Spare capacity is the oil sector's ultimate shock absorber.
These buffers shot up to COVID-19-induced 35-year highs but are now rapidly reducing. A rising trend of security incidents in the Middle East, a tentative demand recovery and OPEC+ pumping more could see oil risk premium back on the market's radar.
Violence aimed at oil infrastructure in the Persian Gulf has tripled on an annualized basis since the start of 2018, according to data in the S&P Global Platts Oil Security Sentinel, a new study on geopolitical risk and price. This year so far has seen 27 confirmed incidents. The attacks have spread in regional diversity over the past five years, to include the 400,000 b/d Jazan refinery and terminal in Saudi Arabia and Bab al-Mandab waterway in the west from the larger Strait of Hormuz chokepoint and crucial Abqaiq area in the east, the study shows.
But this has barely registered on the oil market Richter scale. The Platts Dubai benchmark, used to price or hedge nearly all of the Middle East region's oil exports to Asia, is the most sensitive barometer to regional disruptions and even here price fluctuations have been limited.
The reason is fourfold: spare capacity, with the ability to sustainably pump extra crude at short notice more than double the roughly 2 million b/d average since 1990; commercial oil stocks are healthy; strategic petroleum reserves have risen; and the nature of attacks have been generally been low-intensity.
"OPEC's role in stabilizing markets through readily available spare capacity is often understated," said Paul Sheldon, chief political adviser at Platts Analytics. "During periods of large supply disruptions OPEC (now OPEC+) possesses the world's only readily available production to offset sudden losses elsewhere.
"The price impact of supply disruptions or security risks to production typically depend on the level of available spare capacity," Sheldon added. "When the market has a thin buffer, the demand for inventory can quickly increase or decrease, creating a volatile price environment."
Spare capacity shifts
But global spare capacity is in the hands of a handful producers within the OPEC alliance, which aims to ease their production quotas and bring an extra 2 million b/d to market by end-2021.
Platts Analytics sees spare capacity falling to 3.3 million b/d by year's end, with 95% of this in the hands of core OPEC+ — Saudi Arabia, Russia, UAE and Kuwait — up from 84% in July. This change is also set to exacerbate the importance of Saudi Arabia's role to the oil market, with the majority of the spare capacity residing with the kingdom.
This level of spare capacity should be able to cover most supply shortfalls. However, Platts Analytics warns if there is no deal to remove sanctions on Iran, this could leave the market vulnerable to a large, unexpected disruption. While the oil market could tap IEA-mandated emergency stocks in times of crisis, they have only been used three times — the Gulf War, the US hurricanes of 2005 and the Libya collapse in 2011 — and are very much the final guardrail.
Iran has the ability to bring an extra 1 million b/d within a year of a deal being reached. But without one the ongoing risks with critical producers Libya, Nigeria and Iraq come back into focus, as highlighted by the Platts Oil Security Sentinel.
Given the current questions over US shale and investment in oil longer term, the outlook for oil demand post-pandemic will be crucial and whether a strain is put on spare capacity.
Carole Nakhle, CEO of Crystol Energy, noted that while high prices are typically observed when oil demand is rising fast and OPEC spare capacity is running low, this time round oil supplies would still be plentiful.
"The longer-term price development will depend on whether we face a period of strong economic growth, causing oil demand to continue growing beyond the levels it had reached prior to the pandemic in early 2020," Nakhle said.
Toril Bosoni, the International Energy Agency's head of oil markets division, told Platts earlier this year that even by 2026 spare capacity would be above 2 million b/d excluding Iran, playing down fears of a supply-demand imbalance.
However, independent oil consultant Anas Al-Hajji warns further out that "even if we include the large spare capacity that exists today and the lower demand growth that result from high oil prices, the likelihood of global shortages is high," noting that all medium- and long-term outlooks are underestimating global oil demand.
The nature of that demand and the role of spare capacity to meet in terms of shocks has a quality premium too. Core Gulf OPEC producers typically supply heavier and sourer crude grades to Asia buyers such as China and India. Supplying regular customers with the right grades in times of crisis through spare capacity is also important.
The Brent/Dubai spread, an indicator of the crude quality split, has reflected the shortages of Middle East crude, such as when the Abqaiq strike briefly knocked out 5.7 million b/d in September 2019.
In times of plenty, spare capacity can often be overlooked. But in times of tension or disruption, it is one of the last lines of defense. And those times may not be too far away.