Much of the debate over the future path of oil prices can be framed as an argument about the Organization of Petroleum Exporting Countries' (OPEC) spare capacity to produce crude. This single fundamental goes a long way towards explaining the action in crude oil prices in recent years.
OPEC is the world's swing producer of crude oil. Countries outside OPEC don't have enough capacity to satisfy global crude oil demand and, consequently, must rely on exported supply from OPEC to fill the gap. The cartel manages its production quotas in an effort to control supply and maintain the oil price at a profitable level.
Spare capacity is the amount of excess production that OPEC can bring online quickly and sustain. It's essentially mothballed wells that can be brought on-stream as needed to boost supply. The higher spare capacity, the larger the world's cushion against oil supply and demand shocks. As you might have surmised, periods when OPEC’s spare capacity is high and/or rising tend to be associated with weak oil prices; when capacity is tight, crude prices tend to be well-supported. Here's a look at that pattern in graphical terms since 1991.
Source: Energy Information Administration (NYSEMKT:EIA)
Some pundits publish graphs showing global spare capacity in terms of barrels of oil production per day. But that presentation isn't that meaningful: Supply in barrels per day should properly be compared to global demand. After all, 5 million barrels per day of spare capacity would have meant a lot more to prices in 1991, when global oil demand was at 67 million barrels per day, than in 2008, when global oil demand was 85 million barrels per day.
My graph depicts spare oil production capacity as a percentage of global oil demand. This makes comparison between different time periods more meaningful. As the graph shows, spare capacity was generally high and rising through much of the 1990s and peaked at 6 to 7 percent of global demand. This was generally a period of weak crude oil prices.
After 2002, spare capacity contracted sharply and remained tight through 2008. As most investors are well aware, this was a period of rising crude oil prices. The mainstream media often treats OPEC production cuts as a reason to be bullish on crude oil prices. That assessment is true in the short term because it removes supply from the market and tends to tighten inventory statistics. However, over the intermediate to longer term, the opposite is the case: OPEC production cuts add to spare capacity, as they represent the idling of capacity. OPEC is effectively increasing the cushion of production capacity.
My graph shows projected spare capacity for 2009 and 2010 rising sharply to above 6 percent. This is more than three times the level that's prevailed in recent years and is high by any historical standard--at first blush, a bearish indicator for crude oil prices.
But don't rush to conclusions. My general view is that most of the major international organizations that make projections of future oil supply and demand dramatically overestimate spare capacity growth in coming years. And a number of factors affect the data depicted in my graph: global oil demand, non-OPEC production and OPEC's ability to increase its production capacity.
Global Oil Demand
Most of the jump in spare capacity that occurred in 2009 is due to a fall in global oil demand that allowed OPEC to idle more production and cut its quotas. The EIA’s data estimates that global oil demand fell by 1.65 million barrels per day in 2009 compared to 2008 levels.
The EIA estimates that global spare capacity increased by 2.85 million barrels per day between 2008 and 2009. That means the drop-off in global oil demand that resulted from the global recession and financial crisis of 2008-09 accounts for about 60 percent of the total jump in spare capacity in 2009 compared to 2008 levels. But demand is clearly coming back this year, and I wouldn’t be surprised to see more upside revisions to global oil demand in coming months.
The first point to note is that the EIA estimates that liquid fuel demand for emerging markets (non-OECD) actually rose slightly in 2009 from 2008 levels, which suggests that the decline in global oil demand was due to the developed world. But recent data from the EIA suggests that US oil demand is stabilizing and may, in fact, be starting to tick higher on a year-over-year basis.
Meanwhile, demand from non-OECD countries is accelerating. In July, the International Energy Agency (IEA) estimated that non-OECD oil demand would total about 40 million barrels of oil per day in 2010. By the time the IEA released its December report, the agency had increased that estimate to 40.8 million barrels of oil per day. These upside demand revisions are due primarily to showing faster-than-expected economic growth in the developing world.
Higher global oil demand will have the effect of moderating spare capacity; the call on OPEC to produce more crude will rise in 2010.
Over the long term non-OPEC production is a thornier and more important issue than demand. Rising non-OPEC production means that even if global demand rises, the call on OPEC production falls, allowing the group to keep more capacity idled.
Non-OPEC production was relatively robust in 2009 due to strong contributions from Russia and a handful of other producers. But Russia is unlikely to repeat the 2009 experience next year; most of the nation’s growth came from a series of new fields brought online that added as much as 600,000 barrels of oil per day to capacity. Russia doesn't have as many new projects slated to come online in 2010; I expect declines from mature fields in Russia to become more evident.
Although the deepwater Gulf of Mexico, offshore Brazil and offshore Africa all have promising production growth prospects over the long term, much of this growth will come years in the future. And as I explained in the Dec. 30, 2009, issue of The Energy Letter, Down Mexico Way: Oil and Politics South of the Border, production declines from mature, non-OPEC fields have been a good deal faster than most observers had expected. Most of this new oil production from tough and expensive-to-produce fields will simply replace declining production from mature oilfields.
Unconventional oil production will help. But, these projects require relatively high prices to be economic, and activity and production are price-sensitive. The best evidence of this I can imagine is the experience of late 2008 and early 2009 when big oil sands producers like Suncor Energy (NYSE: SU) drastically cut back their capital spending plans as crude prices tumbled. Many have been slow to bring back that spending even though oil prices doubled in 2009; producers are understandably gun-shy and want to see sustained higher prices.
In a recent presentation at an energy conference, oil service giant Schlumberger's (NYSE: SLB) CEO Andrew Gould noted that already between 1 and 2 million barrels per day of expected oil production capacity have been lost due to the drop-off in investment in late 2008 and through 2009.
This basic fact makes projections of much lower oil prices untenable in my view. For crude oil prices collapse under USD40, in non-OPEC supply would need to increase sharply. But a jump in non-OPEC supply would require a big rise in investment in exploration and production. The experience of the last two years tells us that oil companies won't make the necessary investments unless prices are relatively high and stable.
OPEC Production capacity
OPEC production capacity is another factor that’s open to debate. The medium-term outlook from the IEA shows total OPEC capacity rising by 2.76 million barrels per day between 2008 and 2014.
If I am correct in saying that non-OPEC oil production is near a peak and demand will increase going forward, OPEC capacity growth of 2.76 million barrels per day will be insufficient to grow spare capacity; under this scenario, the call on OPEC would actually increase, forcing the group to bring idled capacity into production.
The table below shows the expected source of this capacity.
As you can see, most of the expected growth is set to come from Saudi Arabia. The desert kingdom has a number of major projects that should come online in coming years and see peak production between 2015 and 2020. Questions abound as to whether actual capacity will reach stated targets and make up for declining production from existing mature fields.
But even if we assume Saudi Arabia posts solid capacity growth, there are still a number of huge question marks. Nigerian production, for example, has been impacted by rebel groups’ disruptive activities. And Iraqi production growth is also up for debate. Investment is beginning to flow into the country, but significant geopolitical risks remain.
Moreover, declines in capacity for countries such as Venezuela and Iran could also prove much larger than expected. The Chavez government's aggressive stance towards foreign oil companies, for example, has all but eliminated foreign investment in the Venezuelan oil sector and created risk of an economic meltdown for the nation as a whole.
It's highly unlikely that rosy forecasts for increasing global spare oil production capacity will come to pass. Rising demand from developing countries coupled with flat-to-declining production outside OPEC will result in a retightening of the global oil market in 2010 and 2011. I expect oil prices to top USD100 per barrel this year and reaching record highs at some point in 2011.
Elliott Gue is Editor of Personal Finance and The Energy Strategist.
Disclosure: no positions