What a difference a few months makes! Today’s monthly update from the Energy Information Administration again slashed estimated OPEC spare capacity by roughly 30%, by a whopping 1.5 mb/d less than foreseen in May (chart below). At 2 mb/d, the world’s current extra-supply buffer is well below the roughly 4-5 mb/d level most analysts would describe as adequate to cushion unexpected supply outages and stabilize crude oil (and therefore pump) prices.
Spare capacity may be an unfamiliar term to many but it matters a lot to anyone interested in understanding what is moving global crude oil and therefore domestic pump prices. More so than any other fundamental metric, it gauges the fundamental tightness and looseness of the global oil supply/demand balance. Low spare capacity indicates a tight global oil supply-demand balance and upward price pressure. Low spare capacity also triggers panic buying and higher prices when supply disruptions or even threats of disruptions appear, as seen recently with regard to Syria and Egypt.
How can the global supply buffer be so low when US oil production is soaring?
Robust oil demand here and especially abroad in developing countries played a role but the main reason for the big drop is unexpected supply outages in Libya and other OPEC and non-OPEC countries. These disruptions force Saudi Arabia to produce more to make up for the loss. Since Saudi Arabia is the only producer that holds spare capacity, as Saudi production goes up the world’s spare capacity cushion goes down.
Despite the huge cut in OPEC spare capacity near term, EIA still projects a weakening starting later this year and continuing through the end of 2014. This projected increase is due to forecasted production capacity growth in North America, Iraq, and other producers as well as restrained demand growth. EIA’s rosy forecast is reassuring especially given turmoil in the Middle East. It may be one reason why officials haven’t been scrambling to prepare a strategic stocks during the recent oil price run-up over Syria.
I am skeptical that the 2.5 mb/d increase in OPEC spare capacity EIA projects by end-2014 will take place. As long as economic growth hangs in there, the oil market is likely to keep “surprising” to the tight side relative to official forecasts due to continual supply disruptions and stronger than expected oil demand in fast-growing countries.
But if I’m wrong and surging supply growth swamps tepid demand growth, I doubt
OPEC Saudi Arabia will cheerfully cut production by over 2 mb/d, effectively handing over market share to its rivals in Iraq, North Dakota, and Texas. More likely (and consistent with analogous historical experience), Riyadh would keep production high and watch prices fall, threatening investment in North American oil production capacity.
Tight or loose, I would not bet such a big increase in OPEC spare capacity anytime soon.
Turning to Congress and Iran sanctions, EIA’s much tighter revisions and the recent run up in oil prices underscores the hazard of selling new sanctions on the view that the oil market is “loose and getting looser” due to booming US production. We can safely drive Iran’s oil off the market, so the argument went, without driving pump prices up here at home. This view overlooks the fact that pump prices at home are set in a global oil market and outside the US that global market is far from hunky-dory.
But it would be unfortunate if after being mugged by the reality of a tighter-than-hoped-for oil market, Congress shirked from tightening oil sanctions at this late stage in the diplomatic effort to prevent Iran from acquiring a nuclear weapons capability. Despite the tight oil market balance and real risk of higher pump prices, quarantining all of Iran’s oil exports still makes sense because the consequences of failing to convince Iran to halt its drive toward nuclear weapons capability are more destabilizing for global peace and gasoline prices than coercive sanctions aimed at preventing it. But let’s do it with our eyes open to the reality of a today’s tight and fearful global oil market, and be prepared to offset the lost supply not only with higher Saudi production if available but also strategic stock releases.