The most recent Opec meeting, on June 11, was as casual as a post-World Cup brunch. Opec ministers breezed into Vienna, declared that markets were well supplied, affirmed their 30 million barrels per day (bpd) production ceiling, and were off again. Just two days earlier, Iraqi insurgent forces had swarmed into Mosul.
Would Opec have decided differently had it had more time to react to the dramatic events in Iraq? Probably not. The organisation’s 3.3 million bpd of official spare capacity is concentrated anyway in Saudi Arabia, with some in its allies the UAE and Kuwait – the task of meeting any supply crisis will fall to the Gulf triumvirate. They have already been filling the gap left by Libya, then Iran, for the past three years.
This leads to two competing narratives. One points to the need for record output from Saudi Arabia, to more robust demand than expected, from the US in particular, to disappointing supply from non-Opec countries outside North America, and to risks to Iraqi output. The International Energy Agency (IEA), mostly representing rich-country oil consumers, said that markets were “considerably tighter than they were a year ago”.
Geopolitical tensions are often advanced as a cause of higher oil prices. But mere tensions themselves – as opposed to actual physical disruptions – cannot elevate prices permanently. The short-term price increases as oil goes into storage as a precaution, but the “fear premium” is not permanent – in the longer term, high prices increase supply and decrease demand.
The other view, represented by Opec and forecasters such as Citigroup’s Ed Morse, regards the market as quite well supplied, with US shale oil growth continually outpacing the IEA’s projections. Brazil may have been unimpressive so far, but the Latin American stars Colombia and Argentina have increased output.
So far oil markets have followed the second narrative, with prices rising only modestly on the Iraq news and since easing. This is probably the right view – though not leaving much room for further upsets.
Depending on the forecaster, Saudi Arabia may have to produce anything from 10.2 million bpd to a record 11 million bpd in the third quarter of this year, as its own internal oil use rises steeply to meet summer electricity demand.
With an official 12.5 million bpd of capacity, this should be achievable. Libyan production cannot fall much further (and has edged up recently), most Iraqi production in the south is not yet directly threatened, and Iranian exports have also increased somewhat in past months.
Spare capacity is the expensive substitute sitting on the bench and may never be required to play a game. Opec countries have resisted the IEA’s entreaties for wider safety margins – with 1 million bpd of reserve capacity costing Saudi Arabia perhaps US$10 billion to construct. On the other hand, during a crisis that drove oil prices to $150 per barrel, this investment would be recovered within 70 days.
When global spare capacity becomes very tight, the swing producers – Saudi Arabia above all – face a dilemma. If they increase production in the face of disruptions elsewhere, they may calm prices temporarily. But the market notes that spare capacity has shrunk further, thus increasing vulnerability to a further outage. This is a reason to leave 1 million to 2 million barrels per day untouched except for the most stringent emergencies – so spare capacity for ordinary market management may be effectively exhausted this summer.
And so the Saudis’ cagey game continues. Their three-year-long, successful defence of prices around $100 per barrel can be broken in two ways – a further geopolitical disruption that finally exceeds their capacity, or the long-anticipated easing of the market as competition within Opec itself resumes.
Robin Mills is the head of consulting at Manaar Energy and author of The Myth of the Oil Crisis
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