut into some of the few sources of supply that can be called upon at a moment’s notice.
“So were they to raise by 1 million bpd, then 1.3 million bpd is left, scraping the low end of the range historically and uncomfortably tight given the high and rising geopolitical disruption risk,” Robert McNally of the Rapidan Energy Group, told Reuters.
In the past, whenever spare capacity ran low, it coincided with periods in which oil prices were high and extremely volatile, such as in 2008 when prices broke records.
Any unexpected outage would have an outsized impact on the market because producers would have even more trouble replacing missing barrels. That means that a pipeline explosion in Nigeria or Libya, for instance, could send prices skyward. Unexpectedly sharp declines in Venezuela – worse than the market is already taking into account – would have a similar effect. Disruptions to Iranian supply are also possible.
Saudi Arabia claims it can produce 12.5 mb/d, or perhaps even more, but analysts question those figures. Because Saudi Aramco’s operations are a closely held state secret, nobody really knows. If Riyadh decides to boost output and run down spare capacity, their capabilities might be put to the test over the next year if there is a major unexpected outage. The oil market would be in for a wild ride.
By Nick Cunningham of Oilprice.com
