OPEC, for the time being, has at least overcome the political divisions between Saudi Arabia and Iran, but solving its spare oil capacity problem will be much harder to crack.

There is even some debate of what spare capacity means and how it should be measured.

S&P Global Platts news feature: OPEC Influencers interactive chart

A basic rule of thumb is spare capacity is the amount of oil a producer can bring on stream at short notice. The International Energy Agency defines this in terms of crude which can be produced within a 90-day period and sustained for an extended phase of time. But few producers can meet those criteria.

After a week of tense negotiations, which saw Iran’s oil minister Bijan Zanganeh storm out of a meeting, the group of 14 producers agreed Friday to increase nominal output by 1 million b/d starting July 1 in partnership with its allies led by Russia.

Given the tense political acrimony with Iran in the background, the deal is a triumph for Saudi Arabia. The group’s largest exporter is also its only member really capable of opening its taps to put significant volumes of extra barrels into the market.

But it already looks like a pyrrhic victory before the ink has dried. Keeping a lid on oil prices by releasing more crude will briefly appease critics, see US President Donald Trump, but it won’t help Riyadh and its allies invest in their reservoirs long term.

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With about 2 million b/d of spare capacity, Saudi is in an enviable position, even in a group which controls almost 82% of the world’s proven reserves. Maintaining this buffer is expensive for a kingdom, which has been forced to run budget deficits and requires prices around $80/b for its treasury to break even.

“It costs us between capital and ‘opex’ tens of billions of dollars to keep 2 million b/d of spare capacity, and we weigh very carefully whether it needs to increase or not,” Saudi oil minister Khalid al-Falih said Friday. “I think, at the end of the day, we have to look at what other countries are doing. Many other countries have announced intentions to increase capacity and we’re watching what the US is doing.

“I think 2 million barrels of spare capacity is very high for one country to have and it’s very expensive. I don’t want Saudi spare capacity to be 3 million-4 million b/d.”

Years of underinvestment and tepid prices have left the OPEC group’s spare capacity at dangerously low levels. Before its new agreement, OPEC produced 31.9 million b/d in May, according to the latest S&P Global Platts survey, about 840,000 barrels below its previous ceiling of about 32.74 million b/d. If enacted fully, its new agreement with the 10 producers led by Russia outside the cartel will end over-compliance.

Oil spare capacity

Outside OPEC

Unhindered by quotas and political intrigue, producers in the US have forged ahead. The world’s largest economy will soon become its biggest producer of crude based on the latest forecasts. The Energy Information Administration predicts US crude output to average 10.79 b/d in 2018, climbing to 11.76 million b/d in 2019.

Outside Saudi Arabia, it is difficult to see where any additional crude will come from within OPEC in its current form. Short of an agreement to restart output from the so called “Neutral Zone” straddling the border between Kuwait and Saudi Arabia, even the kingdom will find increases difficult unless it dramatically increases upstream investment.

Elsewhere, Gulf producers have consistently failed to reach capacity targets, which in some cases have been in place for over 20 years.

Although prices have more than doubled over the last year, investment in the oil industry has lagged far behind. Global spending peaked at $900 billion in 2014 but was halved by 2017. And the situation isn’t improving. Even with prices holding above $70/b, investment is only expected to reach $510 billion this year, according to Qatar energy minister Mohammed Al-Sada.

“It;s hard for OPEC to invest at these price levels and not sure the market really appreciates the limits on spare capacity,” Joe McMonigle, senior energy analyst at Hedgeye Risk Management, said Friday.

Sanctions strain

To complicate matters even more, output from Venezuela and Iran could soon go into freefall once US economic sanctions bite.

Iran had regained its spot as OPEC’s third-largest producer, after Saudi and Iraq, before being hit by new embargoes, which come into force in November. The country could lose 1 million b/d of output capacity over the next year as a consequence of the legislation.

In Venezuela, sanctions are “practically immobilizing” state-owned oil company PDVSA, Venezuelan oil minister Manuel Quevedo said Thursday. Output is plunging toward 1 million b/d, and the country realistically has no spare capacity.

“Looking ahead, greater volatility looks nearly certain,” Paul Sheldon, Chief Geopolitical Advisor at S&P Global Platts Analytics, said Friday. “Given widespread geopolitical risks to oil supply in the Middle East and elsewhere, the level of spare capacity in global oil markets will be uncomfortably low after OPEC raises production.”

International oil companies are also reluctant to invest and develop new resources in areas they can access. During OPEC’s seminar ahead of the group’s meeting, energy executives repeatedly warned of the lack of investment, which could create dangerous shortfalls in the future. The problem is compounded by rising demand, which some estimates show could reach more than 110 million b/d globally by 2040.

Although OPEC has become obsessed with presenting itself as a unified, open and transparent organization, it is failing to address its biggest weakness — spare capacity.

–Andrew Critchlow, andrew.critchlow@spglobal.com

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