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Energy risk in all shapes, all sizes

Geopolitics may be bullish or bearish. But it will almost certainly bring volatility to the oil market

The beverage options in Calgary restaurants just narrowed. On 6 February, Alberta's premier Rachel Notley announced that her province was now banning imports of wine from British Columbia (BC). It is the first shot in a budding trade war between the neighbouring provinces. BC is blocking the expansion of a pipeline from the oil sands to the Pacific Coast. Notley now says that unless BC lifts its objections, Alberta might stop trading electricity across the border.

For Alberta, the BC foot-dragging over Kinder Morgan's C$7.4bn ($5.8bn) plan to almost treble capacity of the Trans Mountain pipeline, to 890,000 barrels a day, is serious stuff. Evacuation capacity from the oil sands will be insufficient to handle increased production, meaning Alberta's bitumen will have to sell at steep discounts to find a market. Even now, while pipe capacity is not yet exhausted, the western Canadian benchmark is selling for almost $30 a barrel less than WTI.

Politics has mired all new proposals to take Alberta's oil to market. The Keystone XL pipeline to the US Gulf is going ahead with White House approval, unless environmentalists stop it. The Energy East proposal to ship oil to eastern Canada and Northern Gateway, the Enbridge plan to pipe oil to another west coast port, have both died. All told, political objections in BC—provincial, First Nations', environmental non-governmental organisations'—have combined to stop about C$60bn worth of investment in new projects in recent years, says the Canadian Association of Petroleum Producers.

As Alberta's experience shows, political risk isn't just found in warzones or dictatorships. It comes also in the shape of unexpected regulation (like fracking bans across Europe), fiscal-regime changes (like the windfall tax on the UK's North Sea in 2011) or shock votes (Brexit and Trump). Mexico's presidential election this year could, in theory, reverse some of the country's energy reforms. And geopolitical events aren't always bullish. A nuclear war with North Korea or a conflict that affected trade flows through the South China Sea would be bearish. Obama's nuclear deal with Iran was a major geopolitical event that increased global oil supply by 1m b/d, contributing to the market's downwards turn.

But supply-side geopolitical risks now look more price-supportive than they have in some time. Worse still, any oil-price weakness—caused by brief rallies that yield more short-term US supply—may exacerbate underlying tensions. Rising oil demand, falling stocks and dwindling spare production capacity will make price reactions more volatile. The macroeconomic backdrop, in a year when the US Federal Reserve is expected to raise interest rates at least three times—a prospect that, in mid-February, already seemed to be vexing equity markets—may also be unsettling. Global economic bonanza years often breed oil-market volatility. Witness the run-up to the bust of 2008.

Bullish risks…

As a supply risk, Venezuela tops the list. Its production losses have already been spectacular: 1.7m b/d has gone in the past 10 years, and the slide is steepening. Output is now just 1.6m b/d, almost 600,000 b/d less than in 2017—a loss equivalent to shutting the entire oil output of fellow Opec member Qatar. The market seems to be pricing in further declines to about 1.3m b/d later this year. Civil strife, more US sanctions, a bond default, an oil-worker strike or even regime collapse—none of which can be ruled out-could take output down to 1m b/d.

Political developments in Libya and Nigeria also hang over the market. Libya has almost quadrupled its oil output since mid-2016 to more than 1m b/d. State firm National Oil Corporation wants to increase this to 1.3m b/d. But two governments still vie for control of the country, each supported by foreign backers, weapons and unruly militias; Islamic State (IS) has returned and is targeting energy installations again; and the civil conflict endures. In a failed state where forces fight for control of oil, production is vulnerable.

Nigeria is a year away from another presidential election. But the incumbent who may run again, Mohammadu Buhari, has succeeded neither in passing crucial new upstream legislation nor settling the Delta. There, the militant group that in 2016 launched a sabotage campaign that wiped out around 400,000 b/d of production says it is ready again to unleash "doom" on the oil sector. In mid-January, it named Shell's Bonga project, Chevron's Agbami increase capacity in 2018-among its targets.

… and bearish ones?

In the Middle East, the political risks are, on balance, less bullish than those in North and West Africa. Under deputy crown prince Mohammed bin Salman's direction, Saudi policy is now less predictable than it was. But it's hard to see how the Yemen war or the Qatar crisis, both launched on his watch, can worsen. The stand-off with Iran transcends the region—and has brought truly bizarre developments, like the resignation (eventually rescinded) on Saudi TV of Lebanon's prime minister—but doesn't look like turning into a hot war soon—even though the tone of the rhetoric from the Saudi side is sounding more warlike. New US sanctions on Iran would be bullish, but probably wouldn't cut as much as the 1m b/d lost before 2016.

Likewise, the odds seem greater that Baghdad and Erbil will strike an agreement allowing for more oil output in northern Iraq than things will disintegrate further. Prime minister Haidar al-Abadi's strength has grown since the federal army's victory over IS in Mosul, but he may need Kurdish support to remain in office after the May parliamentary elections (or to prevent Kurds supporting his rivals). Meanwhile, Iraq's oil-production capacity is rising in the south, more than compensating for the losses from the Kurdish region. Despite the chaos on Iraq's northern borders, the country's main threat to oil markets looks to be more oil in 2018, not less.

Spare incapacity

That's a good thing, because global spare oil-production capacity is not so ample. The Opec-non-Opec's cuts, of 1.8m b/d, mask this reality, partly because much of the drop has been involuntary. Of the volume removed from the market, Petroleum Economist estimates that just 1.44m b/d could be quickly restored, more than half from just two producers, Russia and Saudi Arabia (see table).

The US Energy Information Administration says Opec's total spare capacity was just 2.11m b/d in Q4 2017. The average since 2001 has been 2.33m b/d and when it has dropped as low as Q4 2017's level the market has been troubled. The International Energy Agency puts spare capacity higher, at 3.24m b/d. But 68% of it, or 2.19m b/d, lies in Saudi Arabia, which the agency thinks could pump up to 12.16m b/d. But this would depend on the kingdom's willingness to test its production limits, the sustainability of the level and whether the spare (heavy) oil could meet the market's needs. In mid-2008, under huge pressure from Western politicians to tame raging prices, Saudi Arabia only pumped another 300,000 b/d or so, despite estimated spare capacity of 1.45m b/d. As Petroleum Economist noted at the time, the volume was "too little, too heavy, too late".

Venezuelan output is now just 1.6m b/d, almost 600,000 b/d less than in 2017

Does it matter now? Endless, fast-reacting tight oil supply, in a world that might soon stop needing so much oil, has made Opec spare capacity an irrelevant marker, believe some. The backlog of drilled-but-uncompleted shale wells is a new spare capacity. Look at the evidence: the rise in oil prices of recent months has already sent US production above 10m b/d and more oil is on the way. The US is even selling off some of its own strategic reserve.

But if oil demand keeps rising at 1.5m b/d a year, the world will need another 7.5m b/d of net supply growth by 2023—almost double the amount tight oil has added in the past five years. Canada, Brazil, Russia, Guyana, West Africa and others would chip in too. But you don't have to be a peak-oil theorist to wonder if supply can keep up with demand indefinitely, or if superlight tight oil could prevent a price spike during a major outage in a heavy-grade-exporting Middle East producer.

It might not turn out that way. But soaring demand combined with myriad geopolitical risks in 2018 mean no one should ignore the risks. The recent drop in oil prices is not an indicator of stability in the market, it is a harbinger of more instability in the countries that depend on oil income, a deterrent to investment, and a boost to demand. This is a recipe for volatility. Many market watchers will remember the headlines about "drowning in oil" from 1999. Less than 10 years later, the deluge had turned to drought. Beware cycles and beware geopolitics. Most oil-price troughs have ended with a bang-bang.

This article is part of an in-depth series on Geopolitics.

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