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Releasing the Strategic Petroleum Reserve Will Make Volatility Surge

by | published June 24th, 2011

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.

And now…

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:

  1. provide additional supply (which is not the issue),
  2. increase demand (a genuine pressure for rising prices moving forward), and
  3. 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.

Sincerely,

Kent

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  1. Ted
    June 24th, 2011 at 14:28 | #1

    Very thoughful, well written article and unfortunately true. Trying to disrupt supply/demand forces is futile and self defeating : cheaper oil / gasolene prices implies increased demand & ultimately increased prices; this storage is finite and will most likely be “refilled” with a much higher cost crude in the future.

  2. dick cohen
    June 24th, 2011 at 14:35 | #2

    What’s the big deal? That release will take care of two days demand!!

  3. Bill
    June 24th, 2011 at 14:38 | #3

    What has been ignored in the debate about the release of 60 million barrels of crude oil is that the oil will be auctioned to oil companies which will yield nearly six billion dollars for the IEA countries releasing the oil. A nice piece of change.

  4. Rob
    June 24th, 2011 at 14:41 | #4

    No quantitative easing but lower fuel costs for a time

  5. Alan Mabe
    June 24th, 2011 at 14:49 | #5

    While Dr. Moors is quite right in most of his analysis, there is one item he did not comment on–that is whether this move by the IEG may be a component in making speculators more caution about running up the price of futures contracts. It would seem that this does not have to be a continuous policy of releasing a certain amount of oil every month in order to have an impact of making traders in futures contracts more cautious. In fact if it were a regular release every month it could be accounted for. What will give pause to futures contracts will be the possibililty of releases when they are least expected. The willingness of the IEG to make periodic releases but not telegraphing when it will do so would appear to make traders more cautious. And that might bring futures prices closer in line with “demand” prices.

  6. Buz Davis
    June 24th, 2011 at 14:55 | #6

    Why has this move driven the refiners down so much ?

  7. ye
    June 24th, 2011 at 15:06 | #7

    Yes – and the price of oil will drop another 15-20% over the next few months for the dual purpose of a quasi QE3 and the 2012 elections.

  8. Darius Gregoire
    June 24th, 2011 at 16:14 | #8

    How about this, China economy slowing, rising prices, make a deal put some low price oil out there and we’ll come to the Euro party? Coincidence moves just prior to China’s top gun visit. Long term move next make US gold reserves available for China purchase prior to new world currancy (with coincidently, some gold combined standard). Too far fetched? Let me know in 4-5 yrs. Darius ps… Oil LT I agree up,up and away. Too little available, Too much reqd. No rush for Cal. offshore reserves. They just keep appreciating in value. In time the Saudis will buy from you.

  9. Martin
    June 24th, 2011 at 16:52 | #9

    This action must be completely driven by short term politics. Only politicians could so badly confuse illusion with reality. The impact will be momentary at best, and then prices will return to those based on prevailing supply and demand. Like many unusual and unexpected market events, the short term price reaction will be much more extreme than underlying conditions warrant. Allowing chest thumping by politicians.

  10. Sunny
    June 24th, 2011 at 17:08 | #10

    Is there a way to trade oil through ETFs like UCO for example?

  11. g haber
    June 24th, 2011 at 17:42 | #11

    Dr Moors , with cheaper gas and thus more consumption and driving season upon us,WHY with a favorable crach-spread is VLO and other refiners falling in price today. Please endow me with your expertise

  12. Ventureshadow
    June 24th, 2011 at 18:12 | #12

    For an organization that has long asserted that interfering with competition is illegal, the US Federal government is extremely hypocritical. They seem to do nothing BUT interfere with competition these days. The entire point of releasing oil now seems to be showing that they can and will interfere with competition at their own whim. They imperiously changed the purpose and justification of the strategic oil reserve, believing they had the right to do so. I don’t know if they have the right, but even if they don’t I expect they will evade accountability for misdeed as usual.

  13. jack gordon
    June 24th, 2011 at 18:13 | #13

    now if we could just get the govt to buy oil for the SPR when oil is cheap & release it when oil is expensive (instead of the other way around) we would have a money maker.
    > jack

  14. Mannstein
    June 24th, 2011 at 20:13 | #14

    Bad for speculators good for consumers over the shorthaul. Nice to see speculators take a haircut once in a while.

  15. King Ralph
    June 24th, 2011 at 20:36 | #15

    Politician’s have so much gas I’m surprised they didn’t release that to the public.

  16. Mir
  17. Nate
    June 25th, 2011 at 00:40 | #17

    @Alan Mabe

    From what I understand from what I’ve read so far, (from The Vega Factor) the problem is the trading model itself and the intricacies of how it operates. If what Alan theorizes is true, then this would seem like a great combatant, albeit partial, to some of the flaws – correct? Let’s hope you’re right and they are this prudent with behavioral finance.
    -Nate

  18. Richard Giles
    June 25th, 2011 at 09:53 | #18

    Dr. Moors: it may be all greek to me, but I think that you have some fuzzy math in your paragraphs discussing the impact of the oil release. If a decline of $4 per barrel in New York represents a saving at the pump of 10 cents a gallon, then a $6.50 decline in Brent crude would save 16 cents a gallon in Athens, not 11 euros. This would make the price about 6.5 euros (or $4 not $9.65) a gallon. Thank you.

  19. Bob
    June 26th, 2011 at 12:30 | #19

    I get the impression King Ralph is referring to Methane type gas not motor car type. Politicians are full of that is.

    Speaking of the other type gas. Whats going to happen with natural gas now that Congress has delayed or canceled the favorable legislation?
    I’m conflicted as to what is right or wrong about the Government rewarding the Natural gas sector over others.

  20. Bart
    June 28th, 2011 at 13:33 | #20

    Global daily crude oil consumption is now around the 86,400,0000 barrels per day figure which equals 1,000 bbls per second. The SPR release covers 17 hours of global consumption. Its impact on fundamental supply-demand is nearly negligible.

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