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Market Focuses on Shrinking Spare Capacity

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Dwindling spare capacity among Opec-plus oil producers poses a potential threat to energy security and has become an important driver of market sentiment, with big implications for prices.

It's difficult to quantify the world's effective spare capacity, but concerns have mounted as rising levels of production and capacity losses among key members of the alliance have eaten away at this critical supply buffer.

At the same time, financing bottlenecks mean that US shale producers can no longer respond to market imbalances as swiftly as they did a few years ago, which makes Opec-plus spare capacity even more crucial.

But the alliance's spare capacity has been contracting as its combined production rose by more than 3 million barrels per day between May and December of last year.

And that helps explain why the alliance's recent monthly production increases have done little to bring down crude prices: The additional output further erodes the buffer that the world would have to draw on in the event of a major supply disruption.

"The cupboard is nearly bare," says Bill Farren-Price of consultancy Enverus Intelligence."

"If a major producer falls over in 2022, Opec is close to its real operational ceiling. In that case, only stockdraws and higher prices can come to the rescue," he adds.

Producers Fall Short

Nigeria, Malaysia and Angola have produced below their Opec-plus ceilings for over a year now, and the gap has been growing in recent months.

Several other countries — such as Azerbaijan, Congo (Brazzaville) and Brunei — are also falling short, with total Opec-plus production for December coming in around 750,000 barrels per day below target.

Output in Iraq and Libya has been erratic, with the former hampered by creaking infrastructure and the latter by security problems. Iran and Venezuela are largely out of the picture, with sanctions and economic woes keeping exports at minimal levels.

In the past, the market could rely on the triumvirate of Saudi Arabia, the United Arab Emirates (UAE) and Kuwait as reliable pillars of spare capacity. But a lack of investment in recent years has led to a concentration of spare capacity.

Kuwait's production is approaching capacity limits, for example.

And sources say that while the UAE has a nameplate capacity of 4.3 million b/d, infrastructure bottlenecks mean it could only maintain output at that level for a short time, with effective sustainable capacity closer to 3.7 million b/d.

To a greater extent than ever before, spare capacity — and market power — is now increasingly concentrated in the hands of Saudi Arabia.

"That's why the market is reacting like this. There is no oil. Backwardation is very, very steep. And this is the biggest signal," one trader argued, referring to a price curve in which barrels for prompt delivery are priced above barrels for later delivery.

Professor Paul Stevens of think tank Chatham House says the current anemic levels of spare capacity have implications for global energy security.

"When spare capacity is tight, the system is vulnerable," he notes.

Return Of the Hormuz Premium?

In 2019 there were several attacks on oil tankers in the Mideast Gulf and on Saudi oil infrastructure, but the impact on oil prices was fairly muted.

That's because spare capacity was seen as higher at the time and it was also assumed that US oil shale production could ramp up to cover any shortfall.

But that might not be the case if there were a similar wave of attacks today.

"If anything were to happen now, in this market, you would get a really spiked reaction," the trader argues. "The only thing that could change things is if Iran could come back."

Stevens agrees that limited spare capacity would mean that prices would show more of a response if tankers and other oil infrastructure were to be attacked now. "The market is quite jumpy," he says.

On the other hand, prices may not be as sensitive to flare-ups in the Gulf as they were before the rise of US shale oil production.

That's because US shale remains a significant factor, if not quite to the same degree as before the Covid-19 pandemic. But also because Gulf producers have taken steps to mitigate the impact of a potential closure of the Strait of Hormuz to tanker traffic.

The UAE has a 1.5 million b/d pipeline that runs from Habshan in Abu Dhabi to the port of Fujairah, which lies outside the Strait of Hormuz.

And Saudi Arabia has expanded the capacity of its East-West Pipeline to its Red Sea coast from 5 million b/d to 7 million b/d.

Saudi defenses against drone attacks are also much improved since the September 2019 attack on the kingdom's Abqaiq processing center and Khurais oil field that briefly knocked out some 5.7 million b/d of capacity.

On the other hand, the war in Yemen and the rise of drone and missile warfare have highlighted the potential for strikes against targets far from the Gulf, such as the giant Shaybah oil field in southeast Saudi Arabia and facilities along the kingdom's Red Sea coast.

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