The Big Wild Card Behind the Oil Boom Headlines

The International Energy Agency (IEA) made headlines around the world earlier this week when it published a major report predicting that the United States would pass Saudi Arabia to become the world’s largest oil producer by 2017. It is a striking conclusion that reinforces much of what industry analysts have been writing for the past several months.

But buried in the report is a major assumption that underpins its conclusions: the IEA analysts assume that OPEC producers will hold a substantial amount of oil off the market in order to prop up prices. A similar assumption, often implicit rather than explicitly stated, underlies many other optimistic analyses too.

The IEA report tips its hand in an aside on page 124. Here’s what it says:

“In the New Policies Scenario, demand rises by 5.7 mb/d by 2017, implying a substantial increase in the amount of effective spare capacity, all of which is in OPEC countries, from 2.6 mb/d in 2011 to 5.9 mb/d in 2017.”

The New Policies Scenario assumes some modest moves toward new policy on energy efficiency and alternatives; the “Current Policies Scenario” sees roughly a million or so more barrels a day of demand by 2017. It’s reasonable to say that the IEA assumes that OPEC will hold an extra four million barrels a day or so of spare capacity beyond what it has in recent years by 2017.

This is a big assumption. As Bob McNally and I wrote in Foreign Affairs last year, a host of forces are conspiring against OPEC members choosing to hold much more spare capacity than they have carried in recent years. Indeed when I visited Kuwait earlier this week, I consistently heard that the country was likely to essentially get out of the spare capacity game, leaving only the UAE, and primarily Saudi Arabia, balancing the market.

It doesn’t strike me as reasonable to assume that Saudi Arabia to more than double its spare capacity over the next five years (though anything can happen). That leaves two other possibilities. The first is that OPEC members could cut back on their planned investments. That would leave them with less oil to sell – certainly a financial sacrifice, but far less of one than building new infrastructure and then not using it to produce oil. Indeed the head of OPEC warned of just this possibility in London conference yesterday.

If that doesn’t happen then there is a third possibility: oil prices will fall in order to balance the market. Part of their function would be to incentivize greater oil demand. But plunging prices would also serve to deter investment and production outside of OPEC. New Canadian oil sands projects would probably be the most vulnerable – but depending on how far prices fell U.S. tight oil could be next.

The IEA report acknowledges the possibility of a price decline. It says in response that it “assume[s] (as apparently does the oil futures curve) that geopolitical risks will counterbalance the better supplied market to sustain oil prices in this period.” I’m skeptical of this claim. “Geopolitical risks” are often trotted out to explain temporarily elevated prices. But it’s very difficult to see how they’d be sufficient to sustainably bridge a gap as big as the one that the IEA identifies. (More on that, perhaps, in another post.) The agreement of the futures curve with the IEA projections is at least as likely to be coincidental.

That leaves us with three possibilities: U.S. oil booms and OPEC producers massively raise the amount of spare capacity they hold (unlikely); U.S. oil booms and OPEC producers cut back on investment (more likely); and an oversupplied market pushes prices down far enough to stall the U.S. oil boom, at least temporarily, within the next five or so years (not unreasonable either). Only time will tell which one of these comes to pass.