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Prices are firming, but don't ignore shots across the bow

Supply disruptions are firming oil prices. But the market is still too blasé about the risks, which may include a shrinking spare-capacity buffer

FIVE years ago this month civil war in Libya had shut in most of the country’s oil production, spooking the market. The International Energy Agency (IEA), fearing a squeeze on Brent that was pushing its price above $110 a barrel, coordinated a stock release. It helped prevent a more damaging spike.

Civil conflict in Libya – historically significant to crude markets because of the quality of its oil – is still shutting in much of its output. Violence and sabotage in the Niger Delta has cost Nigeria, another exporter of high-end crude, almost 0.8m barrels a day of production. Wildfires have disrupted output from Canada’s oil sands. The market has largely shrugged. Brent has firmed above $50/b, but is hardly spiking.

Global stocks are one reason for this nonchalance. In the OECD they are rising more slowly than last year, but still rising, says the IEA, and despite some pull from inventories in February, they won’t draw steadily “until some point in 2017”. Crucially, they remain about 357m barrels above their five-year average. In June 2011, that surplus stood at just 4.7m barrels. Demand would have to outpace supply by almost 1m barrels a day, for a year, just to bring the current overhang down to June 2011 levels, to say nothing of strategic stocks built up by China since then.

Other factors stand in the way of a strong supply-disruption-led rally. The forward curve, still in contango, implies a mild strengthening of prices over the coming year but not a sharp enough surge to make storing oil – in a tight storage market – profitable. Yet traders are still stashing barrels, especially offshore, taking longer positions in the hope that the market will wake up. One way of interpreting this is that near-term demand is simply not robust.

Saudi Arabia could even widen the price war by pumping more oil − further eroding its spare capacity

For all the recent outages, meanwhile, the Opec members that can are producing flat out: the group’s supply rose by 330,000 b/d in April to 32.76m b/d – the most since August 2008, when prices were just coming off their record highs. The swift recovery of Iranian oil output (it reached almost 3.6m b/d in April, and exported 2m b/d, near its pre-sanctions level), stronger production from Iraq, and persistently high supply from Saudi Arabia have all more than overcome the deficiencies from other members.

A dismal science

Prevailing notions about supply abundance now grip the market as tightly as peak-production ones did in the run-up to 2008’s price spike. Broadly, the market assumes that any price rise will simply yield more oil, especially from American shale. Sound economic logic underpins that theory, but no one can say, yet, how quickly US drillers will react to a rising market. Their role as global swing producer has not been tested.

So it might be wise to challenge the new orthodoxy with two older ones. The major oil-price troughs of the past 45 years have ended with geopolitical supply disruptions: the Arab oil embargo, the Iranian Revolution, the Iraqi invasion of Kuwait, and the US-led invasion of Iraq. Second, Opec spare capacity has always been decisive.

The first of those conditions is in place – and the risks of further disruptions are rising. All of Opec’s members are under fiscal pressure, but Venezuela, Nigeria, Iraq, Angola and Libya – between them holding nominal capacity of more than 11m b/d – are all already tottering or in political danger.

The second, Opec’s spare capacity, is now also a doubt. The tacit agreement in past supply disruptions – whether Hurricane Katrina or Libya’s civil war – was that the IEA would defer first to Opec to plug any gaps. But Opec’s spare capacity five years ago, during the Libyan disruption, stood at 3.6m b/d. Today it is 2.5m b/d, just a bit more than Canada’s oil sands produce.

In 2011, Saudi Arabia was responsible for 65% of this spare capacity. Today, the kingdom accounts for over 80% of the emergency oil Opec could draw on. This should worry the market – if not today, while stocks remain high, but when balance is restored.

Despite Saudi Arabia’s growing domination of Opec’s spare capacity, its commitment to maintaining the buffer has never been more in doubt. Both the move to list Aramco – the valuation of which, we understand, will be made on cashflow, and therefore volume not reserves – and recent statements from deputy crown prince Mohammed bin Salman about big expansion in production imply a fundamental shift in policy on spare capacity. It suggests that Saudi Arabia, pursuing oil-market share and volume, now sees the buffer as a costly field left fallow for too long. It is now plausible that the kingdom will widen the price war by pumping more oil − further eroding its emergency buffer.

The market might ignore this change in Riyadh, as long as global stocks remain high and perceptions of non-Opec abundance prevail. But the recent supply disruptions point to dangers lurking in the months ahead. Geopolitical risks in oil-producing countries are rising, not diminishing. The fires and wars crimping output are a warning. Sooner than later, such disruptions will matter to prices again – and the market will remember why Opec’s spare capacity was such an obsession during earlier crises.

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