John Kemp, Reuters

Sanctions on Iran and the continued decline in output from Venezuela will leave the oil market vulnerable to any further production or consumption surprises next year.

Output and demand in the global market are each currently running at almost 100 million barrels per day (MMbbl/d).

To ensure a steady flow of oil from the wellhead to consumers, the industry relies on a series of shock absorbers to handle any interruption in supplies or unexpected strength in demand. In rough order of responsiveness, these buffers are:

  • Commercial inventories;
  • OPEC spare capacity;
  • Strategic stocks;
  • Short-cycle production and
  • Consumption restraint.

Both commercial inventories and OPEC spare capacity have become dangerously eroded over the last 12 months, leaving the oil market much more vulnerable in 2019. If all the other shock absorbers become exhausted, oil prices will have to rise to the point where consumption growth begins to slow.

OECD Inventories

The oil market’s first line of defense comes from changes in the volume of commercial inventories held by producers, traders and refiners.

OECD commercial stocks currently stand at 2.8 billion barrels (Bbbl), composed of crude (1.1 Bbbl), other liquids (300 MMbbl) and refined products (1.4 Bbbl).

Additional stocks are held in non-OECD countries, as well as on tankers and in pipelines, either in transit from oil fields to refineries and on to final customers, or as floating storage.

The vast majority of stocks are held for operational reasons to ensure the uninterrupted flow of oil from wellhead to final customers. Only a small percentage, generally less than 15%, can be considered discretionary and available to act as a shock absorber.

OECD crude and product stocks are already 27 MMbbl below the five-year average, according to the International Energy Agency. The five-year average was inflated by the glut of oil between 2015 and 2017, so it may not be representative of the normal level of inventories.

But global oil consumption has also increased by more than 6 MMbbl/d over the five years since 2013, so other things being equal, producers, traders and refiners will want to hold more stocks for operational reasons.

The fact that futures prices for both Brent and WTI are in backwardation implies oil traders see stocks as already fairly tight and expected to tighten further.

OPEC Spare Capacity

For the last four decades, the oil industry’s second line of defense has been the existence of significant volumes of spare production capacity.

Nearly all spare production capacity is held by Saudi Arabia, with smaller volumes held by Kuwait and the United Arab Emirates. Russia may also hold a small amount of spare capacity at the moment, following the decision taken in 2016 to restrain production.

Other OPEC and non-OPEC members essentially produce as much as they are able and do not hold significant spare capacity.

OPEC’s spare capacity currently amounts to less than 2 MMbbl/d, according to the U.S. Energy Information Administration.

In its latest oil market update, the International Energy Agency (IEA) explored a scenario in which exports from Venezuela and Iran could decline by as much as 1.5 MMbbl/d by year-end 2019. To compensate for the lost output, Saudi Arabia, Kuwait and the United Arab Emirates could boost production by just over 1 MMbbl/d, with additional supplies from Russia, according to the IEA.

But if this scenario comes to pass, OPEC spare capacity will be reduced to less than 1 MMbbl/d, the lowest level since 2004.

Short-cycle Production

With oil inventories already tight and spare capacity set to shrink, the industry will have to fall back on strategic stocks and short-cycle production to meet any unexpected shortfall.

OECD governments and refiners hold almost 1.6 Bbbl of crude and products in strategic storage, which can be released in the event of an emergency.

China has also amassed a strategic stockpile estimated at more than 800 MMbbl, according to the IEA.

Strategic stocks are the third line of defense. But the circumstances under which OECD and China’s strategic stocks would be released to the market remain opaque.

Experience suggests governments react to the security and economic threat from both actual shortages of crude and/or a sharp rise in prices. However, strategic stock releases cannot be predicted, and strategic stocks are not generally considered available to the market.

The industry will therefore be forced to rely on short-cycle production, its fourth line of defense.

Most short-cycle production comes from the U.S. shale sector, with smaller volumes available from the accelerated development of existing oilfields in other parts of the world.

But even short-cycle production can take 6 to 12 months or more to reach the market, given the lengthy delays involved in securing extra drilling rigs, fracking wells and connecting them up to the distribution system.

The U.S. shale supply chain is already extremely stretched, with reported shortages of experienced fracking crews and truckers. And pipelines to move the produced oil from the shale fields to refining centers on the U.S. Gulf Coast or onto tankers for export are full.

Short-cycle producers may therefore struggle to plug any additional shortfall in oil supplies next year, especially if consumption growth remains strong.

Consumer Demand Restraint

Medium-cycle and long-cycle production from new oil fields takes too long to develop to be of any real use as a shock absorber.

So the final shock absorber is always the consumer. Oil prices will have to rise high enough in 2018/19 to slow growth in consumption and restore inventory and spare capacity buffers to a more comfortable level. Rising prices will slow consumption growth through some combination of behavioral changes to cut fuel use, switching to alternative fuels, and slower GDP growth in consuming countries.

Consumption is not very responsive to a small change in oil prices, at least in the short term, so large price increases are required to enforce demand restraint. Between 2006 and 2008, and again between 2011 and 2014, high oil prices coincided with falling consumption in the OECD.

In both cases, the rise in prices was followed by a slowdown in consumption growth and a faster increase in production, eventually rebuilding stocks and spare capacity.

The combination of falling Venezuelan output, sanctions on Iran, low commercial stocks, low spare capacity, and constraints on the expansion of U.S. shale is priming the market for higher prices in 2018-2019.

The most likely outcome is a further rise in prices to enforce demand restraint and/or a recession in the major consuming countries to bring the market back to balance again.