Is Saudi Arabia Setting the World Up for Major Oil Price Spike?

In order to maintain a grip on market share by pushing U.S. shale producers out of the market, Saudi Arabia (and OPEC) is willing to use up its spare capacity. That could lead to a price spike.

Saudi Arabia produced 10.3 million barrels per day in the month of March, a 658,000 barrel-per-day increase over the previous month. That is the highest level of production in three decades for the leading OPEC member. On top of the Saudi increase, Iraq boosted output by 556,000 barrels per day, and Libya succeeded in bringing 183,000 barrels per day back online. OPEC is now collectively producing nearly 31.5 million barrels per day, well above the cartel’s stated quota of just 30 million barrels per day.

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The enormous increase in production comes into a market that is still dealing with extraordinarily low prices. The move could be interpreted as a stepped up effort on behalf of Saudi Arabia to maintain market share at all costs. More output will prolong the slump in oil prices, which will force even more U.S. shale production out of the market. The signs of success are already showing – the U.S. is set to lose 57,000 barrels per day in production in May, and rig counts are still falling.

The increase in Saudi production would also suggest that global markets are well-supplied. But, more Saudi oil comes at the cost of a shrinking global spare capacity. Saudi Arabia is essentially the only oil producer that has significant slack production capabilities, which can be ramped up or down depending on market conditions. That is what has allowed Saudi Arabia to influence prices to its liking for so many years. But when the Kingdom produces near flat out, it starts to run out of ammo. It is kind of like a central bank running interest rates near zero – once you are at that point, you run out of tools in the event that you need to do more.

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OPEC’s actual levels of spare capacity are somewhat opaque, which makes estimates difficult. But Saudi Arabia producing at its highest level in three decades certainly eats into that reserve. Moreover, Saudi Arabia typically consumes more oil in the summer for domestic purposes, which could further shrink spare capacity in the months ahead. PIRA Energy Group warned of such a scenario in its latest weekly oil report. “Incremental Saudi crude burn demand could push its volume this summer to levels that would substantially reduce global spare capacity, at a time when oil markets will be tighter and geopolitical risks to supply are growing,” PIRA wrote on April 14. Spare capacity may shrink to just 1.7 million barrels per day.

Saudi Arabia is succeeding in pushing out U.S. shale production, but in the meantime, the world is getting hooked on low prices. Oil demand is growing quickly – the IEA predicts global demand will jump from 92.66 million barrels per day in the second quarter up to 94.67 million barrels per day in the fourth quarter.

That will put oil markets in an interesting situation. U.S. production will continue to shrink as the year goes on and Saudi Arabia will have very little spare capacity. If a supply disruption occurs somewhere – more loss of Libyan oil, violence in the Middle East, or a faster-than-expected drop off in U.S. production – the Saudis will be left with little firepower to control a price spike (not that a price spike would necessarily be bad for them).

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There is an argument that U.S. shale has emerged as a sort of collective swing producer – shale operations ramp up and down much quicker than conventional drilling. But they don’t turn on and off that quickly. They can’t mimic the latent supply that the Saudi’s have in their back pocket. Furthermore, shale production is the result of drilling by hundreds of companies, and future investments and drilling will be made by private individuals based on individual financial circumstances, as opposed to state-level geostrategic calculations.

In other words, shale producers, now that they are shrinking their footprints and production levels, will not be able to step up to the plate in a pinch. If global supplies shrink unexpectedly, and Saudi Arabia has run down its spare capacity to low levels, oil markets will tighten to a precarious point.

This article originally appeared on Oilprice.com.

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