Shrinking spare capacity leaves oil market exposed to geopolitics, supply risks

Oil markets have resumed their bullish trend and prices have hit multi-year highs, defying expectations that supply would outpace demand in the first quarter and prompting analysts to raise their forecasts. On Jan. 19, ICE March Brent rose to a seven-year peak of $89.05/b after oil flows along the Kirkuk-Ceyhan pipeline were shut in due to an explosion on the line near the southeastern Turkish city of Kahramanmaras.

"Multiple production threats are escalating simultaneously, led by diminishing odds of an Iran nuclear deal (with disruptive geopolitical implications), deteriorating political stability in Libya, and a potential Russian military incursion into Ukraine upsetting the international status quo," said Paul Sheldon, chief geopolitical advisor at S&P Global Platts Analytics.

Capacity constraints in almost OPEC+ members, barring Saudi Arabia, as well as the UAE will make the oil market more vulnerable to supply risks, including geopolitical disruptions and weather impacts such as the US hurricane season, according to analysts.

Spare capacity shield

For the past few years, diversity of supply, higher levels of global spare capacity and the expansion of strategic petroleum reserves have helped to insulate markets from the risk of supply disruptions.

But with OPEC+ spare capacity poised to fall to fresh lows later this year, this crucial market buffer may not be effective in shielding the market from geopolitical risk and outages.

Sheldon said planned OPEC+ production hikes will reduce "sustainable spare capacity" to an uncomfortably low 800,000 b/d by June, just as oil demand is set to grow by 3.5 million b/d in H2 2022 over the first half of the year.

Sustainable spare capacity is capacity defined by Platts Analytics as voluntarily idled production which can be brought online for an extended period of time.

The price impact of supply disruptions or security risks to production typically depend on the level of available spare capacity.

Global spare capacity ranged between 7 million-9 million b/d from May to December 2020 as OPEC+ embarked on massive production cuts as the COVID-19 pandemic rattled the global oil markets. But by the end of 2021, spare capacity was around 3 million b/d, with almost 90% of this in the hands of core OPEC+ producers Saudi Arabia, Russia, the UAE and Kuwait.

The shrinking capacity also comes amid an increase in security incidents targeting oil facilities, pipelines and tankers.

Data compiled from Platts Oil Security Sentinel shows there have been there have been 70 confirmed security events between early 2017 and Jan. 19m 2022. Security events -- such as physical attacks on petroleum infrastructure or shipping -- in the Persian Gulf and the Arabian Peninsula region have tripled on an annualized basis since 2017, Platts Oil Security Sentinel showed.

There have already been five incidents so far in 2022 such as the closure of the 600,000 b/d Iraq-Turkey pipeline following a blast late Jan. 18 and a drone attack by Yemen's Houthi militia on a fuel depot in Abu Dhabi on Jan. 17.

The International Energy Agency, in its latest monthly oil market report released Jan. 19 noted that the omicron variant's reduced virulence and geopolitical tensions had reinforced robust fundamentals, creating a volatile environment for the months ahead.

"If demand continues to grow strongly or supply disappoints, the low level of stocks and shrinking spare capacity mean that oil markets could be in for another volatile year in 2022," the IEA said.

Iran, Russia

The potential derailment of Iran nuclear talks is the largest geopolitical oil market risk in 2022, according to Platts Analytics, and this could be followed by an uptick in regional attacks by an isolated Iran.

"The failure of an Iran nuclear deal not only prevents Iran's additional production capacity from entering the market, but it could also interrupt its current supplies in the market," said Sara Vakhshouri, president of energy consultancy SVB Energy International. "Tensions in the Middle East also pose a significant threat to both oil and natural gas supplies and prices."

However, Sheldon said an interim deal in 2022 is more likely than talks derailing altogether, or a full return to the Joint Comprehensive Plan of Action, known commonly as the Iran nuclear deal.

Platts Analytics forecasts Iranian crude and condensate exports to grow by 500,000 b/d in April-May to 1.2 million b/d, and another 200,000 b/d by December as the efficacy of existing sanctions wanes.

A possible Russian military incursion into Ukraine could have a major effect on the natural gas and oil markets too, and this would trigger strong sanctions response by the West.

"Financial sanctions would be certain, which could raise Russian reliance on OPEC+ cohesion and higher oil prices, and potentially trigger a tax hike on oil companies at some point," added Sheldon.

Political chaos in Libya, Iraqi instability and subsidy reforms in some oil producers such as Kazakhstan and Nigeria were some of the other key geopolitical risks in 2022, according to Platts Analytics.