Want Power in the Oil Market? Hold Spare Capacity! (But Not Too Much)

State-run oil giant Saudi Aramco announced last week that the Saudi government had directed it to pause plans to increase the company’s maximum sustainable capacity (MSC) for crude oil production to 13 million barrels per day (Mb/d). The expansion program had aimed to reach that target by 2027, rising from the current MSC of 12 Mb/d, with work already underway on a number of oilfields.

While the announcement has attracted a good deal of attention (and lots of speculation about the government’s rationale), it is important to recall that, amid ongoing OPEC+ production cuts, current Saudi crude oil production is just under 9 Mb/d. That means the kingdom already holds some 3 Mb/d of spare production capacity. Its unused capacity is far greater than any other country’s, accounting for some 60% of spare capacity globally. Indeed, while other OPEC members in the Middle East hold spare capacity due to current production cuts, Saudi Arabia is unique in maintaining a strategic buffer of spare capacity it has invested in over decades. (The United Arab Emirates currently holds a large cushion of spare capacity, in part because its OPEC quota has not yet caught up to Abu Dhabi’s recent capacity expansion plan.)

And that is the true source of the kingdom’s importance to the global oil market; holding spare capacity is far more important than the Saudi’s role in global oil production and exports. (With global shares of about 13% for both production and exports, according to the Energy Institute’s Statistical Review of World Energy.)

The Value of Spare Capacity — To the Holder, and to the Oil Market

Why is spare capacity so important? I would argue that there are four dimensions that make spare capacity — and the countries that hold it – so powerful in the world’s oil market and with knock-on effects for the global economy and geopolitics. The first two dimensions are fairly obvious to oil market watchers, and the others are more subtle … but all are important.

The Value of Market Stability

The Saudis’ favorite argument is a good one: Spare capacity is part of a system that helps reduce oil price volatility. Spare capacity is the flip side of the long history of OPEC (and more recently, OPEC+) production management; when the group cuts production, by definition spare production capacity increases. And since the group tends to cut production when global market fundamentals are weak (that is, when prices are falling) and increase production when the market tightens, spare capacity can help smooth out price volatility. More strategically, in an industry where supply disruptions happen regularly — for what is by far the world’s dominant energy source — the ability to avoid regular supply crises serves the interests of both oil producers and consumers worldwide.

The Value of a Threat

Spare capacity is an important part of the tool kit for building consensus within OPEC and OPEC+ to implement and maintain production discipline. While diplomacy, peer pressure, and financial incentives have all been applied to encourage group members to agree on, and implement, production cuts, the holders of spare capacity — and especially a dominant one, like Saudi Arabia today — can threaten other producers with a price war if overproduction becomes a problem.

The Financial Value of Flexibility

From the perspective of the country holding it, the flexibility provided by spare capacity has significant financial value (what we economists call option value). That is, spare capacity can be used to increase production whenever a country chooses to do so. Typically, that happens when the oil market is tight and prices are high.

The Antiseptic Value

Holding strategic spare capacity helps to keep oil-consuming countries from pursuing more drastic policies that would ultimately reduce oil demand and lower prices. In essence, producers with spare capacity can tell consumers, “Don’t worry; we’ve got a security buffer.” Indeed, that buffer has become the de facto first line of defense in oil supply disruptions: The U.S. and its International Energy Agency allies frequently give the kingdom (and OPEC more broadly) the first opportunity to offset a supply outage before they move on to releasing strategic stockpiles and employing other emergency measures. And moving from the tactical to the strategic, holding (and using) spare capacity also serves to mitigate the sense of crisis that could drive oil consumers to adopt more aggressive policies, including increasing fuel efficiency standards and pushing for more rapid uptake of electric vehicles — policies that would damage long-term oil demand prospects.  

But Not Too Much Spare Capacity!

And yet there is clearly a sense that, at this point, growing spare capacity has become too much of a good thing. This is because:

• Holding spare capacity does incur costs, both to install and to maintain.
• It undercuts market sentiment by reducing the risk premium that traders associate with potentially disruptive events, such as those currently unfolding in the Middle East.
• To the degree that the growing spare capacity is held outside Saudi Arabia, it increases the opportunity for other countries unilaterally to cheat on their production targets, undercutting efforts by OPEC and OPEC+ to support prices and straining relationships within the organization.

Last week’s Saudi Aramco announcement is a clear indication that the Saudi leadership’s cost-benefit analysis has concluded, for now, that the cost of adding capacity outweighs the potential benefits of additional (spare) capacity.

How to Value Spare Capacity? And What Makes Saudi Arabia Different?

How does that cost-benefit analysis get done? While options theory provides a relatively straightforward method for quantifying the option value of spare capacity based on the frequency of disruptions and related price volatility, the other dimensions are more difficult to objectively measure.

What we can say is that, as mentioned above, Saudi Arabia is the only country ever to invest in building and maintaining a buffer of spare capacity on an ongoing, strategic basis.

Why is that the case? Initially, holding spare capacity was less a matter of policy than of market forces: In the early 1980s, following the twin oil shocks of the 1970s, falling global demand and rapidly growing non-OPEC supply meant that Saudi output dropped precipitously. Saudi output fell from 10.3 Mb/d in 1981 to a low of 4.5 Mb/d just three years later in 1984. While Saudi output wouldn’t return to its 1981 level until 2004, the strategic value of spare capacity was demonstrated in 1985, when the kingdom renounced its role as swing producer to reclaim market share (and triggered a years-long collapse in oil prices). Similarly, the ability to quickly ramp up supply following the Iraqi invasion of Kuwait in 1990 showed not only Saudi leaders, but governments in the U.S. and other oil-consuming countries, the critical value of spare capacity.

By the early 2000s, Saudi oil policy had come to include an explicit promise to maintain a strategic buffer of spare capacity, beyond the spare that would come and go as OPEC production fell and rose.

But again, why is Saudi Arabia the only country to follow this path?

First, the kingdom has unusually low-cost resources and a large national infrastructure of existing processing and export capacity, which make it relatively inexpensive to maintain spare capacity. With production controlled solely by Saudi Aramco, a national company largely owned by the state, the strategic policy choice to hold spare capacity is insulated from private shareholder desires for maximum short-term returns. In a related vein, the country’s leaders have historically taken a long-term, strategic perspective, emphasizing the kingdom’s central role in stabilizing the oil market and earning themselves the sobriquet “the central bank of oil.” By far the largest OPEC producer, the kingdom’s long-standing role at the center of U.S. policy in the Middle East supports this strategic perspective.

Times May Be Changing, But Spare Capacity Still Means ‘Power’ in the Oil Market

Does last week’s announcement signal a change? New leadership in the kingdom may be shifting its priorities as it seeks to modernize and diversify the Saudi economy. That leadership has also been keen to chart a more independent course vis-à-vis the United States. Additionally, the partial privatization of Saudi Aramco — with another offering apparently in the works — may make it more difficult for the company to bear the cost of maintaining a strategic buffer of spare capacity. Finally, a potential peak in global oil demand may portend a prolonged period of oversupply and rising spare capacity in the oil market, even if Saudi officials are keen to say that they don't believe such projections, especially if combined with continued strong growth in supply from the U.S. and other non-OPEC producers.

But with the kingdom already sitting on 3 Mb/d of spare capacity, and other Gulf producers holding a further 2 Mb/d, it appears more likely that for now, this is a tactical decision about “too much” spare capacity rather than the beginning of a long-term strategic shift.

After all, President Joe Biden wouldn’t have swallowed his pride to visit the kingdom in 2022 seeking relief from rising oil prices if Saudi Arabia lacked the ability to increase production — a stark demonstration of the power of spare capacity.

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