SPR drawdown barely passes the laugh test, but don’t get used to it

President Obama’s decision to release 30 million barrels from the Strategic Petroleum Reserve, as part of an International Energy Agency (IEA) coordinated release totaling 60 million barrels, has been roundly criticized from the right to center-left.  Reaction from Senate Energy Committee Chairman Senator Jeff Bingaman (D-NM), the Washington Post, and Financial Times ranged between luke warm support to scathing opposition on the grounds that the President’s decision was unjustified,  political and too late.

Even though Libya was a real disruption, in my opinion, SPR use now is not justified.  The SPR should be used quickly in response to a major supply emergency caused by an act of God or major geopolitical emergency, such as a Gulf hurricane or conflict in the Arabian Gulf.  A better response to February’s Libya disruption would have been for the IEA to immediately release stocks in Europe, which was most affected.  (Since most European countries do not hold government-owned strategic stocks, this would have meant allowing refiners to hold lower minimum levels, as the Japanese did after Fukushima.)  In addition, ideally the US and IEA would have succeeded in convincing Saudi Arabia to aggressively discount its spare capacity, some of which was not of the same quality as the lost Libyan supply, in order to encourage importers to stock up.

But far more important is whether Thursday’s move marks the beginning of several more SPR draws in coming years to tame global oil prices.

The Administration and IEA described last week’s decision as a one-time bridging action designed to tide the markets over until hoped-for supplies from Saudi Arabia and other producers arrive.  However it is far from clear that producers will export much more oil:  Saudi Arabia’s production is going up this summer, but so is its consumption.  It’s often overlooked that oil demand growth in scorching hot Saudi Arabia is the third largest in the world after China and Russia.

Last year, oil prices were rising on tightening supply-demand fundamentals and year well before the “Arab Spring”, and most analysts expect a return to the $100 range is more a matter of when than if.  As Michael Levi and I discuss in the current issue of Foreign Affairs, about six years ago we entered an era in which oil prices swing more wildly and will continue to do so, with or without oil supply disruptions.  The reason is global oil demand growth, mainly in Asia, is outstripping net supply growth, requiring Saudi Arabia to drain its spare production capacity: a quickly producible oil supply Riyadh holds off the market to balance price swings.  With spare capacity low or gone, oil prices swing more wildly because in the short run, oil demand and supply are insensitive to price changes.  That is because oil is a must-have commodity for which there are few substitutes and new oil production takes years to find and produce.   (Note: Views expressed here about the wisdom of SPR use are mine alone.)

What this means is as the price mechanism assumes the supply-demand balancing role instead of Saudi production decisions, oil prices revert to boom-bust cycles.  In times of strong GDP growth prices will rise steadily – and sometimes sharply – to ration consumption.  Growing economies may be thirsty for oil, but at the end of the day the world cannot consume what has not been produced.  As rising energy costs or other factors cause recessions, oil prices will fall sharply as demand collapses (oil demand responds much more to income changes than prices changes.) Leaders are starting to realize OPEC can no longer prevent rising oil prices from angering voters and threatening economic growth.  Traumatized, they will be strongly tempted to use strategic stocks – whether there is a disruption or not.

This would be a big mistake. Aside from principled opposition to such government intervention in markets, strategic stocks aren’t large enough to balance supply and demand over the long haul.  Officials do not have sufficient information about global supply and demand to know when and how much to buy and sell.  And even if they did, politicians would insist on SPR releases in response to political pressure -I’d guess around $4/gallon gasoline prices.  There is precedent for politicized misuse of strategic reserves:  President Clinton allowed Vice President Gore to announce an SPR drawdown 6 weeks before the 2000 election, although there had been no disruption in supplies.  Finally, OPEC producers could offset strategic stock draws by cutting production and if the private sector believed Uncle Sam were going to cap oil prices, refiners would hold lower commercial inventories.

So turning to last week’s SPR decision, which is it – a one-time release to bridge the loss of Libya or the beginning of many releases to cap prices?  We should find out when crude oil prices head back toward triple digits.  If economic growth is slowing or double dipping, oil prices may have peaked for many months or quarters.  But if growth remains strong, oil prices are headed back sooner to levels that will reignite voter discontent, threatening the recovery and the President’s reelection.

It is likely that whenever oil prices resume marching upward, Libya’s production will still be partially or wholly disrupted. But at some point, prolonged supply disruptions become the new normal.  Since 2003, the world has lost some 0.5 mb/d of champagne quality crude from Nigeria due to unrest.  Some 0.3 mb/d of Yemeni crude has been out in recent months.  If officials want to justify SPR releases because of ongoing geopolitical disruptions that OPEC has failed to fully offset, they will have excuses.

If Thursday’s SPR drawdown was just a one-time response to the Libyan disruption to bridge the arrival of new OPEC supplies, then while it wouldn’t have been my call, it just barely passes the laugh test.  But if it inaugurated a strategy of repeated releases to cap oil prices, then the US will futilely waste resources while jeopardizing national security, and that would be no laughing matter.


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