With around 2.5 million barrels per day (mb/d) of Iranian supply targeted by the Trump administration, how will the oil market cope with the losses? Is there enough supply capacity to make up for the shortfall?
There is a great deal of debate about the true extent of the world’s spare capacity. Or, more precisely, there are a range of guesses over how much surplus is located in Saudi Arabia, the one country that really has the ability to ramp up large volumes of supply on short notice.
Saudi Arabia claims it could produce 12.5 mb/d if it really needed to. However, that claim has not been put to the test. Saudi Arabia’s all-time highest level of production was just over 10.7 mb/d in 2016, just before it helped engineer the OPEC+ production cuts.
Adding around 2 mb/d of extra supply – as President Trump demands – is a tall order.
“More recent history shows Saudi has never produced more than 10.6mn b/d on average over a single month. And even in the recent period, we have observed a steep decline in domestic Saudi oil inventories,” Bank of America Merrill Lynch wrote in a note, arguing that there is plenty of reason to question the notion that Saudi Arabia has around 2 mb/d of idled capacity. “Thus, it appears the oil market has little confidence that Iran volumes can be easily replaced.”
The International Energy Agency estimates that there is around 1.1 mb/d of total global spare capacity that can truly be ramped up in a short period of time. A looser definition of spare capacity that encompasses the ability to add supply over several months puts the figure at about 3.4 mb/d, 60 percent of which is located in Saudi Arabia. Smaller additions come from the UAE, Kuwait, Iraq and Russia.
The problem is that Saudi Arabia is already ramping up output to replace lost barrels elsewhere. Saudi Arabia added 500,000 bpd in June compared to a month earlier, putting output at 10.5 mb/d. But that increase only offset losses in Libya, Angola and Venezuela. In other words, Saudi Arabia had 2.5 mb/d of spare capacity at the start of June, proceeded to burn through 0.5 mb/d, but because of the losses elsewhere, the oil market saw no net increase in supply.
News reports suggest the production increases will continue in July, perhaps to as high as 11 mb/d. That leaves roughly 1.5 mb/d of remaining spare capacity. But again, ongoing losses in Libya and Venezuela could eat up the additions.
That means that Saudi Arabia could use up two-fifths of the spare capacity that it had without the market really feeling the extra supply. And that is before we get to the potential outages in Iran. If all of the 2.5 mb/d of Iranian exports are shut in, it would theoretically add $50 to the price of oil, according to Bank of America Merrill Lynch.
In an extremely problematic scenario, it could be the case that Saudi Arabia does not have the 2 mb/d of extra supply that it says it does. Or, perhaps that capacity is not immediately available. Some analysts have argued that it would require additional drilling to push output as high as 12.5 mb/d, and it could only take place over many months. Ultimately, that would mean Saudi Arabia would be unable to plug the hole leftover by Iran, and oil prices would likely skyrocket.
Not everyone is that pessimistic, however. Barclays argues that global spare capacity could actually be about 1 to 1.5 mb/d higher than is commonly thought. The investment bank acknowledged that the deteriorating situation in Libya, combined with the potential catastrophic losses in Iran, puts the oil market in a bind.
“However, these eventualities are not completely certain. In the meantime, we believe that the market is less focused on some of the weakening demand indicators and stronger supplies that are signaling a softer market balance, thus, we maintain our bearish view in the short term,” the investment bank wrote in a note. Barclays estimates an average Brent price of just $73 per barrel in the second half of 2018 and $71 in 2019.
The crucial difference between a lot of bullish forecasts and the one that Barclays envisions is that Barclays believes the oil market will remain in a net surplus. The bank conceded that severe outages in Iran would blow up that scenario, but argued that “the US government will quickly find it politically unpalatable in an election year to quickly reduce to zero Iranian exports to India and China.”
Plus, the bank says, after factoring in 0.5 mb/d from the idled neutral zone on the Saudi-Kuwait border, which could restart next year, in addition to some other surplus capacity in the UAE, Russia and Saudi Arabia, total global spare capacity could be 1.5 mb/d higher than the EIA has suggested.
To top it off, government inventories could be drawn down. Barclays says that, in theory, governments could add a whopping 5 mb/d of supply onto the market for a period of 180 days, which would only use up about half of the overall stockpiles they are sitting on. Obviously, that is an unlikely scenario, but the investment bank says it illustrates the quantity of oil that could be called upon in a pinch.
Barclays is somewhat of an outlier in its restrained price forecast. Needless to say, there is quite a bit of disagreement over the true extent of Saudi spare capacity. But we may finally gain some insight into Saudi Arabia’s maximum capabilities if Iran really starts to see supplies shut in.
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