The main reason the markets moved to sell oil in the past month or so has been the rumor that Russia and Saudi Arabia may seek to increase production by as much as 1.5 mb/d at the upcoming OPEC meeting. After years of the market worrying about a supply glut, it makes sense that the market is now reacting to the news by selling oil futures and betting on lower oil prices in coming months and years. This, despite the fact that the IEA recently estimated that OECD oil stored is now at its five-year average, while distillate inventories are under the five-year average. It also matters very little it seems that Russia and Saudi Arabia are mostly considering this move in response to expectations that Iran's exports may plunge by as much as 1 mb/d, while Venezuelan production seems to continue shrinking at a steady pace. In other words, this proposed increase would merely keep OPEC at 100% compliance, versus an estimated rate of compliance that is currently at a record rate of 172% as was reported by the IEA in its May report. It seems that very little attention is being paid to the possibility that an agreement on increasing production may not necessarily come together. One factor, which in my view most oil analysts are completely ignoring, is the fact that both Saudi Arabia and Russia are producing their oil from some massive but also very old fields, meaning that they are unlikely to want to see a repeat of oil prices plunging to levels seen in 2016. Therefore, any increase in production may be very cautious, because they are facing increasing production costs. They may be starting at 1.5 mb/d just so they can have some room for compromise, while any final OPEC deal may involve a much smaller increase, if any increase will be seen at all.
The supply/demand outlook
We should try to keep in perspective the fact that any OPEC increase at this point would at most help keep the supply/demand situation from spiraling out of control, with a supply shortage most likely causing a sharp price spike by next year at the latest in the absence of OPEC offsetting the continued decline of Venezuelan output and the expected decline in Iranian exports due to US sanctions.
The IEA graph above depicts what would happen in terms of global supply/demand if an additional 1.5 mb/d of oil production will be lost due to Venezuela and Iran seeing a plunge in production. As we can see, even in the event that OPEC will agree to the proposed 1.5 mb/d increase, it will still mean that by the fourth quarter of 2019 we will be back to seeing a supply deficit, assuming the Iran and Venezuela situations do not improve. Given that we are currently no longer in a stockpile glut situation in the OECD, I don't think that this is a reason to assume another major glut is on the horizon.
OPEC deal may not materialize
On the surface, it may seem that countries opposed to an OPEC deal to increase production, such as Iran, Iraq and Venezuela, may not have any way to seriously oppose the will of Saudi Arabia, Russia, and presumably, UAE and Kuwait. But if we take a step back and contemplate the situation from a wider perspective, we should keep in mind that no one involved would want to burn bridges either. In other words, Saudi Arabia would not want to destroy all future goodwill by the likes of Iran and Iraq. After all, these are countries which could potentially increase their production capacity significantly and potentially undermine any future attempts to put together another agreement like OPEC did back in late 2016, which included many non-OPEC contributors to the deal. After all, there may be a need for a similar deal in the future.
There are other reasons why OPEC as well as Russia might not want to push through with such an increase. One reason might be because while the IEA is forecasting an increase in oil demand next year of 1.4 mb/d, in reality, that forecast is increasingly looking unrealistic, given all the global trade tensions we are seeing, which is now starting to take the unmistakable shape of an open trade war. The trade tariffs already implemented or announced and awaiting implementation are on their own sufficient to necessitate a downward revision in global GDP growth prospects and inevitably a downward revision of global oil demand growth prospects as well.
I doubt that Russia or Saudi Arabia would want to return to an oil supply/demand environment where they would be facing another price crash. Russia's economy may be becoming less and less dependent on oil, but it remains a huge part of its economy nevertheless. As for Saudi Arabia, it needs the oil revenue surplus in order to maintain its lavish welfare expenditures, as well as its robust military spending, which by some accounts are the third-highest in the world behind the US and China, making up as much as 10% of its GDP. Its budget deficit for this year is estimated to be 7.3% of GDP, which would get much worse both this year and next if they get the oil supply management agenda wrong at the OPEC meeting. Russia would most likely be alright even if oil were to plunge to $40-50/barrel, given its increasingly diversified economy as well as its solid fiscal situation, but Saudi Arabia has almost nothing else but its oil industry. At the same time, Russia's oil industry is not the one with the significant spare capacity, so it is by no means the one who would benefit the most from a relaxation of the quotas, so it has very little reason to fight very hard for a significant increase in production at the OPEC meeting.
OPEC production increase would most likely wipe out all surplus capacity
One aspect that we should keep in mind when contemplating the effects that an increase in OPEC oil production would have on the global markets is what that would leave in terms of surplus capacity going forward. I know that there is an assumed Saudi capacity of about 12.5 mb/d, while it is currently producing about 10 mb/d, leaving an assumed surplus capacity of about 2.5 mb/d, but I personally do not believe that this picture adds up when we consider the facts.
I know that it is sometimes hard to avoid the short memory aspect of the market, but if we think back to a decade ago, just as oil prices were spiking towards $150/barrel, Saudi Arabia failed to come up with extra production above and beyond the 9.5 mb/d it achieved in early 2008. In other words, that was as much as it could produce given the capacity of its aging fields it relied on back then.
Source: Trading economics
Since then, we have seen production gains from Saudi Arabia, which were made possible by a series of projects involving mostly relatively large fields that Saudi Arabia discovered a long time ago but did not develop them because they were technically more challenging and financially more costly to produce. Projects like Khurais and Manifa, as well as a number of other capacity expansion projects, may have added about 3 mb/d of extra capacity since 2008. This fact on its own might suggests that Saudi Arabia does indeed have the ability to produce perhaps as much as 12.5 mb/d. Thing is, however, that we have to factor in probable declines that may have occurred in other fields in the past decade or so. In my view, its Ghawar field is most likely nowhere near producing 5 mb/d as is still being assumed. Based on most estimates, it has produced about 70-75 billion barrels of oil, out of 173 billion barrels of oil initially in place. In other words, it already produced at least 40% of the oil that was originally in place. A realistic scenario for ultimate recovery for the field is a maximum of about 65% in my view, meaning that almost 2/3 of the oil that will ever be recovered from this field has already been recovered.
While there is no way to know for sure, given that Saudi Arabia is not exactly forthcoming with its operating details, my guess is that it may have lost at least 1 mb/d in production capacity from Ghawar alone in the past decade or so. Other fields where production has probably been reduced due to severe depletion includes Abqaiq which is thought to be near the end-stages of its production life. In conclusion, I think it is entirely reasonable to suspect that while 3 mb/d of new capacity may have been added in the past decade, there may have also been a decline in capacity from other fields which may amount to as much as 2 mb/d. Not only that, but it is possible that Saudi Arabia is continuing to lose a few hundred thousands of barrels per day in capacity every year. If the production increase plan will go ahead, it will most likely mean that Saudi Arabia will be producing close to its maximum capacity, meaning that while there will be more supply in the market, there will also be very little, if any, surplus capacity left in the world.
Most likely outcome of OPEC meeting
It is important to keep such considerations in mind when contemplating the most likely outcome of the next OPEC meeting. Saudi Arabia may want to produce more in order to bring in more revenue as well as to keep oil prices in a comfortable price range for both consumers as well as producers. But it would not want to max out its production capacity, leaving it vulnerable if called upon to increase production, due to any unforeseen disruptions, as well as being exposed to its own shrinking capacity becoming visible if called upon to maintain that level of production for a prolonged period. I also don't think that any of the OPEC members or Russia would want to do something that would lead to another oil price crash, which is what might happen in the shorter term if they were to increase production by 1.5 mb/d after the meeting.
The most likely outcome will be a rather small increase in OPEC and non-OPEC production quotas, perhaps reflecting the increase that already occurred recently in Russia and Saudi Arabia, motivated by the decline already incurred in Venezuela. There will probably also be some statements referring to future adjustments in production in the event that more OPEC production will be taken offline by a variety of factors, such as political turmoil, conflicts or sanctions. Where this will leave the market for the rest of the year is most likely in a situation where OECD and global stockpiles of oil will continue to decline slightly, meaning that oil prices are likely to continue increasing for the remainder of the year.
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