Modeling near-term crude oil prices with inventory and OPEC spare capacity

OPEC spare capacity has become correlated with oil prices in recent years

Another key indicator of market balance is spare capacity held by the Organization of the Petroleum Exporting Countries (OPEC). Although OPEC does not have an explicit definition of ‘spare capacity’, the U.S. Energy Information Administration defines spare capacity as “the volume of oil production that can be brought on-line within 30 days and sustained for at least 90 days”. We can calculate a rough approximation of this using Bloomberg estimates for OPEC production and capacity.

Historically, the relationship between OPEC spare capacity and Dated Brent prices was statistically insignificant. However, it has improved since the start of 2018, which coincided with the rapid rise of U.S. crude exports. As more U.S. crude reached world markets, OPEC’s active management of its production has been its primary mechanism for balancing global markets and sustaining oil prices. OPEC’s withholding of production translates into higher spare capacity, and thus, spare capacity can be used as a proxy to gauge the oil market balance.

On the other hand, when the market is loose and supply is outpacing demand, OPEC often reduces output to balance the market, which leads to higher spare capacity. Therefore: loose market balance (and weaker oil prices). OPEC responds by reducing output, which leads to higher spare capacity.
During periods of market tightness when demand is outpacing supply, OPEC can increase production by tapping its spare capacity. Therefore: tight market conditions (and along with stronger oil prices). OPEC responds by increasing output and spare capacity falls.

OPEC spare supply capacity correlation also indicates big cuts needed for $60 Brent

BloombergNEF created another model, this time using OPEC’s spare capacity, and we tested two versions: One is based on total OPEC spare capacity using the Bloomberg terminal’s spare capacity ticker, which estimates August 2020 OPEC spare capacity at 10.2m b/d. The second version excluded Venezuela and Iran’s spare capacity, thereby reducing OPEC’s August 2020 spare capacity to 7.4m b/d.

In both, using the prior quarter’s Dated Brent prices improves the model. This implies that spare capacity lags prices, but in reality OPEC is just responding to market conditions, although on a time-lagged basis. It is also possible that OPEC often signals its production plans ahead of time, and these forward expectations get incorporated into commodity prices prior to the actual change in output.

The first model has an R2 of 0.87, and based on this correlation, Dated Brent is unlikely to reach the $60 range until spare capacity falls to 5.5m b/d, a 4.6 m b/d reduction from current levels. Excluding Venezuela and Iran further improves the model, resulting in anR2of 0.93. In this case, spare capacity needs to contract by 3.8m b/d to signal $60 Brent.