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OPEC’s Spare Capacity Ignored By Crude Oil Market at Trader’s Narrative

While the crude oil market has sharply corrected from its bubble heights, there is reason to believe that it still does not truly reflect the underlying demand and supply equation at the heart of price discovery.

Here’s a chart showing OPEC’s spare capacity in millions of barrels over the past 8+ years:

OPEC spare capacity chart
Source: Bloomberg

We are right back to where we were at the beginning of the year in 2000 and 2002. Since this isn’t relative (to total production or demand) it is difficult to look at this data series over time. But assuming that 9 years isn’t that long, it is still valuable.

Of course, there are many variables that go into determining the price of a barrel: total capacity of production, how much oil is flowing from OPEC, how much demand there is from the global economy, as well as the demand from institutions not for use but for investment.

This last rationale has been the driving force in recent years as ‘animal spirits’ have taken hold. While last year’s crude oil bubble returned to normalcy, it looks like it is reflating right back up again. And the same basic script is being used as large institutions and hedge funds plow money back into this market.

Considering the extreme economic downturn, crude oil should have fallen to $20 - previous support from 2002. That’s just my own guess. Or it could have not gone up so much in the first place. Instead of acting as a ballast to rescue the global economy when it most needs it, it has instead been acting like an anchor, dragging it down further.

Here’s a chart of crude oil futures for the same time period showing each time that spare capacity reached above 6 million barrels:

crude oil futures OPEC excess capacity

Looking at these two charts together makes one wonder if the crude oil market is ignoring the excess spare capacity or whether it successfully discounts it. For example, most recently by falling from $147 in 2008 to less than $40 in early 2009 as spare capacity shot up to multi-year highs.

It is impossible to speak on behalf of a collective such as the market but my hunch is that, for the past few years, the oil market has been driven by tectonic shifts in asset allocation more than that which can be explained by fundamental analysis (such as supply and demand variables).

While we’re at this discussion, here’s an intriguing thought experiment. Imagine if instead of crude oil, we had to rely on a cartel such as OPEC in setting the price of a ubiquitous commodity like say, water. How would the price of water be set? would we just go along? or would we simply refuse to allow a cabal to dictate the price of water by turning their spigots on or off?

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8 Responses to “OPEC’s Spare Capacity Ignored By Crude Oil Market”  

  1. 1 stantam

    $20? Maybe you are just not patient enough. After all, gold had a 25 year “correction”….

  2. 2 Pej

    to answer your closing question: many are doubtful about the ability of OPEC to “set prices” and they are also not trusting figures coming out of this “organization”. That said, it seems like you are trying to ignore the “investment demand” as part of your supply and demand equation. I don’t think there’s anything wrong with people wanting to buy and store oil now to sell at a higher price in the future?

  3. 3 Mike C

    One of these days, when you have a spare couple of hours, you should check out this site, and then just start reading every post for the past couple of years:

    I’d love to know the original source of data for Bloomberg. I think there is pretty fierce debate about what OPEC’s true spare capacity and reserves are. AFAIK, they don’t let outsiders in to do comprehensive geological audits.

    Oh well…that’s what makes a market, different views. I suspect in 5 years, and in 10 years, and in 20 years that people will be wishing they loaded up on $70 oil.

  4. 4 stantam

    Hey Mike, In 10 years, battery, capacitor, or other technology will negate the need for oil to drive autos and many other needs (what emerges may surprise even the most doubtful of us). After all, GM gave up on batteries 10-15 years ago, now look at where they are trying to be. It’s going to be a constant catchup game. Look at what’s happening in digital cameras. Every 6 mo there are more fascinating and mind boggling breakthroughs. I see the same thing in auto propulsion/ fuel systems.
    Build them and they will sell. NOW we finally have some incentives (prospects of eventual $100 to $300 oil if no one acts in the interim).

  5. 5 Mike C

    I forgot to mention that one should also read the 2nd half of Jeremy Grantham’s most recent quarterly letter. Just my opinion, but focusing on a single datapoint is likely to have one missing the forest for the trees.

  6. 6 Babak

    Stantam, perhaps you’re right.

    Pej, nothing wrong with speculation, it is valid and a necessary function, akin to lubricants on the wheels of commerce. But when it grows so much that it supplants the much more valid functions of usage, then we’re in a pickle.

    Mike C, I had a back and forth with Gregor last year just before the oil bubble peaked. Basically, he insisted that it wasn’t a bubble and I said it was. I haven’t gone back to him to ‘told ya so!’ :)

  7. 7 Pej

    Babak, IMHO, you cannot distinguish investment from speculation. They are both the same really.

    Also, it’s a bit ironical that if someone goes an buy 200 kg of rice wheat or whatever to store at home, he is said to be contributing to the economy, while if somebody buys 200 (or 2000 or 20,000) kg of the same basic commodity on the futures market, he is said to be an evil speculator, destroying the lives of many and also destroying the economy.

  8. 8 Matt

    What do you type into bloomberg to get the above chart re spare capacity?

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