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OPEC has no answer for its spare oil capacity problem

Vieinna — OPEC, for the time being, has at least overcome the political divisionsbetween Saudi Arabia and Iran, but solving its spare oil capacity problem willbe much harder to crack.

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There is even some debate of what spare capacity means and how it should bemeasured.

A basic rule of thumb is spare capacity is the amount of oil a producer canbring on stream at short notice. The International Energy Agency defines thisin terms of crude which can be produced within a 90-day period and sustainedfor an extended phase of time. But few producers can meet those criteria.

After a week of tense negotiations, which saw Iran's oil minister BijanZanganeh storm out of a meeting, the group of 14 producers agreed Friday toincrease nominal output by 1 million b/d starting July 1 in partnership withits allies led by Russia.

Given the tense political acrimony with Iran in the background, the deal is atriumph for Saudi Arabia. The group's largest exporter is also its only memberreally capable of opening its taps to put significant volumes of extra barrelsinto the market.

But it already looks like a pyrrhic victory before the ink has dried. Keepinga lid on oil prices by releasing more crude will briefly appease critics, seeUS President Donald Trump, but it won't help Riyadh and its allies invest intheir reservoirs long term.

With about 2 million b/d of spare capacity, Saudi is in an enviable position,even in a group which controls almost 82% of the world's proven reserves.Maintaining this buffer is expensive for a kingdom, which has been forced torun budget deficits and requires prices around $80/b for its treasury to breakeven.

"It costs us between capital and 'opex' tens of billions of dollars to keep 2million b/d of spare capacity, and we weigh very carefully whether it needs toincrease or not," Saudi oil minister Khalid al-Falih said Friday. "I think, atthe end of the day, we have to look at what other countries are doing. Manyother countries have announced intentions to increase capacity and we'rewatching what the US is doing.

"I think 2 million barrels of spare capacity is very high for one country tohave and it's very expensive. I don't want Saudi spare capacity to be 3million-4 million b/d."

Years of underinvestment and tepid prices have left the OPEC group's sparecapacity at dangerously low levels. Before its new agreement, OPEC produced31.9 million b/d in May, according to the latest S&P Global Platts survey,about 840,000 barrels below its previous ceiling of about 32.74 million b/d.If enacted fully, its new agreement with the 10 producers led by Russiaoutside the cartel will end over-compliance.

Outside OPEC

Unhindered by quotas and political intrigue, producers in the US have forgedahead. The world's largest economy will soon become its biggest producer ofcrude based on the latest forecasts. The Energy Information Administrationpredicts US crude output to average 10.79 b/d in 2018, climbing to 11.76million b/d in 2019.

Outside Saudi Arabia, it is difficult to see where any additional crude willcome from within OPEC in its current form. Short of an agreement to restartoutput from the so called "Neutral Zone" straddling the border between Kuwaitand Saudi Arabia, even the kingdom will find increases difficult unless itdramatically increases upstream investment.

Elsewhere, Gulf producers have consistently failed to reach capacity targets,which in some cases have been in place for over 20 years.

Although prices have more than doubled over the last year, investment in theoil industry has lagged far behind. Global spending peaked at $900 billion in2014 but was halved by 2017. And the situation isn't improving. Even withprices holding above $70/b, investment is only expected to reach $510 billionthis year, according to Qatar energy minister Mohammed Al-Sada.

"It;s hard for OPEC to invest at these price levels and not sure the marketreally appreciates the limits on spare capacity," Joe McMonigle, senior energyanalyst at Hedgeye Risk Management, said Friday.

Sanctions strain

To complicate matters even more, output from Venezuela and Iran could soon gointo freefall once US economic sanctions bite.

Iran had regained its spot as OPEC's third-largest producer, after Saudi andIraq, before being hit by new embargoes, which come into force in November.The country could lose 1 million b/d of output capacity over the next year asa consequence of the legislation.

In Venezuela, sanctions are "practically immobilizing" state-owned oil companyPDVSA, Venezuelan oil minister Manuel Quevedo said Thursday. Output isplunging toward 1 million b/d, and the country realistically has no sparecapacity.

"Looking ahead, greater volatility looks nearly certain," Paul Sheldon, ChiefGeopolitical Advisor at S&P Global Platts Analytics, said Friday. "Givenwidespread geopolitical risks to oil supply in the Middle East and elsewhere,the level of spare capacity in global oil markets will be uncomfortably lowafter OPEC raises production."

International oil companies are also reluctant to invest and develop newresources in areas they can access. During OPEC's seminar ahead of the group'smeeting, energy executives repeatedly warned of the lack of investment, whichcould create dangerous shortfalls in the future. The problem is compounded byrising demand, which some estimates show could reach more than 110 million b/dglobally by 2040.

Although OPEC has become obsessed with presenting itself as a unified, openand transparent organization, it is failing to address its biggest weakness --spare capacity.

--Andrew Critchlow, andrew.critchlow@spglobal.com