Fuel for Thought: Deal or no deal, many OPEC+ countries will struggle to produce more oil

OPEC's latest rift between estranged oil allies Saudi Arabia and the UAE has dominated market headlines, but even bigger cracks within the organization are looming.

As the world continues to look to the bloc and its partners for more volumes of crude, gaps between its haves and have-nots are widening.

Even setting aside the UAE's insistence on a higher output target, plans by the OPEC+ group to lift production could run into many members' practical limits on how much crude they are able to pump.

S&P Global Platts Analytics estimates that as of June, the alliance holds about 6.35 million b/d of spare production capacity -- 590,000 b/d above the current 5.76 million b/d in collective OPEC+ cuts.

That spare capacity is increasingly concentrated in a handful of OPEC+ members, with Saudi Arabia, the UAE and Russia accounting for almost three-fourths of it.

Internal disruptions, political disputes, underinvestment and US sanctions have all contributed to many countries' inability or unwillingness to drill new wells and invest in infrastructure to keep growing their crude flows.

This is not a new phenomenon, as prior to OPEC's partnership with Russia and other allies that began in 2017, its production policy often consisted of Saudi Arabia and Gulf neighbors the UAE and Kuwait serving as the market's swing producers, while the rest of the bloc pumped as much as it could.

But the situation has been worsened by the pandemic, with the price crash forcing the entire industry to retrench and many countries' oil sectors significantly worse off than before.

Already, some OPEC+ countries, notably Angola and Malaysia, have regularly been unable to produce at their quotas.

Their involuntary compliance, combined with actual production restraint from Saudi Arabia, the UAE and other members with spare capacity, has contributed to collectively high quota conformity levels. Platts calculated June compliance at 110%.

For now, the standoff between Saudi Arabia and the UAE has thrown a preliminary deal on higher production levels into doubt. Members are still bound to the existing agreement, which calls the alliance to hold its crude output flat through April.

But with or without a new deal, quota discipline could erode quickly, as oil prices are already well above pre-pandemic levels and forecasters see booming demand for crude.

Any production rises will favor those with spare capacity, and constrained countries will lose out on market share.

That may explain why all members, except for the UAE, appear united behind Saudi Arabia's proposal to extend the OPEC+ supply management pact beyond its April expiry to the end of 2022, as a condition of rolling back quotas for the rest of 2021. That would help ensure that production hikes occur in a more orderly fashion, removing the risk of a pump-at-will free-for-all if the deal ends or the alliance collapses.

A question of fairness

This was supposed to be the summer of love for OPEC and its allies.

Global economies were finding their footing a year on from the worst of the pandemic, and oil consumption – except in the aviation sector – has mostly recovered.

With bumper seasonal demand expected and US shale rivals still wary of committing capital for more drilling, this was an opportunity for the producer group to share in the bounty of higher output and higher prices.

Even the lingering threats of COVID-19 variants and the prospect of increased competition from Iran with a revived nuclear deal could not dampen the positive vibes.

In fact, OPEC+ ministers were so chill in June that their gathering that month – to reaffirm an April decision to raise crude output by 841,000 b/d in July – wrapped up in about 30 minutes, record time for a group whose routine meetings can drag on for hours.

A further deal that would see OPEC+ quotas lifted by another 2 million b/d from August to December seemed in the bag, when ministers convened online July 1.

But to hear Emirati officials tell it, the Saudis inserted a poison pill by insisting on the end-2022 extension.

This was unacceptable to the UAE, unless its output baseline, from which quotas are set, was revised up by some 700,000 b/d to account for its capacity expansions since the levels were first set in late 2018. It raised the question of fairness, with the UAE obliged to hold more of its capacity offline than other members.

Saudi officials, however, say the kingdom is more keen on maintaining harmony with the rest of the group and that the extension is necessary to provide a more flexible glide path to eventually tapering the full 5.8 million b/d in OPEC+ cuts.

Oil supplies wanted

Traders appear to still be weighing the fallout of the dispute and whether it will result in actual adherence to July quotas or devolve into sloppy compliance.

Dated Brent retreated from nearly three-year highs in recent days before rebounding to $75.55/b on July 9.

Closer to home for the alliance's core Middle East members, the September/October spread for Dubai crude prices has blown out from 73 cents/b on June 30, the day before OPEC+ ministers began their negotiations, to $1.53/b on July 9, the highest since January 2020, according to Platts assessments. The spread widens even further with the November prices.

The ballooning backwardation in Dubai indicates strong demand for Middle East sour barrels amid tight supply, with significant buying from Indian refiners lifting prompt prices, before the market potentially loosens in later months.

OPEC+ watchers still largely expect that the coalition will eventually regroup and forge some sort of compromise agreement. At the moment, though, both the Saudis and Emiratis appear entrenched in their positions, and no date has been set for formal talks to resume. Until that happens, market volatility looks set to rise.

Beyond the near-term implications of any deal, however, OPEC+ ministers could soon have a spare capacity problem on their hands, exacerbating inequities within the bloc that could threaten further cohesion and cooperation -- and its control over the oil market.