Releasing the Strategic Petroleum Reserve Will Make Volatility Surge
It is now approaching 6 p.m. here in Athens. The city is winding down its normal daily activity, and people are already anticipating the next major protest – tomorrow.
I will be there, talking to some of the opposition leaders. Will let you know what I find out on Monday.
Meanwhile, my attention is fixed on the combined action yesterday, by the Obama Administration and the Paris-based International Energy Agency (IEA), to release 60 million barrels of crude oil reserves into the market this month.
The IEA will provide 30 million, and Washington will add 30 million more from the U.S. Strategic Petroleum Reserve (SPR).
Established after the Arab oil embargo of 1973-1974, the IEA represents the interests of the developed – largely Western – economies. It had been discussing possible approaches to the widening pressure on global oil prices for some time. Yesterday's announcement was the coordinated Washington-Paris response.
It immediately drove crude oil prices down more than 4.8% in New York (the West Texas Intermediate (WTI) benchmark for NYMEX trading), while slashing the Brent price in London by more than 6%.
Both recovered a bit before the close, but the impact has clearly been to reduce price – at least in the short-term.
As far as the policy goes in that respect, it has accomplished its purpose.
But it makes you wonder…
What Was the Real Reason for the Move?
While the IEA has assumed a low-key approach, Washington has had to defend its actions against critics from the Right (assailing its assault on the free market) and those on the Left (arguing that the move has not gone far enough to suppress the price).
The timing is also strange; the market itself had been moving down without the outside help of government action.
Both U.S. and IEA officials have suggested that the volume injection was required by supply interruptions due to the unrest in the Middle East and North Africa (MENA).
Yet the market in general, and a Saudi decision to increase production, in particular, had already solved the Libyan export halt. The unrest elsewhere in the region, while disconcerting, has had a negligible actual impact on crude moving into the market.
MENA may have been a legitimate reason several months ago. It's hardly one now.
The real reason lies somewhere else.
Yes, there are political motives behind the U.S. move, as we move into an election year cycle. However, the concern prompting the action from Washington is directed at something about to hit. And at least some in the government are candid enough to admit it (albeit privately).
Demand Is Finally Coming Back
Renewed U.S. demand will intensify the pressure on prices, drive volatility up, and make for a more unstable situation all around.
It is against this projected backdrop that the decision was made.
The main rationale is not to meet Libyan volume interruptions (a backward-looking approach), but to arrest increasing demand pressure beginning to emerge in the market (that is, to preempt a problem before it occurs).
The U.S. market demand has remained sluggish. Elsewhere, demand has been increasing for some time. In fact, global demand levels are now moving much higher than anticipated. Estimates by OPEC, the IEA, and the U.S. Energy Information Administration (EIA) all point to a major upswing in oil requirements internationally.
Last week, anecdotal indications that U.S. demand was also beginning to rise were reflected – for the first time – in the EIA weekly report. The American consumer (both retail and industrial) is finally starting to march to the same drummer as consumers elsewhere.
This is why the move yesterday will not deflect the demand surge developing. Government action to use reserves is an artificial device. It does nothing to change the market dynamics. In fact, when you suppress the price, even marginally, demand is likely to increase even further.
Lower energy prices always result in the consumption of more energy.
Yet, available supply is not the problem – not when crude oil prices were going up through the end of April, nor when they were going down throughout much of May.
The problem has been the inability of traders to determine an acceptable price for crude, given its prevailing market price.
The problem, therefore, has been in trade, not in supply. By adding to the supply side of the equation, Washington (and the IEA) has merely distorted the situation further.
Two Things Will Result
First, the actual price of the crude oil will now encompass the reserve injections, with traders setting new risk approaches that include the artificially determined volume. It will further distort the actual trading market without providing significant benefit.
That's because this additional supply will not drive the price of crude down to a level that will result in substantial savings to end-users.
The $4 decline in New York oil prices resulting from yesterday's move will save the average U.S. driver about 10 cents a gallon for gasoline. And that's assuming the policy of adding volume to the market from reserves is even continued beyond the first month (and it now must be, or the resulting volatility will quickly provide a very unstable trading environment).
Elsewhere, such as here in Greece, the $6.50 decline in the Brent price will save about 11 euros at the pump, making the average price about 6.7 euros ($9.65) a gallon.
Both nice, but hardly likely to start an economic recovery on their own.
And then, with demand rising, prices will begin feeling upward pressure whether there are government-stimulated crude injections or not.
Second, assuming this policy of injections continues, the reserves will need replacement. That means the U.S. and other governments involved will need to purchase additional crude from oil producers.
These purchases will offset the “advantage” of using the reserves to begin with.
However, the price commanded by purchases of “replenished” volume (which will be done at market prices, by the way) will merely serve to become the price at which the market will base futures contracts.
Any way we look at it, using up the SPR will:
- provide additional supply (which is not the issue),
- increase demand (a genuine pressure for rising prices moving forward), and
- distort the dynamics by which the market determines actual pricing levels.
This is not a cure; it is a surrogate. Once the use of strategic reserves ends (this is not, after all a permanent fix), the volatility will intensify.
All government has done is remove the methadone… The addict is still an addict.