OPEC Spare Capacity Will Calm Oil Markets

There is a wide variety of opinions on whether or not OPEC will deliver on its promised cuts of 1.2 million barrels per day, and a lot hangs in the balance.

The difference between OPEC members complying with the deal and ignoring it altogether is a big one. It will go a long way in determining whether or not the oil price rally continues on its upward trajectory or begins to fizzle, Oil Price reported.

But while large cuts from OPEC are generally very bullish for oil prices, there is a side effect on the oil market from those reductions that could mute the price impact.

Taking such a large volume of oil off the market does not make that production capacity go away. Indeed, moving 1.2 million barrels per day of capacity from active production into idled capacity will provide a substantial buffer to any unforeseen supply disruption.

That has always been the logic behind OPEC’s use of “spare capacity.” Saudi Arabia is pretty much the only country that has a large volume of oil capacity sitting on the sidelines, output that can be ramped up within a few weeks or months.

The EIA defines spare capacity as output that can be turned on within 30 days and sustained for at least 90 days. Periods of low oil prices and low price volatility tend to correspond with periods of time in which Saudi Arabia has a large cushion of spare capacity.

If the global oil market suffers from a surprise outage – say from a natural disaster like Hurricane Katrina or a man-made disaster like the war in Iraq – then there is capacity that can be called upon to plug any supply deficit.

Saudi Arabia has done this in the past, and because the oil markets are aware that such a capacity exists, volatility tends to be lower than it otherwise would be.

When Saudi Arabia ratchets down production, which necessarily creates a larger buffer of spare capacity, volatility tends to soften. The opposite also tends to be true: when the market tightens, and Saudi Arabia ramps up production to meet demand, it does not always lead to lower prices.

A smaller spare capacity can spook oil traders, especially when an outage occurs. In the period between 2003 and 2008, when OPEC was producing at elevated levels and running down spare capacity, it corresponded with the largest and longest bull-run for oil in recent memory. OPEC’s spare capacity ran below 2 million bpd for most of that period.