In November 2014, OPEC announced that in spite of a global oil glut, it would leave its official output quota unchanged, keeping the cartel’s collective production at 30 million barrels per day.
The group’s official quota hasn’t changed since 2011, although actual output has varied in the years since. Nevertheless, the move shocked the markets, causing oil prices to plummet by more than 7 percent. In a world so well supplied with oil, why would OPEC continue to pump at such a high level?
Many of the group’s members actually wanted a production cut, but the one that mattered—Saudi Arabia, the perennial “swing producer” and market stabilizer—balked. Having been burned in the 1980s, this time the oil kingdom chose to protect market share rather than achieve a targeted price level.
As we have seen in the months since, Saudi Arabia wasn’t kidding around. Squeezing higher-cost producers, the kingdom upped its oil production from 9.6 million barrels per day in February to nearly 10.3 million barrels per day in March, a more than 6 percent increase. In April, production ticked up by another 14,000 barrels per day. As a result of the ramp up, Saudi Arabia is now producing at the highest level in nearly thirty years.
The country has even added new rigs in an attempt to boost oil production beyond current levels, pushing its rig count to its current record high. Granted, some of this increase is part of their strategy to keep oil flowing from some of their older fields, but given the fact that their production is increasing, this doesn’t fully explain the upswing in the Saudi rig count.
All of this has brought consequences for U.S. shale companies. U.S. rig counts have more than halved, and production has leveled off and is just starting to dip. In other words, Saudi Arabia is prepared to ride out the downturn by putting the burden of adjustment on the shoulders of US drillers.
But there is danger that Saudi Arabia creates by going all out with its oil production: It sacrifices a significant portion of its spare capacity, and that has huge implications for the global market.
The traditional market stabilizer
No other country in the world can rival Saudi Arabia’s spare capacity. Indeed, the ability to ramp oil production up or down in order to target a certain desired price is what has given OPEC its clout, and Saudi Arabia largely holds the key to that ability. With a few landmark exceptions, when markets get tight, Saudi Arabia opens the spigot. When there is a glut, it holds back.
And if the kingdom doesn’t, or can’t, open that spigot? History provides some insight. Past price spikes have occurred when Saudi Arabia’s spare capacity has run low. In the historic run-up in prices between 2004 and 2008, for example, OPEC’s spare capacity (which really means Saudi Arabia’s) ran extremely low, dropping beneath the 1 million-barrel-per-day mark in 2004-2005, and again in 2008. Spare capacity recovered after the financial crisis as OPEC paired back production in dramatic fashion to rescue prices.
But in the ensuing years as the global economy recovered, spare capacity began to shrink again and oil prices surged above $100 per barrel. Enter U.S. shale, which added several million barrels per day, and prices crashed. Only this time, Saudi Arabia chose not to cut back—it wants the U.S. to play that role instead.
The Saudis’ approach is working. In June, the EIA projected the US will lose 86,000 barrels per day. More is likely to come, although perhaps the bigger question is how much production we would have seen from Texas and North Dakota if prices had stayed high.
However, unlike Saudi Arabia, U.S. drillers cannot ramp up at a moment’s notice, despite the bravado from oil executives who insist they are on their way back to the shale patch now that oil prices have recovered slightly.
In sum, Saudi Arabia’s low spare capacity, which hit the second lowest level since 2008 when it dropped below 1.7 million barrels per day in the second quarter of 2015, creates a vulnerability in oil markets. In fact, the current level of spare capacity is a mere 1.8 percent of global supplies.
The EIA says that spare capacity below 2.5 million barrels per day “is an indicator of a relatively tight market.”
Of course, we are in an entirely new situation in 2015 compared to years past, particularly given the U.S.’s increased role in supply. Global supplies exceed demand by around 2 million barrels per day. In the U.S., crude inventories are only starting to come down from 80-year highs. That in itself provides a bit of cover for supplies in the event of a disruption.
Nevertheless, since the 1970s, global consumers have always depended on Saudi Arabia to step in when there is a supply outage somewhere. Violence, industrial accidents, or major policy changes can cause unexpected shifts in supply. But with little room to maneuver at this point, the oil kingdom may not be able to come to the rescue if there is a major disruption.
Such an occurrence remains within the realm of possibility. Since July 2013, an average of 2.5 to 3.0 million barrels per day have been offline due to a variety of problems around the globe. Violence in Libya has kept most of its oil output on the sidelines for at least a year, while Iran lost around 1 million barrels per day in exports after the West imposed harsh sanctions in 2012, while sabotage and unrest in Nigeria have knocked out some output from time to time. Disruptions happen, and they are hardly ever anticipated—even though it’s somewhat the nature of the business.
The U.S., shale, and Saudi Arabia
Meanwhile, in the U.S., shale producers are slowing down, and if production drops significantly, the global oil glut could ease—yet the spare capacity of historic backstop Saudi Arabia would still be left at low levels.
In the event of a disruption, couldn’t U.S. shale come to the rescue? Yes and no.
The EIA defines spare capacity as oil output that can be brought online within 30 days and sustained for 90. Shale drillers can ramp up in a matter of months, not weeks. If a significant geopolitical flashpoint ignites somewhere, putting a severe strain on global supplies, U.S. drillers may not be able to respond quickly enough. And Saudi Arabia, having run down its spare capacity, may lack the firepower to cover the production loss as well.
In the short-term, Saudi Arabia is achieving its goal: It is certainly maintaining its market share. But with spare capacity at a seven-year low, the world could be left with few options in the event of a major disruption in global oil supplies.