Can the Saudis Save the Oil Market?

As US sanctions against the Central Bank of Iran (CBI) start to bite and the EU hammers out the details of a continent-wide ban on Iranian oil imports, all eyes are on Saudi Arabia and whether the Kingdom will step in a replace lost Iranian supply. Yesterday the Saudi Oil Minister told CNN that Riyadh will increase output if customers ask, which drew a sharp rebuke from the Iranian Foreign Minister earlier today. While an increase in Saudi output would  help blunt the oil market impact of growing international pressure on Tehran, its not the silver bullet policymakers are looking for. As important will be whether China is willing to take on additional Iranian supply.

Finding Alternatives to Iran

Iran exports between 2.2 and 2.5 million barrels of oil per day (bpd), depending on which data source you track.  Europe is currently the largest buyer at 600,000 bpd, with China close behind at 550,000 bpd (Figure 1. See RHG’s Iran Oil Desk for more detailed trade statistics).  Japan and Korea buy another 550,000 bpd with India, Turkey, South Africa and a handful of smaller countries splitting the rest. As the EU prepares to wean off Iranian oil and Japan and Korea look to reduce imports enough to placate the US, the hunt is on for alternative sources of supply.

European and Asian refiners are looking for non-Iranian suppliers with both spare production capacity and a product similar to the medium gravity high sulfur crude that comes from Iran (see our December 22nd note Iran and the 2012 Oil Market Outlook). The good news is that the countries with meaningful spare capacity produce crudes that are a pretty close match. And on the surface, it appears these countries have enough capacity to replace all the oil Iran currently supplies.   

By and large, spare capacity in today’s oil market is limited to OPEC countries, for whom production headroom is required for the cartel to operate effectively. According to the IEA, as of November of last year OPEC countries (excluding Libya) had 3.9 million barrels of unused production capacity (Table 1). But this headline number is a bit misleading. Most OPEC producers would have a hard time ramping up production in a pinch. That’s certainly true of Iraq and Nigeria where infrastructure and security issues keep output below potential, not a conscious decision by leadership to restrain supply.

It’s really only the Gulf Cooperation Council (GCC) countries of Saudi Arabia, Kuwait, the United Arab Emirates (UAE) and Qatar that have the ability to quickly increase supply, with the Kingdom accounting for more than 80% of upside potential. That takes effective OPEC spare capacity down to 2.8 million barrels per day (Table 1).

Higher Output Doesn’t Come for Free

With more GCC spare capacity than total Iranian supply, what’s the problem? First, while there is a high degree of market confidence that Saudi Arabia’s can increase and sustain production from the current 9.8 million to 11-11.5 million barrels per day, there is considerable doubt about the Kingdom’s ability to effectively tap the remaining 500,000-1,000,000 bpd of capacity. The Kingdom is already testing historic highs in terms of overall oil output, and reaching the upper end of current production capacity will likely yield heavier and higher sulfur crudes that are poor substitutes for Iranian supply.  

More important, however, is the impact a significant increase in GCC output on the oil market’s ability to weather additional supply shocks. There is an inverse correlation between GCC spare capacity and global oil prices (Figure 2). In the short-term, non-OPEC supply is relatively fixed. So the market balances either through an increase in OPEC output, a reduction in demand through higher prices (demand rationing), or some combination of both. If the GCC pumps more oil to replace Iranian supply the market will have to rely on demand rationing should any number of other supply disruptions occur during the coming year. And with increased security concerns in Iraq, continued civil strife in Nigeria, oil transit disputes in Sudan and production problems in the North Sea, there is no shortage of potential supply-side risks on the horizon.

Lower GCC spare capacity leaves the market more exposed to demand shocks as well.  In their last oil market report, the IEA marked down their global demand estimates for 2012 by 200,000 bpd, primarily on the back of economic weakness in the Eurozone. OPEC followed suit in their January report out yesterday. Should EU growth surprise on the upside, or Chinese growth not slow as quickly as expected, there would be little room to increase OPEC output.

These supply-side and demand-side shocks don’t actually need to occur for lower GCC spare capacity to translate into higher oil prices. Developed countries have burned through most of the crude oil inventories built up during the financial crisis and are now back at 2007/2008 levels (Figure 3). Without GCC production headroom available as a buffer, refiners will look to guard against potential supply disruptions or demand surprises by building inventories, putting upward pressure on crude prices.

Table 2 maps out the potential impact on GCC spare capacity this year should Gulf countries increase output to replace Iranian supply in major markets. Ramping up production by 600,000 bpd to replace current Iranian supply to Europe would reduce GCC headroom to 1.5-2.0 million bpd or 1.6%-2.2% of global demand. That’s in the range of what we experienced during the 2003-2008 oil price run-up. Under this scenario we’d expect to see some upward pressure on prices at the margins but not a significant scarcity premium. Replacing the 550,000 bpd of Iranian crude currently going to Japan and Korea, however, would push spare capacity down to 1.0%-1.6% of global demand, historically low levels for the GCC. This would leave the market highly exposed and translate into a meaningful increase in oil prices.  Increasing GCC output beyond this point could have price impacts similar to a commensurate reduction in global oil supply, but we doubt GCC countries would push spare capacity that low.  

The China Question

As discussed in Iran and the 2012 Oil Market Outlook, increased OPEC output is not the only way to mitigate the oil market impact of a reduction in European and Asian imports of Iranian crude. If a European refiner cuts their purchases from the National Iranian Oil Company (NIOC), that oil is still available to the market, the questions is whether or not the Iranians can find a willing buyer. If they do, an increase in GCC production is not necessarily required. NIOC can probably sell up to an additional 100,000 bpd to smaller players like Turkey, Pakistan, Sri Lanka and South Africa. But going much beyond that will require redirecting supply to countries with large amounts of refining capacity capable of handling medium gravity high sulfur crude, i.e. India and China.

Unless New Delhi finds a new solution to its Iranian payment problems (a delegation in is Tehran this week trying to work something out), we expect a meaningful decline in purchases from Iran over the course of 2012. At best, India keeps Iranian imports flat at 300,000 bpd. We see almost no prospect of an increase in the year ahead. So in the end it comes down to China, and what kind of deal Sinopec and CNPC (through their trading arms) can work out with Tehran.

As mentioned in our January 4th note Iran Sanctions: Off to the Races, Sinopec is already seeking better 2012 payment and price terms in negotiations with NIOC, which thus far the Iranians have been reluctant to give. We expect Tehran’s negotiating position to soften considerably later this month once the EU embargo is adopted. But a significant increase in Chinese purchases from Iran will be a political, not a company-level decision, and Beijing will need to weigh a number of factors in deciding which way to go.

On the one hand, fewer buyers of Iranian oil means lower prices for those that remain. While the Chinese government only gets 10% of the profit resulting from such a discount (though the oil company dividends), Beijing would have more latitude to keep gasoline and diesel prices fixed should global oil prices increase (important for combating inflation).

On the other hand, Chinese diplomats worry about the reputational cost of being seen as flaunting international efforts to pressure Tehran by swooping in and snatching up discounted Iranian oil. And buying more from Tehran means buying less from someone else, like Saudi Arabia, which has implications for China’s supply diversification and long term energy security. A number of analysts have recently cited these concerns to argue that Chinese refiners will not increase the amount of Iranian crude they buy. But should Beijing chose to keep imports from Iran flat in the face of reduced European, Japanese, Korean and potentially Indian purchases, the result will be a significant increase in global oil prices, something Chinese leadership would like to avoid.

In our view, Chinese behavior depends in large part on how the US implements the CBI sanctions in the months ahead. By the end of February (and likely a few weeks before), the Obama Administration will publish a rule that defines some of the key terms in the Menendez-Kirk bill. This includes the “significant reduction” in Iranian crude purchases by other countries called for the legislation. If “significant reduction” is defined as either quantity or price (something the Administration argued for when the legislation was being crafted and that some in Congress support), then Chinese refiners will have more room to increase purchases from Iran, provided they buy the oil at a discount. This, in combination with a modest increase in GCC output (400,000-600,000 bpd) could mitigate most of the upside oil price risk of US sanctions and an EU embargo.

Finally, in our December note, we flagged the possibility that China buys more oil from Iran to fill its new strategic oil reserves rather process in domestic refineries, a theme other analysts have picked up in recent weeks. This both helps shield China from international criticism as SPR imports are easier to hide and maintains existing supply from non-Iranian producers. The impact on global oil prices depends on whether China keeps the overall SPR fill rate at currently projected levels or significantly increases it. We expect Beijing to limit the fill rate to levels that keep Brent in the $105-$115 per barrel price band.

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