Slack Capacity in the Global Oil Market
Both production and consumption of oil have consistently been at all-time highs in recent years. Oil stockpiles and slack production capacity could, in theory, somewhat attenuate a disruption's effect on the price of oil: if less Persian Gulf oil made it to the market, producers elsewhere could turn on their excess capacity, and their added pumping would satisfy global demand.
But in reality, it is difficult to know how much spare production capacity exists, because producers closely guard that information. In many producing countries, information on oil industry investments, maintenance status of the oil infrastructure, and even basic geology of oil fields is treated as a state secret. So while it is reasonable to presume that there is some slack capacity out there, and the International Energy Agency even publishes estimates of the amount available, it may not be wise to count on global slack to compensate for a problem in the Strait of Hormuz " especially since we know that some of the biggest oil producers in the world, who might reasonably have the most slack capacity, are located behind the Strait, too.
Stockpiles, of course, offer another alternative that can help ameliorate the effects of a disruption: if consumers have "extra" oil on hand, they can simply consume from the inventory until the disruption is over. But stockpile management has its problems, too. Stockpiles are always vulnerable to speculation " it is hard to time stockpile releases "just right" " and government strategic stockpiles are subject to political pressures that make them hard to use as a practical buffer against oil supply shocks.
World Oil Production and Consumption Trend
Source: Graphs built using Energy Information Administration data. See: http://www.eia.doe.gov/emeu/international/oilproduction.html
Even with all the uncertainty, though, slack production capacity and stockpiles surely provide some margin of protection against relatively small disruptions, perhaps up to a couple of million barrels of supply per day. A campaign to interrupt oil flow through the Strait of Hormuz would have to overcome that margin in order to really harm the global economy.
Global Oil Stockpiles
The oil shocks of the 1970s spurred international concern over global oil supplies and especially the ability to manage supply disruptions. Creation of strategic stockpiles was a natural response. Global stockpile inventories reside in both public and private reserves. Private oil companies stockpile oil for two main reasons[ii]: 1) to profit from selling oil in the future; or 2) to maintain access to oil in times of physical shortage. However, there are barriers to private stockpiling, such as relatively high storage costs[iii] and the threat of future imposition of price controls and other forms of government intervention.[iv] Because private firms are likely to provide less than the optimal amount of inventory, governments "fill gaps in private stocks."[v]
In response to the oil shocks of the 1970s, the Organization for Economic Cooperation and Development (OECD) formed the International Energy Agency (IEA), with the goal of making it virtually impossible for OPEC to embargo any set of nations.[vi] The IEA requires that each member store enough oil to satisfy ninety days of import consumption. The strategy emphasizes collective, coordinated stock draws.[vii]
Based on government estimates, globally reported public and private oil stockpiles stood at nearly 4.2 billion barrels as of July 2007.[viii] The United States and Japan account for over two-thirds of the total publicly held oil stockpiles, and the U.S. public and private stocks account for over 40 percent of the global stockpile. The U.S. Strategic Petroleum Reserve (SPR) is the largest public stockpile in the world.
Total OECD Public and Private Oil Stockpiles, Key Actors (millions of barrels)
Source: Graphs built using Energy Information Administration data. See: http://www.eia.doe.gov/emeu/international/oilproduction.html
Stockpiles, no matter how plentiful they may be, serve little purpose if they are not readily available in the event of a supply disruption. According to the Government Accountability Office,[ix] the U.S. SPR maximum drawdown rate is 4.4 million barrels per day (mbpd). According to the IEA,[x] the remaining IEA countries can collectively drawdown an additional 8.5 mbpd, for a total maximum drawdown of nearly 13 mbpd. That drawdown rate applies to the first month. As time goes by, the maximum drawdown rate decreases to five mbpd after ninety days and less than 0.5 mbpd after 180 days. To date, the largest IEA coordinated stockpile drawdown took place in 1991: 2.5 mbpd for less than a month.[xi]
The U.S. Strategic Petroleum Reserve
In 1975, President Gerald Ford signed the Energy Policy and Conservation Act, which among many things created the United States Strategic Petroleum Reserve (SPR) to be used in conjunction with International Energy Agency efforts to respond to a "severe disruption" of oil. The legislation gave the U.S. President full authority over exercising the SPR. Current capacity of the reserve stands at 727 million barrels. As of April 1, 2008, the inventory of oil in the SPR is 700.4 million barrels.[xiii] In 2007, President George W. Bush authorized the expansion of the SPR to nearly 1.5 billion barrels, which will require the addition of new storage sites.
Oil has only been released from the SPR three times in nearly 30 years:
- 1991 - Five months after Iraq invaded Kuwait, President Bush released 21 million barrels from the SPR
- 2000 - President Clinton sold thirty million barrels of SPR oil
- 2005 - President George W. Bush sold 23 million barrels to Gulf refiners after Hurricane Katrina
Even after the president decides to release oil from the SPR, it takes time to begin the physical pumping of oil. For example, oil did not flow until two weeks after the 1991 presidential decision to use the SPR.[xiv]
U.S. energy policy calls for using stockpiles in the event of a "significant disruption" to oil supplies, but the phrase "significant disruption" is not clearly defined. Originally, the IEA defined a significant disruption as one that blocks 7 percent of daily world consumption. In the past, however, there have been very few disruptions of that magnitude (none since the late 1970s) [xv]. With today's worldwide demand of more than 80 million barrels per day (mbpd), the old definition of "significant disruption" would require that 5.6 mpbd come off the market " slightly less than Iran's daily production or about 30 percent of crude oil traversing the Strait each day.
Furthermore, the U.S. President has historically been reluctant to authorize the use of SPR oil because of the "general public view [that] the SPR [be used] as a means to combat actual physical shortage rather than high prices."[xvi] Therefore, because of the general public's preconceived notions of the SPR as a tool of national security, a prolonged drawdown of oil from the SPR may not be politically viable.
Excess / Surge Production Capacity
Many people fear that as demand for oil has steadily climbed in recent years, slack production capacity has gotten tighter and tighter. Historically, it takes years of consistent high oil prices to stimulate significant investment in oil exploration and production. The last significant burst in investment occurred during the 1970s, resulting in a significant increase in production capacity. The burst in capacity helped lead to "overcapacity" and, ultimately, lower oil prices in the 1980s because of the slowdown in worldwide oil demand. Since then, the oil industry's excess capacity has been slowly worked off by the changing worldwide oil demand and supply balance. Low oil prices in the 1980s and "˜90s inhibited investment.
In July 2008, the IEA issued a comprehensive medium-term outlook for the global oil market. The IEA predicts that global oil markets will remain very tight over the next five years.[xvii] The IEA forecast that oil production per day will rise only 6 million barrels, or 6.6%, by 2013, to just over 96 mbpd from 90.4 mbpd in 2008.[xviii] From a demand perspective, the new IEA report also predicts slowing consumption due to a weakening global economy and high gas prices.
The IEA estimates total excess productive capacity in 2008 at about 2.5 million barrels per day (mbpd), or about 3% of global demand.[xix] As additional infrastructure comes online, the IEA estimates that slack capacity will increase to slightly more comfortable levels in 2009 and 2010, before precipitously falling starting in 2011. By 2013, the IEA estimates a mere one mbpd of slack capacity.[xx]
But where does this slack capacity exist? Non-OPEC countries probably do not currently have much slack production capacity: they generally produce and export as much oil as possible at any given price of oil. If a disruption leads to a price increase, non-OPEC suppliers may increase output at the margin, but probably not by a large amount.
OPEC countries, especially Saudi Arabia, may have more slack capacity based on past investment in production infrastructure. In recent years the IEA suggested that the Saudis had 1.5-2 million barrels per day (mbpd) of spare production capacity, and Saudi Arabia has announced major investments in expanding capacity in recent years.[xxi] Because the whole point of a cartel is to reduce output below the level that sellers would offer in a competitive market, it is reasonable to assume that other OPEC members have some excess capacity.
Moreover, production in some other OPEC countries has dropped precipitously in recent years, perhaps for political reasons or due to poor management decisions " hypotheses frequently applied to Venezuela, for example. In the event of a disruption, these producers might find it in their interest to correct these correctable problems, for example by re-hiring expert field managers, because the value of their expertise would be higher in the wake of the disruption. But how quickly these producers could ramp up in response to the new conditions " or indeed whether they would try " is highly uncertain.
It would be overly optimistic to rely on slack capacity for protection against a major (4-5 mbpd) disruption of flows through the Strait of Hormuz, even if slack could compensate for a less successful disruption campaign. Furthermore, because over 65 percent of OPEC oil production and virtually all of OPEC's excess capacity lies in the Persian Gulf, OPEC would have a hard time compensating the world market for any disruption there.[xxii]
[i] Graphs built using data from: Energy Information Administration, International Petroleum (Oil) Production. Online. Available: http://www.eia.doe.gov/emeu/international/oilproduction.html. Accessed: November 15, 2007.
[ii] George Horwich and David Leo Weimer, ed., Responding to International Oil Crisis (Washington, D.C.: American Enterprise Institute, 1977), p. 70.
[iii] Brian D. Wright and Jeffrey C. Williams, "The Roles of Public and Private Storage in Managing Oil Import Disruptions," The Bell Journal of Economics, vol. 13, no. 2 (Autumn, 1982), p. 342.
[iv] Phillip K. Verleger, Oil Markets in Turmoil: An Economic Analysis (Cambridge, Massachusetts: Ballinger Publishing Company, 1982), p. 200.
[v] Robert J. Weiner and Alvin L. Alm, ed., Oil Shock: Policy Response and Implementation (Cambridge, Massachusetts: Ballinger Publishing Company, 1984), p. 197.
[vi] David L. Goldwyn, ed. Energy and Security: Toward a New Foreign Policy Strategy (Washington, D.C.: Johns Hopkins University Press, 2006), p. 99.
[vii] David L. Goldwyn, ed. Energy and Security: Toward a New Foreign Policy Strategy (Washington, D.C.: Johns Hopkins University Press, 2006), p. 99.
[viii] Numbers as of July 2007, according to the EIA. [ix] U.S. General Accountability Office, Strategic Petroleum Reserve (Washington, D.C., August 2006), p. 25.
[x] International Energy Agency, Fact Sheet on IEA Oil Stocks and Emergency Response Potential. Online. Available: http://www.iea.org/textbase/papers/2004/factsheetcover.pdf . Accessed: November 21, 2007.
[xi] International Energy Agency, Fact Sheet on IEA Oil Stocks and Emergency Response Potential. Online. Available: http://www.iea.org/textbase/papers/2004/factsheetcover.pdf . Accessed: November 21, 2007.
[xii] David G. Victor and Sarah Eskreis-Winkler, "In the Tank: Making the Most of Strategic Oil Reserves," Foreign Affairs, Vol. 87, No. 4 (July / August 2008), pp. 70-83.
[xiii] U.S. Department of Energy, Strategic Petroleum Reserve - Quick Facts and Frequently Asked Questions. Online. Available: http://www.fossil.energy.gov/programs/reserves/spr/spr-facts.html. Accessed: April 1, 2008.
[xiv] David L. Goldwyn, ed. Energy and Security: Toward a New Foreign Policy Strategy (Washington, D.C.: Johns Hopkins University Press, 2006), p. 101.
[xv] Jerry Taylor and Peter Van Doren, "The Case Against the Strategic Petroleum Reserve," Cato Institute, Policy Analysis, no. 555 (November 21, 2005), p. 13.
[xvi] Jerry Taylor and Peter Van Doren, "The Case Against the Strategic Petroleum Reserve," Cato Institute, Policy Analysis, no. 555 (November 21, 2005), p. 10.
[xvii] Guy Chazen, "Energy Watchdog Expects Oil Markets to Remain Tight," Wall Street Journal (July 2, 2008), p. A-8.
[xviii] Guy Chazen, "Energy Watchdog Expects Oil Markets to Remain Tight," Wall Street Journal (July 2, 2008), p. A-8.
[xix] Guy Chazen, "Energy Watchdog Expects Oil Markets to Remain Tight," Wall Street Journal (July 2, 2008), p. A-8.
[xx] Guy Chazen, "Energy Watchdog Expects Oil Markets to Remain Tight," Wall Street Journal (July 2, 2008), p. A-8.
[xxi] Steve Hargreaves, "Pumping the fear factor out of oil," CNN Newswire (August 21, 2006). Online. Available: http://money.cnn.com/2006/08/18/news/economy/oil_fear/index.htm. Accessed: November 20, 2006.
[xxii] Data taken from: Energy Information Administration. STEO Table Browser. Table 3c. OPEC Petroleum Production (February 12, 2008). Online. Available: http://tonto.eia.doe.gov/cfapps/STEO_Query/steotables.cfm?periodType=Annual&startYear=2004&startMonth=1&endYear=2008&endMonth=12&tableNumber=7. Accessed: March 6, 2008.
This page last modified in August 2008