The Myth Of OPEC+ Spare Capacity

Summary

• OPEC+ likely has less spare capacity than represented.
• Russia and Saudi Arabia examined more closely, biggest contributors.
• Could lead to much higher oil prices.

As energy prices across the globe rise, many observers and pundits continue to downplay the possibility of a global energy supply crisis, often citing OPEC+ spare capacity as the panacea. The perception that OPEC+ is flush with spare capacity is pervasive. But due to a lack of reliable data and no formal reporting or verification requirements, many industry experts and analytics firms have adopted OPEC+’s self-reported numbers. No one knows exactly how much spare production capacity OPEC+ really has, and few seem interested, despite the potential implications.

In the last few months, I have shared my perspective and work indicating that OPEC+ has materially less spare capacity than advertised on financial TV and podcasts, in conference presentations, and elsewhere. Below, I explore this possibility in-depth, with a particular focus on OPEC+’s two most important producers, Russia and Saudi Arabia.

OPEC+ - Dominant Oil Cartel

OPEC+ controls about 50% of global oil supply, most of which comes from Russia and Saudi Arabia. The latter are known as “swing producers” because they can adjust their spare production capacity in response to changing market fundamentals. As of July 2021, EIA estimates that OPEC+ has 6.9M bbl/d of spare capacity, approximately 75% of which is controlled by UAE, Russia and Saudi Arabia. Saudi Arabia controls the lion’s share of the cartel’s spare capacity and therefore holds the most sway over major cartel decisions. Historically, there has been a negative relationship between oil price and spare capacity, as the cartel has reacted to rising prices by increasing production, and reacted to falling prices by withholding production.

Less Spare Capacity Than Advertised: Bison’s Differentiated View

OPEC+ has less spare capacity than advertised. What is left of the cartel’s spare capacity could be fully absorbed, as oil demand approaches pre-pandemic levels. Some of the evidence that informs this view is as follows:

Declining Production Capacity

First, actual production capacity for most OPEC+ member countries has declined materially in the last 3 years. This is primarily the result of logistical hurdles, political turbulence and U.S. sanctions, which have contributed to underinvestment in new wells and infrastructure to maintain output. Indeed, production capacity has declined between October 2018 and July 2021 for nearly all OPEC+ member countries.

Difficulty Delivering Higher Production Levels

Second, early evidence suggests that OPEC+ is having difficulty meeting its higher production quotas, and this comes after cutting production by a record 9.7MM bbl/d in April 2020 (~10% of 2019 global demand) in a desperate attempt to stabilize oil prices. More specifically, the cartel announced in mid-July that they would collectively increase output by 0.4MM bbl/d beginning in August, which would equate to a 2MM bbl/d increase by the end of 2021 and put them on track to fully restore production by September 2022:

Despite these lofty promises from the cartel, OPEC+ only increased production by 0.1M bbl/d in August, which is 75% below their target. Obviously, this raises concerns about OPEC+ members’ capacities to meet future production quotas.

Oil Demand Recovering Faster Than Anticipated

Third, oil demand in the world’s largest economies is recovering faster than anticipated. According to SIA estimates, China’s oil demand is expected surpass pre-pandemic levels by 13% in the next quarter, driven by a 20% increase in gasoline use. In India—where demand is traditionally muted due to monsoon season—refiners are already running at full capacity to meet gasoline demand that has already surpassed pre-covid levels. In response to demand pressure and rising input costs, The China National Food Strategy Reserves Administration began releasing crude oil reserves into the market to provide some relief. While this may dampen prices in the short-term, this supports our macro view that the market will be in a structural deficit in the long term.

Biggest OPEC+ Producer Capacity Lower Than Advertised: Saudi + Russia

Finally, Bison research suggests that the actual production capacity of the two largest OPEC+ producers, Saudi Arabia and Russia, may be materially lower than claimed.

Saudi Arabia

OPEC’s official estimate of Saudi Arabia’s productive capacity is approximately 12 million barrels per day, which closely matches the consensus. Yet there is evidence that, when Saudi production has been near 10MMbbl/d historically, their onshore oil inventories would deplete. This indicates that true productive capacity may not be 12MM. In fact, Saudi inventories have been falling precipitously since 2016 despite lower exports, during which they were producing an average of 10Mbbl/d:

According to the U.S. Energy Information Administration (EIA), Saudi Arabia is keeping 1.5-2MM bbl/d of production as spare capacity. It is important to note, however, that Saudi Arabia is both able and incentivized to overrepresent this spare capacity, as their reporting requirements are opaque and the perception of higher production capacity allows Saudi to exert more influence on both OPEC+ member countries and global oil markets:

Estimating Saudi Arabia's True Spare Capacity

The EIA defines spare capacity as “oil production that can be brought online within 30 days and maintained for at least 90 days”, while Saudi Aramco (ARMCO) uses the minimum sustainable capacity (MSC) standard, which they define as “the average maximum number of barrels per day of crude oil that can be produced for one year during any future planning period”.

​​Despite the conflicting definitions, the MSC figure used in Aramco’s 2020 annual report is the same as the total capacity figure which Saudi Arabia reported to the EIA. Given that the Saudi definition includes oil that could take up to three months to bring to market, compared to the 1-month standard used in the EIA figures, we can conclude that their “true” total capacity (including effective spare capacity as defined by the EIA) must be lower than 12MM bbl/d.

Having established that Saudi spare capacity is overstated, it is productive to estimate true Saudi Arabian spare capacity. We would like to caution that the following represents an estimation using available information, which may not be precisely accurate, but which may be more indicative than the 12MM bbl/d consensus - we prefer generally correct to “precisely wrong.”

We rely on the follow observations:

• Aramco’s “actual” production capacity is likely at most 10MM bbl/d (based on inventory depletion at and around that production level)
• Aramco’s stated capacity is 12MM bbl/d (with spare capacity as defined by the MSC)
• MSC’s “time to market” definition is 3 months
• EIA’s “time to market” definition is 1 month
• The assumption that, if X barrels can be brought to market in 3 months, then X / 3 barrels can be brought to market within 1 month

From these observations, we observe that Saudi Arabia’s “true” spare capacity under the traditional EIA definition lies above the highest amount it ever produced consistently for a period of at least 90 days, (10M bbl/d) and is capped by the MSC (12M bbl/d), a less conservative definition of spare capacity. Linear interpolation implies that Saudi Arabia’s “true” spare capacity = 10 + (12-10) / 3 = 10.66MM bbl/d – a figure that may be overstated due to recent inventory depletion at lower production levels.

To validate our interpretation, we wanted to see if Aramco’s production exceeded 10.66MM bbl/d for any 90-day period over the last decade. We observed that although Saudi Arabia has produced over 10.66MM bbl/d 3 times in the last 10 years, it has never sustained it for more than 90 days (as per the EIA definition). It’s also worth noting that oil prices were already rallying in early 2020, and it would have been relatively profitable for Saudi Arabia to maintain higher production at that time given their low stated variable cost.

Russia

Russia joined with OPEC to form OPEC+ in 2016, with current production averaging 10.7MM bbl/d as of September. Despite being one of the most important producers in the expanded cartel, we suspect that Russia likely has very low spare capacity levels relative to current production, owing to a history of mismanagement of petroleum resources.

In the 1980’s, the communist Soviet regime employed wasteful extraction techniques that rapidly depleted wells—in many cases reducing their productive capacity. The situation worsened after the fall of the Soviet Union in 1991, where privatization and introduction of new technology in the industry allowed the Russian oil industry to increase their production base replacing it with new reserves, accelerating reserve depletion. Russian oil companies subsequently back-filled reserves through aggressive exploration, but have reduced exploration and new field infrastructure capital expenditures since the oil crash of 2014. This recent period of lower investment may have left them with little flexibility to maintain—let alone increase—its current production.

Russia’s most recent production numbers are also unimpressive. As part of OPEC+’s production cuts in April 2020, Russia agreed to curb production by 9% to 10.3MM bbl/d. Yet as global demand recovers, Russia’s production has languished despite having been allotted nearly 0.2MM bbl/d in additional production since April:

Over the longer term, Russia was given a baseline production figure of 11MM bbl/d, which could be allowed to rise to 11.5MM bbl/d by April 2022. Yet Russia has never produced anywhere close to that amount, and when considering their underinvestment in new fields, they may not be able to for some time.

An important nuance lies in definitions, a discrepancy which Russia exploits to overrepresent its production. Specifically, the OPEC+ production targets apply strictly to crude oil production, excluding condensate. Condensate is in some cases extracted from the same wells, and can be an input in some refineries along with crude oil. Russia’s condensate production is significant, estimated to be ~0.8MM bbl/d, or 8% of Russia’s 10.43MM bbl/d production figure in August. This detail is often overlooked because this data is not readily available. By subtracting reported crude oil production numbers from the total crude and condensate figure reported by OPEC+, we constructed the chart below:

The above suggests that Russia is only sustaining its level of aggregate liquids production, and that they may have hit or approached the upper limit of their production capacity for now. Also worth noting is that Russia has frequently surpassed production quotas imposed by OPEC+, which begs the question: If Russia often produces over their quota, why haven’t they significantly increased production with higher prices? We think it is unlikely that Russia has shifted priorities and that is now trying to produce in line with targets. Given its prior history of overproduction with little regard for the cartel’s demands, it seems more likely that Russian current production is nearing its true capacity.

Also, Russia’s true production capacity may have declined after the April 2020 production cuts, as many older, higher water content wells were shut in, in some cases permanently. With many of these wells only temporarily shut in and not yet plugged and abandoned, there may be some room to increase production by ~0.4MM bbl/d in the future as some of Russia’s 40,000 inactive wells are brought online.

Ultimately, the different well-management strategies chosen by producers and the general lack of data make it difficult to quantify Russia’s spare capacity. This becomes clear when examining the variance in Russian spare capacity estimates by analysts, as can be seen below:

Russia’s Gazprom (OTCPK:OGZPY), which accounts for ~66% of domestic natural gas production as of 2020, may also have an inventory problem. Having depleted most of its inventories, the country will need to store about 280M bcf/d, or roughly 80% of its exports to Western Europe, to reach its target of 72.6B bcf in domestic inventories by Nov 1. This is problematic for importers of Russian gas in Europe, who are already seeing natural gas prices at all-time highs and have their own depleted inventories ahead of winter, in a season when inventories have historically built. This natural gas supply issue is supportive of the view that Russia is producing very close to its true productive capacity, which may decline in the future, barring additional substantial capital expenditure.

Implications of Shortfall of OPEC+ Spare Capacity

With likely 2 million barrels per day less spare capacity than claimed and widely believed, the oil market is much tighter than consensus. As world oil demand recovers post Covid-19 and grows to new highs, there may be a call on OPEC+ spare capacity. Particularly as inventories deplete and as US shale is “on strike”, with a new focus away from growth and towards capital return. We may be approaching a time of higher world oil demand than world oil supply capacity. This could result in much higher oil prices and a potential return to the stagflation type economic situation last seen in the 1970s, a time period when OPEC withheld oil from the market. In that time frame, both stocks and bonds did poorly, while oil and gas stocks did quite well:

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