The Times They Are A-Changing'
— Bob Dylan
It's time for some straight talk on the oil supply. On September 12th the Organization of Petroleum Exporting Countries (OPEC) announced that they would raise production 522,000 barrels per day (b/d) to alleviate demand-side pressures in the 4th quarter of this year. Few people in the oil markets were impressed by this conciliatory gesture, for the Nymex price for light, sweet crude closed at $80.09 a barrel on Thursday, September 14th. Let's examine the oil market conditions driving the rising oil price. Demand is strong and slated to increase as winter approaches. On the supply-side, the most important factor is how much surplus production capacity OPEC can bring to bear to ease prices should they choose to do so.
Short-term price movements are insignificant1 because they are influenced by ephemeral events such as profit-taking and reactions to weekly inventories. The longer term price trend is significant (graph from tradingcharts.com, left) because it tells us about the evolving supply & demand balance. The market has been increasingly out of balance for more than 7 years now, as the price signal indicates. The sharp dip in prices that took place last fall/winter was an anomaly in a volatile market when viewed from a longer term perspective. The price trend has resumed its up-and-down but inexorable rise since the recent low point in January, 2007—assuming all things remain equal on the demand-side of the market (i.e. no recession).
You will hear many reasons offered to explain why the oil price is high—speculators entering a futures market in backwardation, the weak dollar, intermittent hurricane threats, lack of refining capacity, disruptions in Nigeria and Iraq, geopolitical tensions with Iran, etc. Don't believe these stories. OPEC representatives will tell you that the oil markets are "well balanced." Don't believe that either. On the supply side, OPEC's spare capacity is the paramount issue, for if there isn't much of it, a tight market is highly vulnerable to any unplanned disruption. Surplus capacity is supposed to be a buffer that can be tapped when demand outstrips supply, but if the world were swimming in readily available high-quality oil, the price would not be fluctuating around $80/barrel. The record nominal price demonstrates market fundamentals at work.
The issue of OPEC spare capacity is contentious because nobody knows what it is. Here's what MarketWatch reported on September 12th:
What is remarkable about this latest spike in oil prices is not the usual knee-jerk reaction, but the fact that it comes on the heels of the Organization of Petroleum Exporting Countries' pledge to raise output to take some of the heat off prices.
Energy traders aren't buying it...
No, the skepticism has ... to do with production capacity or lack thereof. The guys on the Nymex trading floor are questioning whether OPEC has the ability to lift output by another 500,000 barrels a day, the number they agreed on at their meeting Tuesday in Vienna.
Nymex traders don't think OPEC can produce the goods. Contrast this with OPEC Spare Capacity Keeps On Rising from Petroleum Intelligence Weekly published on September 3rd (graph left). Capacity reaches a whopping 5.226 million b/d at the end of 2008. The reliable current capacity—not counting Nigeria—is listed as 3.638 million barrels at year-end 2007. These numbers also reflect the view of OPEC propagandist Dr. Nimat B. Abu Al-Soof, who claimed that there will be "39.7 million b/d of crude capacity by the end of 2010, representing an increase of about 5 million b/d from end 2006" (excerpted from his speech The Role of OPEC Spare Capacity at the Offshore Technology Conference in May, 2007). The estimable Dr. Al-Soof's assessment, as evaluated against the IEA's August figure for OPEC production, assumes an OPEC spare capacity of 4.3 million barrels per day at the end of 2006 (see below).
In a world that is utterly dependent on the oil supply, such divergent opinions shouldn't exist. There is no excuse for it. Nymex traders wonder whether OPEC can even raise production half a million barrels per day, whereas Petroleum Intelligence Weekly confidently states that they could raise production by well over 3 million barrels per day. Let's sort this out, setting some realistic expectations about near-term supply availability and prices.
A Quick Primer
Conditions (1) through (3) describe the supply-side of the world oil market. Equation (1) is taken from Ferdinand Banks' Economic Theory and OPEC, Part 2. Skip this part if you know all this stuff.
- dQO = dQM - dQN, where QO = the demand for OPEC oil, QM is the market demand, and QN is non-OPEC supply.
- dQS = dQC - dQO, where QS = OPEC spare capacity, QC is total OPEC production capacity and QO is as defined in equation (1). Spare capacity refers to the "maximum sustainable production capacity, defined as the maximum amount of production that: 1) could be brought online within a
period of 30 days; and 2) sustained for at least 90 days" (EIA). Capacity also refers to crude + condensate production only. Natural gas liquids, which are not subject to quota restrictions, are put on the non-OPEC side of the ledger.
- Non-OPEC spare capacity is always effectively = 0, except for maintenance or other temporary disruptions.
The (satisfied) demand for OPEC oil (equation 1) is taken as equal to the cartel's production, which was 30.4 million barrels of day (crude + condensate) in August of 2007 according to the IEA's Oil Market Report for September. Useful total OPEC capacity (and therefore the spare capacity) is subject to downstream market conditions as described in the next section.
All of the terms in the equations (1) and (2) are in dispute. The dispute about the change in demand on OPEC oil is called The Call on OPEC. This quantity (in barrels per day) is calculated differently by OPEC and the IEA, with the cartel low-balling the estimated demand and the IEA exaggerating growth projections. Similarly, OPEC overestimates production outside the cartel whereas the IEA increasingly makes a more pessimistic, albeit realistic, assessment. The satisfied demand for OPEC crude affects equation (2), which defines OPEC's spare capacity. Non-OPEC production has topped out for this year—what you see is the most you're going to get (ASPO-USA, September 12th). The IEA's August OPEC production number is the baseline for this analysis.
What is OPEC's Spare Capacity?
The EIA made an historic revision in their assessment of OPEC spare capacity on September 11th, the day of the OPEC meeting. Surplus capacity is estimated to be 2.41 million b/d in the 2nd quarter of 2007, with Saudi Arabia accounting for 79% of that. The former estimate gave a range from 1.90 to 2.40 million b/d for the Kingdom, but the EIA has now settled on the low-end number. The energy agency raised their estimate for the other OPEC members to 0.52 from 0.37 million b/d. Only Kuwait (200,000 barrels) and the UAE (100,000 barrels) are able to increase flows ≥ 0.10 million barrels per day. Algeria can provide 60,000 barrels per day, Iran 50,000, and Venezuela 30,000.
It is useful to make further distinctions about surplus capacity. Demonstrated capacity refers to the difference between a country's highest production level since the start of 2005 and its average monthly output through May, 2007 as recorded by the EIA. The country's assumed capacity is any estimate of capacity beyond that which has been demonstrated. Saudi Arabia's production high water mark was 9.60 million barrels per day, last seen in September of 2005. Therefore, that number is the Kingdom's demonstrated capacity, and the EIA now assumes that the Saudis can produce an additional 0.90 million b/d if called upon. Other OPEC members provide the rest, a potential 0.52 million barrels daily.
In late September of 2005, Reuters ran the story Saudi Arabia finds no takers for additional oil. At the time, most Gulf of Mexico production was shut-in from the hurricanes and the oil price had surpassed $70/barrel for the first time. The world was in a panic. Here are some excerpts—
There are "no takers" for Saudi Arabia's offer to pump more oil for a global market pressured by soaring prices and refining constraints, the kingdom's oil minister [and de facto OPEC head] Ali Al Naimi said yesterday [on September 28th, 2005]...
Al-Naimi also told a World Petroleum Congress in Johannesburg the kingdom would stick to plans to gradually boost its total oil output capacity to about 15 million barrels per day from about 11 million at present, keeping ample spare available.
But he emphasized that Saudi Arabia had not found customers for its existing excess capacity [which is] the lion's share of OPEC's offer last month to pump up to two million bpd more oil, filling any supply shortages caused by hurricanes in the US.
"There are no takers," al-Naimi told delegates after a speech in which he reassured markets on the ability of global suppliers to meet rising demand for oil over the next 3-4 years.
It is now almost exactly two years later. Oil is trading at $80.90 a barrel (at this moment) and the U.S. Department of Energy believes that Saudi surplus capacity was only 1.90 million barrels per day in the 2nd quarter of 2007. The EIA gives a lower preliminary estimate of 2.17 million b/d for OPEC as a whole in the 3rd quarter. But let us take al-Naimi at this word, at least about there being "no-takers" for his oil back in 2005. Why were there no buyers for Saudi Arabia's oil? The glass-is-more-than-half-full optimists writing reports at Petroleum Intelligence Weekly provide a clue.
The quality of OPEC spare capacity clearly matters, as was seen at the end of 2004, when Saudi Arabia had to dip into its heavy [and sour] offshore and Manifa fields to meet rapidly growing Asian demand. Sweet-sour differentials ballooned as a result...
The most plausible hypothesis is—and always has been—that Saudi Arabia could not sell any more oil to the market in the fall of 2005 because there was no more demand for its heavier sour (sulfur-laden) crude—the market was saturated. The Kingdom has cut production 1 million barrels per day since then, with almost all of the decrease consisting of this same "dirty" crude formerly bound for Asian markets (Bloomberg, March 12, 2007). What else has changed? Other than 300,000 light, sweet barrels per day from Haradh III extension—the Saudis are quite proud of it—put on-stream in early 2006, there have been no capacity increases. The Saudi Aramco 2006 annual report also admits that production in the Kingdom fell off 1.7% in that year (0.153 million barrels).
It is uncertain exactly how much of Saudi Arabia's current production for sale is light, sweet oil as opposed to their Arab Heavy and Arab Medium sour grades with API gravity values below 30°. According to the IEA's World Energy Outlook 2005, Saudi Arabia's capacity was 10.352 million barrels in 2004—The Oil Drum provided a breakdown at the time. Of this capacity, 23% came from the heavier, sour fields Safaniyah, Manifa, Zuluf and Marjan. Adding in Haradh, Saudi Arabia has about 8 million barrels of light, sweet crude production capacity. In all likelihood, any rise in the Kingdom's production will consist almost entirely of low quality crude along with marginal amounts of light, sweet oil.
Although there are signs of change in Asian refining to expand processing of sour crudes, the downstream market has not changed appreciably since 2005. The only reasonable conclusion is that Saudi Arabia's demonstrated capacity of 9.60 million b/d is also their effective capacity (give or take a hundred thousand barrels or so), at least as far as the downstream market is concerned. Their surplus capacity is therefore about 1 million barrels. Any assumed capacity beyond that—the EIA estimates 0.90 million barrels—does not affect the world oil balance.
It is thus no wonder that oil prices have gone up since OPEC announced they
would raise actual (not quota level) production by 522,000 barrels per day effective
November 1st. According to Platts' OPEC says Saudis to assume almost two-thirds of output hike, Saudi Arabia will raise production 327 thousand barrels per day starting in November, 2007. This will most likely be heavy, sour crude sold back to the Asian markets. Smaller increases will come from Kuwait (85,000) and, astonishingly, Venezuela (112,000), which opposed the production hike. Iran's "new output target from November (-52,000) is lower than Iran's estimated
production in August." The OPEC increase will be completely offset in November by scheduled maintenance and upgrades at the UAE's Zakum and Umm Shaif fields starting in late October (Reuters). The world awaits the results of OPEC's largess.
When al-Al Naimi "reassured markets [about] the ability of global suppliers [like Saudi Arabia] to meet rising demand for oil over the next 3-4 years" in 2005, he was spouting nonsense. OPEC has taken crude oil off the market, and that has partly driven the price rise. Now they can't put enough high quality oil back to restore the supply & demand balance. If OPEC is the steward of the world's future oil supply, we're all in a whole lot of trouble. Destructive price spikes are a large risk because the surplus capacity we all depend on isn't there to bail us out. The world is now living on the edge, and oil consumers would be well-advised to change their behavior before events do it for them.
A future column will deal with OPEC's future spare capacity and supply-side market conditions.
Contact the author at firstname.lastname@example.org
1. For some perspective—and your amusement—I quote the BBC's story (February 15, 2000) Oil reaches $30 a barrel with the accompanying graph labeled "soaring oil prices".
The price of oil has surged to its highest level since the 1991 Gulf War. One barrel of crude oil is now worth $30.10. Oil futures rose as high as $30.40 before falling back slightly in trading in London...
US President Bill Clinton said the rise was "deeply troubling" and refused to rule out any US action to deal with the situation.