The Saudi capacity puzzle | FT Alphaville

The Saudi capacity puzzle

Could Saudi Arabia be telling porkies when it comes to its spare capacity capabilities?

It’s something Goldman Sachs analysts are wondering on Tuesday.

For example, they’ve deduced — from reverse-engineering the kingdom’s production levels — that Saudi may have raised output before the crisis in Libya ever broke out.

Or, as they put it:

… we believe that Saudi Arabia was already producing significantly more than indicated in official reports. Recent news reports suggest that Saudi Arabia is currently producing more than 9 million b/d of crude, roughly 700 thousand b/d above the official supply number for January. While this sharp increase seems to be a reaction to the recent collapse in Libyan output, some reports suggest that Saudi Arabia had already significantly increased production prior to the turmoil in Libya, which is more in line with our view.

Now, this is potentially problematic because of the implications it has for Opec spare capacity all round, as reflected in the chart below:

As the analysts explain:

Higher Saudi output would have significant implications for current effective spare capacity. While just three months ago we estimated spare capacity to be around 2.5-3 million b/d, recent developments suggest that OPEC spare capacity could actually have dropped below 2 million b/d already. The current developments in Libya have therefore brought forward the drawdown of OPEC spare capacity by about six months. While the current loss of supply might turn out to be short-lived as production can be restored relatively quickly once the current civil unrest settles down, the real risk is that the remaining spare capacity cannot accommodate an escalation in disruption right now in our view.

Which means it looks like Opec may have been producing some 0.5-1m barrels per day over its official quota since as long ago as November — a fact which leaves 2m barrels per day of spare capacity in the global system, not the 3m barrels per day or so some believe.

Not that quota abuse in itself is so surprising. Opec countries have long had problems with compliance.

The thing is, in normal circumstances, the additional production would head straight into global inventories — adjusting forward curves and creating a production buffer as it does so.

This time round though, inventories don’t seem to have adjusted. If anything, Goldman says, they’ve continued to be drawn down at the same pace, indicating actual demand and consumption of those extra barrels — at least from the point of the Libyan crisis onwards.

This, in their opinion, brings forward the drawdown of Opec spare capacity by at least six months.

The good news is that if and when the unrest in Libya settles down, restoring production will be easy since Libyan fields are of the highest quality and very easy to operate. Worse quality fields on the other hand can suffer long-term production losses when shut down, because it’s so much harder to restore flows to their former glory when pressure is compromised.

The bad news, however, is that if Saudi has indeed been over-pumping since at least November onwards, the grade mismatch may be more of an issue than originally thought — because there is already much more low quality crude in the system, making the loss of good quality barrels much more greatly felt.

According to the analysts, the reaction in crude differentials to date suggests they may indeed be on to something:

In addition, we believe that the widening of the heavy-light spreads provides further support to our view that Saudi Arabia increased production long before the turmoil in Libya started. We find that heavy-light spreads such as Maya-LLS and Dubai-Brent are strongly driven by OPEC heavy production. Further, we believe that most of the Saudi spare capacity is heavy crude oil and as this spare capacity is brought back online, heavylight spreads widen. However, the current heavy-light spreads are wider than our modeling would predict assuming the official OPEC supply numbers are accurate. This suggests that Saudi production is likely above the officially reported levels. More importantly, the heavylight spreads widened to these levels long before the turmoil in Libya started, indicating that large volumes of Saudi spare capacity have already come back to the market.

When added to the Wikileaks cables — which already hinted that Saudi capacity was being misreported on purpose — all this draws serious question marks against any comments from Saudi Arabia trying to pacify production fears.

In short, it looks more and more like Saudi Arabia may be bluffing about its ability to make up for lost production.

Related links:
Why you really can’t swap Libyan crude easily, at all – FT Alphaville
The big four ‘known unknowns’ for oil – FT Alphaville
Opec members rush to raise oil output – FT