The Role of OPEC Spare Capacity

Presentation by Dr. Nimat B. Abu Al-Soof, Upstream Oil Industry Analyst, Secretariat, to the OPEC-organized session "The Petroleum Industry: New Realities Ahead?", at the Offshore Technology Conference 2007, Houston, Texas, 30 April - 3 May.

1 May 2007

[Opening]
Ladies and Gentlemen,

Let me begin by thanking our speakers for excellent presentations. All well thought out and offering an interesting perspective on some of the key issues facing the petroleum industry.

My OPEC colleague, Mr Al-Zayer, provided an excellent scene setting overview of the short- medium- and long-term prospects for the oil market, highlighting some of the key challenges the industry faces. His address also touched on the topic I will present on today: the role of OPEC spare capacity in providing stability to the market.

In this presentation I will go into far more detail on this topic. Highlighting not only the importance of OPEC spare capacity, and the role this has played in the past and is expected to play in the future, but also emphasizing the real concerns of possible over-expansion of capacity, and in turn the investment risk burden to OPEC Member Countries.

[Slide 2]
The best place for me to start is by providing you with the most recent trends in OPEC capacity and production, as well as an historical perspective on spare capacity. As this slide underlines, OPEC’s spare production capacity has shown signs of tightness on a couple of occasions over the past 15 years or so. Firstly, in the early 1990s, and then most recently in 2004 and in both cases this was due to unexpected high demand and/or unplanned production losses. Since 2004, however, the levels of spare capacity are much improved despite some ongoing geopolitical tensions in countries such as Iraq and Nigeria.

What is also interesting to note are the periods of large levels of spare capacity, particularly in 1999 and 2002. These are attributed mainly to rising non-OPEC supply, chiefly in Russia. Large levels of idle capacity are obviously a concern for producers and I will document worries surrounding this type of phenomenon later in the presentation.

The key take away here is that OPEC production has always risen to meet market needs. There has always been enough supply to meet the required demand. In fact, OPEC oil production and capacity increased during the 2002-2005 period despite unintended capacity losses in some countries. During this period our Member Countries increased production by around 4.5 mb/d.

Total capacity also advanced during the past year, even though OPEC production fell. The overall production fall was due to the fact that towards the end of last year crude oil supplies were well in excess of actual demand, as the high level of crude stocks in OECD countries demonstrated. The imbalance in the supply and demand fundamentals was destabilizing the market, and thus OPEC reduced production.

The result of all this is that, with OPEC’s upstream capacity on course to rise to around 34.8 mb/d by the end of the year, against an expected average output of 30.9 mb/d for the year, our spare capacity should be at levels that are comfortable for the market.

[Slide 3]
OPEC’s policy has, indeed, ensured that the trend of ample production and sufficient spare capacity will continue for years to come, benefiting producers and consumers alike and enhancing stability. OPEC capacity growth is underpinned by over 130 E&P projects, 50 per cent of which are with International Oil Companies (IOCs). Total cumulative capital expenditure is likely to exceed $130 billion. Due to the timing and nature of projects, the largest increases are expected to be concentrated in Saudi Arabia, Nigeria, Angola, UAE, Libya and Algeria. These projects are in addition to all energy infrastructure projects, such as pipelines, export terminals and downstream expansion.

[Slide 4]
Moves to maintain a healthy level of spare capacity are emphasized clearly in this slide. OPEC has plans in place that are expected to result in 39.7 mb/d of crude capacity by the end of 2010, representing an increase of about 5 mb/d from end 2006. Similarly, production capacity of NGL and other liquids will be expanded by almost 1.7mb/d to 6 mb/d by 2010.

[Slide 5]
Another important element of OPEC’s capacity expansion is that the crude quality of new projects is overwhelmingly medium and light. In fact, over the next three years the predominant crude quality will be light. This is in contrast to conventional wisdom and underlines that OPEC is developing the right projects to help alleviate some of the downstream problems that were touched on by Mr Al-Zayer. It is not only inadequate past investment that has caused lack of effective global refining capacity in the past few years, but also increasingly stringent product specifications. It is extremely important for the downstream market that we look to tap into more medium and light crudes.

[Slide 6]
To complete the picture, I will now turn to non-OPEC supply. The impact of Engineering & Procurement capital expenditure increases on non-OPEC growth since 2002 has been positive. In fact on average, production has increased at record rates. Increased investment has also resulted in the stabilization of production in many mature fields by slowing the decline rate of many, enabled the development of marginal fields, allowed for more exploration and the application of more technology, and kicked off an expansion of projects under development and fields in production.

The one significant blip was 2005, when the Gulf of Mexico witnessed its most intense storms in 100 years.

Other events, such as the sinking of the world’s largest floating production platform in Brazil in 2001 and the collapse of Russia’s largest oil company in 2004 had very little impact on non-OPEC supply. In the six year period from 2000 non-OPEC oil production growth averaged 800,000 b/d per year, nearly five times higher than the period 1990-99, and one of the highest growth rates in 20 years.

However, the fact that non-OPEC production growth fell behind that of world demand growth for the years 2003-06 – reversing earlier trends of exceeding or matching demand growth – combined with the frequency of accidents and of downward forecast revisions, led the analytical community to under appreciate non-OPEC’s recent performance and to essentially write off its potential.

Going forward, the OPEC Secretariat’s medium term assessment of world liquids production capacity indicates that non-OPEC has significant potential and that it will continue to grow. Non-OPEC growth has the potential to average 1.2 mb/d annually in the 2007-2008 period and more than 750,000 b/d in 2009-2010. Non-OPEC production growth is underpinned by over 300 greenfield and brownfield developments, most of which are in construction or in advanced planning stage.

Regionally, Russia and the Caspian region will lead non-OPEC growth, with the bulk of the increase expected to come from the Caspian. Outside these areas, supply growth is driven primarily by increases in offshore West Africa, offshore Latin America, Gulf of Mexico and non-conventional in North America. The Middle East, OECD Asia and other parts of Asia will show modest gains, while Western Europe is expected to decline driven by a fall in output from the North Sea.

[Slide 7]
In all this talk of supply, however, we need to appreciate the flip side of the coin: demand. Although practically all forecasts point to a significant growth in global demand over the medium and long term, there are also several uncertainties that might well contribute to destabilizing the market. As you can see from the slide in front of you, on the one hand, demand growth could be driven up by an increase in the transport sector, the industrialization of developing countries, and a wish for building inventories. On the other hand, demand growth could be negatively affected by a range of consuming countries’ energy and fiscal policies as highlighted by Mr Al-Zayer, as well as new technologies. These factors raise important questions about the future scale of investment that will be required of producers.

[Slide 8]
What I would also like to highlight is that the market has been well-supplied during the recent period of significant demand growth between 2003 and 2006. Investments made some years ago ensured that the market was well supplied. And during this time OPEC raised its production level to help satisfy the increased demand for oil and ensure adequate inventory levels, while accelerating the expansion of crude oil production capacity to meet future increases in demand and maintain sufficient spare capacity. Despite the impact of Hurricanes Katrina and Rita on oil facilities in the US Gulf Coast region, OPEC’s assurances of healthy supply helped prevent this supply interruption from developing into a crisis.

If we look at the future, however, the issue of security of demand, which is intrinsically linked to the issue of security of supply, is of very real concern. Without confidence that there will be demand for OPEC oil, the incentive to undertake investment will also be reduced because of concerns that this will lead to large levels of unused capacity and, in turn, to downward pressures on oil prices.

This would result in huge revenue losses and OPEC Member Countries, as developing countries with strong competing needs for financial resources, would be adversely affected in terms of available resources for education, healthcare and infrastructure.

[Slide 9]
This slide shows the estimated capacity of crude and NGLs until 2010. It also highlights the expected required OPEC crude, based on reference case demand assumptions and non-OPEC supply growth expectations. Please note that we do not expect a significant increase in the demand for OPEC crude until 2009, which means that there will be time to build capacity. Of course, if the demand is lower, then excess capacity will be much larger. Similarly, if non-OPEC supply or demand are higher, then spare capacity will increase but at a slower rate. However, we think the risks are to the down side. This needs to be carefully monitored.

[Slide 10]
OPEC capacity expansion plans therefore give rise to the expectation that significant increases in spare capacity will occur over the medium-term. Indeed, the reference case scenario would involve OPEC spare capacity rising to 6-9 mb/d during this time. Yet as this slide also highlights there are both weak demand and high demand growth scenarios that could impact spare capacity. Again, this needs to be carefully monitored.

[Slide 11]
Allow me now to touch on an issue also highlighted by Mr Al-Zayer. What this means for producing countries in financial terms. As this graph shows, different demand requirements translate into huge ranges of anticipated capital outlay needs. As early as 2010, it is estimated that there will be a gap of $60 billion between the high and the low economic growth case, this gap could increase to $110 billion by 2015 and by 2020 the gap is $170 billion. This demonstrates the key challenge of anticipating, in a timely and effective manner, the appropriate scale of investments needed to maintain and expand upstream capacity and the corresponding downstream infrastructure.

But as a result of these uncertainties affecting security of demand, OPEC Member Countries will be reviewing their future capacity expansion plans. It also begs question: with these investment uncertainties where does the onus of maintaining sufficient spare capacity lie?

[Slide 12]
To conclude, there are challenges and uncertainties, but we believe the overall picture for the industry is positive. During the next few years we expect to see a strong increase in non-OPEC supply and OPEC capacity. OPEC spare capacity is expected to continue to rise in the medium term and the required OPEC crude is likely to drop or remain flat at best until 2009. In order to ensure market stability, however, players in OPEC and non-OPEC countries must collaborate strongly.

This is all the more important given the challenges that the industry is currently facing and the uncertainties driven by factors like the growth of the world economy, consuming country energy policies (substantial downside risk to demand) and technological developments.

From OPEC’s perspective, we will continue to support market stability with regular and steady supplies to consumers, and the maintenance of a adequate level of spare capacity. Yet, in all this, we need to also appreciate security of demand and the importance of this in the determining levels of spare capacity. Spare capacity levels that are too high are a concern for producers, and when too low, they are a concern for consumers. A healthy balance is the best way forward.

Thank you for your attention.

OPEC Spare Capacity

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