By Jim Williams, WTRG Economics (www.wtrg.com)
Current OPEC spare capacity would suggest a lower world oil price, but the distribution of this spare capacity could be one reason why oil prices are higher than many experts think it should be.
Usually the more spare capacity (supply) in a market there is the lower the price – simple economics. But the reality is that Saudi Arabia is the only country in the world with significant spare capacity to produce more oil in the world and influence prices. And they currently favour a $70-$80 barrel oil price.
In 2003, OPEC had 2 million barrels a day LESS spare capacity it has now, and oil was under $40/barrel – but spare capacity was more evenly spread out among the 11 member states.
If everybody has spare capacity, the potential for cheating on production quotas is greatly increased and that carries a higher downside risk for prices. Should the world economy grow more quickly, only the Saudis have the ability to increase production enough to meet demand and influence prices.
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The two charts below show the spare oil producing capacity of each OPEC country now, and in 2003. See how much the Saudi spare capacity has increased as a percentage of OPEC spare capacity.
Back in 2003 the distribution of spare capacity was more evenly spread out – as it had been for several years. The Saudis only had 52% of OPEC spare capacity in 2003. There were three members with over 10% and a fourth at 9%. Again, the more countries with spare capacity the greater the odds that one or more will take advantage of their position with higher production leading to lower prices.
The US government EIA now estimates OPEC spare capacity at 4.96 million barrels per day. Only Saudi Arabia with 3.75 million b/d excess capacity has any significant power. Kuwait and UAE each have an estimated 300,000 b/d of spare capacity and Qatar has 260,000 b/d. With Saudi Arabia controlling 76% of the spare capacity the combined power (16%) of Kuwait, Qatar and UAE is barely enough to influence prices.
It’s the Saudi spare capacity, not their production, which has such dominant pricing power.
Before 2003 there was a strong relationship between price and spare capacity. Low prices generally coincided with spare capacity over 3 million barrels of oil per day (bopd). However, it is important to note that prices can and often and do rise with higher spare capacity in the 3 million plus zone.
In the graph below, note the spikes in spare capacity near the price troughs during the first 10 years. In most cases that are neither increased capacity nor suddenly lower demand, but rather OPEC implementing a new lower production quota to shore low prices.
As prices deteriorate there is even more incentive to cheat to maintain revenue, which adds to the oil on the market and puts downward pressure on prices. This is less likely to happen in the current situation of concentrated spare capacity.
Typically, big OPEC decisions to dramatically lower and realign quotas are only possible in an extremely low price environment. That is why sudden spikes in spare capacity occur at the bottom of the price cycle as OPEC takes production off the market.
The concentration of spare capacity has its risks. Saudi Arabia can easily mitigate the loss of exports from any other OPEC member, but no one can come close to covering any loss of oil from the Saudis. If the Iranian situation ever turns from a shouting match into a shooting match, there will be an attempt by Iran to blockade the Straight of Hormuz. While the Saudis can shift some exports by pipeline to the Red Sea, a blockade still halts the transport of nearly 17 million barrels per day out of the Persian Gulf. A blockade however short-lived would send prices limit up.
It is appropriate that to have an Iranian war risk premium in the oil price, but I do not see this as an immediate risk. However, sanctions are beginning to hurt Iran and the rhetoric is rising. Iran notified the U.S. it was kind enough to dig graves for soldiers from an American invasion force. The level of Iranian threats could eventually have an impact on price, but they have difficulty gaining traction in a market that swings between optimism and economic doom.
A recent Bloomberg headline tells us that we cannot even take internal stability in Saudi Arabia for granted: “Al-Qaeda Seeks Overthrow of Saudi Arabia Monarchy, Killing of Christians.” It is little coincidence this comes at the beginning of Ramadan and the Saudi test of the giant Mecca clock. Some scholars presented arguments that Mecca time should replace Greenwich Mean Time.
It’s also easy to see that spare capacity has always been the key to power within the organization. A country with spare capacity can increase production and with enough, as in the case of Saudi Arabia in 1986, maintain revenues in the face of lower prices. Spare capacity means influence over prices and other members pay attention to that power.
With the current concentration of spare capacity, the Saudis could, for the sake of argument, tell a cheating OPEC producer – hey, stop that or we’ll put 2 million barrels a day on the market, and then watch what happens to your revenue.
To that end, it is puzzling that OPEC members are not mounting much more aggressive drilling and exploration campaigns to increase spare capacity.
Higher capacity is eventually rewarded with higher quotas. To the extent that OPEC output determines prices, prices are now determined by the Saudis.
It is in individual OPEC member’s best interest to increase spare capacity. However, it is clearly not in their collective interest that spare capacity is widely distributed.
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