Crude oil prices could fall significantly and market imbalance would result on full return of Libyan and Iranian Oil supplies in the world market. In such a scenario, how Saudi Arabia responds by lowering production would be vital to sustain market imbalance, according to a report by Bank of America-Merill Lynch (BofAML).

Abrupt supply disruptions roiled the global oil markets in 2013, with Libya and Iran alone deducting 2.3 million b/d from balances last quarter. Oflate, news out of Iran and Libya has been mildly positive. In Libya, the recent start-up of the 340 thousand barrels per day( b/d) El Sharara field, where protests lasted for 90 days, brought output back up to 600 thousand b/d.which is up from 250,000t the end of last year, but remains far below post-civil war highs of 1.4 million b/d.

BofAML foresees that a simultaneous normalization of oil export from Libya and Iran is a real risk for the global oil balance in 2014 and could lead to meaningful downside pressure on fuel prices. In an extreme case, where non-OPEC production strengthens and Libya and Iran partially or completely recover, the global oil supply-demand balance could see a swing of 1.5-3 million b/d, as per the estimates done by the bank.

A partial or full return of production from these countries will require a synchronized response from other OPEC members to cut back. Saudi Arabia will likely take a leading role, as they absorbed much of the supply losses over the past two years. According to BofAML economists, Saudi Arabia's current fiscal budgetary break even oil price stands at $85/bbl, Thus, they have plenty of room to cut before the country's expenditures overtake its revenues.

A positive shock of 1.5 million b/d, met by a Saudi cut of say 1 million b/d, could bring full-year Brent prices down to an average of $95/bbl (versus of Bank of America forecast of $105/bbl), all else equal. This would start to throw Saudi into a budgetary deficit. Yet limited spare capacity across OPEC and a seasonal increase in Saudi domestic demand ahead should prevent Brent prices from falling sustainably below $90/bbl. Meanwhile, it is unlikely that other OPEC members would willingly cut back, as most of them are fighting output losses. The problem really starts at higher production cuts in response to a more substantial supply shock.

While entirely hypothetical at this stage, a partial or full return of production in both countries requires a synchronized response from other OPEC members to cut back.. The question is whether Saudi Arabia will cut back if output returns in the disruption countries. Historical evidence suggests they will make room for a moderate rise in output in other OPEC countries. In 2012, a recovery in Libyan output led Saudi Arabia to cut output down to as low as 9.2 million b/d in December from 10.1 in June. This was one of the four times since the 1990s that Saudi took out 1 million b/d of supply or more in less than 6 months. However, the most Saudi Arabia ever cut back within a year is 1.5 million b/d, which pales in comparison to a theoretical full return of Libya and Iran of 2.4 million b/d.
Source: Bank of America-Merill Lynch (BofAML)