By
Bassam Fattouh
/
University of London
1. Introduction
The oil
price hikes in 2005 revealed an oil market that has lost a great
deal of its flexibility and capacity to deal with oil supply
disruptions or large unexpected (or even expected) increases
in global oil demand. For most of the 1980s and 1990s, spare
capacity of OPEC, chiefly that of Saudi Arabia, helped offset
large demand and supply shocks and hence acted as the “cornerstone
of world oil market stability – both for the upstream
and the downstream”.1 Spare capacity however has witnessed
a gradual decline since the early 1990s. Many observers argue
that the conditions responsible for the emergence of a large
spare capacity cushion in the mid-1980s (mainly the surge in
non-OPEC supply accompanied by a decline in global demand) cannot
be repeated and thus spare capacity is a thing of the past.
International institutions such as the IMF and IEA argue that
the erosion of spare capacity has been the result of worldwide
under-investment in the oil sector and hence they call for removing
barriers to investment in order to restore spare capacity in
all parts of the supply chain. Others such as Goldman Sachs
are more pessimistic about the realization of investments, arguing
that “demand destruction will be needed to recreate a
spare capacity cushion in order to return to a period of lower
energy prices”.2 A group of observers think that Saudi
Arabia’s declared policy of maintaining a volume of spare
capacity of 2-3mn barrels could be achieved, but this spare
capacity is too little for a system as big and complex as that
of world petroleum. It is interesting to note that although
these views are fundamentally different from each other, they
all seem to agree on one thing: we have entered a “new
era” in which oil market’s ability to rely on spare
capacity to absorb shocks has greatly diminished. This situation,
if it turns to be correct, would have dramatic effects on the
behavior and on the stability of oil prices.
2. The Gradual
Erosion Of The Spare Capacity Cushion
Figure 1
below shows the year-to-year changes in global oil demand and
non-OPEC supply over the period 1990-2006. As can be seen, the
year-to-year change in world demand has outpaced that in non-OPEC
supply in almost every year throughout the last decade (exceptions
were 2000, 2001, and 2002 which saw large increases in Russian
oil production).3 In fact, over the period 1990-2004, global
demand for oil increased by around 16mn b/d, while the increase
in non-OPEC supply amounted to only around 6mn b/d. It is worth
noting that during 2000-04, Russia has been responsible for
the bulk of the increase in non-OPEC supply while the production
for other non-OPEC countries has been flat.
The difference
between the increase in global demand and non-OPEC supply had
to be met by OPEC. During 1990-2004, OPEC supplied the additional
10mn b/d with production in 2004 reaching around 33mn b/d. The
impact of the increase in demand for OPEC oil has been the gradual
decline in OPEC spare production capacity, a process which accelerated
in the 1990s and early 2000. While in 1985, spare capacity amounted
to around 10mn b/d it declined to less than 2mn b/d or around
2% of global oil demand in 2004.
Investment
to increase the volume of surplus capacity was required early
on to avoid this situation. Recognizing this critical juncture,
however, has not been timely. The growth of global oil demand
was consistently underestimated by the various energy agencies,
and since demand pessimism was associated with exaggerated expectations
about non-OPEC supply, there was no incentive for OPEC to invest
in maintaining or increasing spare capacity.
The general
decline in the cushion of spare production capacity in the upstream
has been accompanied by bottlenecks in all parts of the oil
supply chain. Investment in downstream assets such as pipelines,
refineries and tankers has failed to keep pace with the growth
in global oil demand. The dramatic rise in oil product prices
in the last two years has brought to the fore the role of shortage
in refining capacity. In a recent speech, the Saudi Foreign
Minister Prince Sa'ud al-Faisal argues that “the basic
problem of the current energy crisis... is that the current
refineries are incapable of meeting demand on oil products,
shortage in storage capacity and restrictions imposed on the
oil industry thus paralyzing it from building more refineries…
Not a single refinery was built in the United States in the
last three decades while the difference in standard requirements
on oil products from one state to the other inside the United
States, particularly due to environmental concerns, has greatly
deteriorated the energy crisis”.4
3. The Decline
In Spare Capacity And Price Dynamics
The loss
of spare capacity has strong implications both on price levels
and the dynamic behaviour of crude oil and oil product prices.
Figure 2 describes a useful model to explain the current behaviour
of oil prices. History of low investment in the oil industry,
accelerated increase in global oil demand and low non-OPEC supply
growth led to the reduction of OPEC spare capacity. These same
factors contributed to bottlenecks in the oil supply chain,
especially in refining. As a result, the global oil system’s
ability to respond to demand or supply shocks weakened considerably
at times when the oil system witnessed a number of such shocks
(political, climatic, technical – and speculation about
the ability of OPEC to respond to them). In the absence of the
capacity cushion, the impact of these shocks is highly magnified
on oil prices. In particular, when capacity constraints become
the main force in the market, the following price dynamics are
likely to emerge. First, we expect to see an accelerated rise
in the average level of oil prices. Second, we expect an increase
in the volatility of oil prices. Third, we are likely to witness
more occasional spikes in crude and product oil prices. Finally,
refining bottlenecks add a further dimension to the oil price
dynamics by widening oil price differentials.
In fact
we have seen all of these effects in the last two years or so.
Figure 3 summarises the main features of recent oil price dynamics
by comparing the distribution of spot WTI prices for the period
1991-2002 (Period I) with that of 2003-05 (Period II). First,
the average price of Spot WTI has almost doubled, increasing
from a daily average of $21.25/B in Period I to $42.30/B in
period II. This is quite evident in Figure 3 where there has
been a significant shift in the mean of distribution between
the two periods. Second, the standard deviation (which can be
used as a crude measure of volatility) has more than doubled
between the two periods rising from $4.92/B to $11.40/B. This
is reflected in the higher dispersion of the distribution in
Period II when compared to Period I. Third, Period II witnessed
many occasional spikes in oil prices with WTI price exceeding
the $70/B mark. As can be seen from Figure 3, there have been
many occasions in which oil prices have hit the $60-70/B range
compared only to few situations in which oil prices have hit
what was considered then the upper range of $35-40/B. Finally,
there is the issue of the widening of oil price differential.
As can be seen from Figure 4, the daily average of price differential
between WTI spot at Cushing and Iranian Heavy Period I was around
$3.5/B and more than doubled to $7.58/B in Period II. This can
be attributed to the two main aspects of the refining problem:
(i)
An insufficient volume of total capacity and
(ii) The mismatch between the structure of refining plants and
that of the world oil slate, and the rising demand for light
petroleum products.
4. Conclusion
It is clear
from the above discussion that the oil industry faces major
challenges – not only to invest in upstream and downstream
to meet the expected growth in global demand for oil, but also
to invest in new spare capacity that is needed to provide the
global oil system with the flexibility required to respond to
shocks and provide a more stable oil pricing system. The main
question is: which parties are going to bear the costs of investment
in spare capacity? The international oil companies are not willing
to bear them. In fact, investment in spare capacity does not
conform to the principle of shareholder value maximization as
it implies the company is holding idle assets. On the other
hand, most national oil companies, due to many financial and
political constraints, may not be able to invest in new spare
capacity, with the exception of Saudi Arabia whose declared
policy is to maintain a volume of spare capacity of 2-3mn b/d.
Failure
or inability to address this complicated issue of who bears
the costs of spare capacity simply means that the world has
to get used to more oil price hikes and price volatility. The
‘international oil order’ where non-OPEC supplies
much of the incremental global oil demand and OPEC provides
the capacity cushion is no longer viable. The huge spare capacity
of the past is a luxury that the oil industry enjoyed for a
while, but seems that can no longer afford.
Notes
1.
Naimi, A (2005), Globalization And The Future Of The Oil Market,
Middle East Economic Survey (MEES), VOL XLVIII, No 22, 30-May.
2. Goldman Sachs (2005) Super Spike Period May Be Upon Us: Sector
Attractive, p18 downloaded from: http://www.oilcast.com/pdfs/superspike.pdf
3. According to the IEA, global demand is also likely to outpace
supply both in 2005 and 2006.
4. Oil crisis very dangerous, lack of refining capacity to blame
Saudi minister, downloadable from:
http://www.mabico.com/en/news/20050922/government_ministries/article47770/
Figure
1
Year
To Year Change In Global Oil Demand And Non-OPEC Supply
Figure
2
Spare
Capacity And Oil Price Dynamics
Figure 3
Oil
Price Distribution
Figure
4
Oil
Price Differentials
Bassam
Fattouh
is a Reader in Finance and Management in the Department of Financial
and Management Studies, SOAS, University of London. Petroleumworld
not necessarily share these views.
Editor's Note: This article is based on the author’s presentation
at The Commodities Investors Forum, Geneva, Switzerland, 16
November 2005 and was first publish by Middle East Economic
Survey-MEES, 30-January-2006. Petroleumworld reprint this article
in the interest of the readers.
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