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Déjà Vu All Over Again

by | published March 16th, 2012

There’s been quite a bit of news on whether the government will tap the Strategic Petroleum Reserve (SPR) to combat rising gasoline prices.

I get the feeling I’ve been here before.

In fact, I wrote about this very topic just three weeks ago. And sure enough, we had conflicting reports on the subject yesterday.

But despite what my wife Marina may think, I don’t cause events in the oil markets merely by writing or talking about them.

She remains convinced that when I go on television and discuss higher oil and gas prices, my words provide energy firms the green light to raise them.

The reality is that I just know how politicians think (and panic) when it comes to the energy markets. So please, refrain from shooting the messenger.

Yesterday we also witnessed mixed messages from both politicians and the market.

Crude oil prices initially dove more than $3 per barrel in both London and New York when the story broke that there was a joint U.S.-U.K. agreement to release volume from each country’s strategic reserves.

Later in the afternoon, prices shot back up quickly in New York (by that time the market had closed in London) following a White House denial that any such deal was in the works.

Still nobody inside the Beltway is claiming the idea is now off the table.

Was yesterday a trial balloon? Some junior staff member with an itchy dialing finger?

A hasty press release?

All are certainly possibilities.

But the confusion created in the aftermath of the “leak” hides one very simple, inconvenient truth.

There are few, if any, genuine options to offset rising gasoline prices.

Everything we need to do will take a few years to work out.

And it should. But you and I need to continue this conversation.

The (Weak) Impact of Government Intervention

Releasing some of the 695 million barrels of crude contained in the SPR would prompt a very short-term reduction in prices for both crude (the immediate impact) and products like gasoline produced from it (the secondary result).

Oil costs remain the single largest overhead component in determining the price of gasoline.

But an SPR release will have no lasting effect unless it becomes a regular occurrence.

And if that happens, each subsequent release would have a declining advantage in stemming price increases – a petroleum equivalent to the principle of diminishing returns.

This results from two essential factors, both on which I commented last summer.

At the time, I addressed an abortive move to use both the SPR and the International Energy Agency (IEA) in a combined attempt to deal (much after the fact) with Libyan supply disruptions.

There are two issues here.

First, traders peg futures prices in a normal market (will we ever really see one of these again?) at the expected cost of the next available barrel.

But in a crisis, unstable or highly volatile market, that price will be set at the anticipated most expensive next available barrel.

An unusually large SPR release might push prices down for a week or so.

But this is not sustainable.

The SPR would ultimately need to be replenished. It is, after all, an emergency fund, not a surplus to manipulate prices.

This would require the government to buy crude at full market price from producers, which would be at a higher price than what they likely paid for it in the past (“just put it on the corporate card”).

That would then become the focus of traders’ attentions, with the higher prices commanded for that replenishment serving only to drive market prices back up anyway.

Traders would now focus on the relationship between the SPR volume and the market in setting forward prices; however, as demand increases on the other end, the SPR would have declining influence.

And of course, once it was no longer possible to sustain such an SPR-to-market balance, the whole experiment would quickly unravel.

When an element outside of (and artificially induced to) the market is introduced, such as an SPR release, traders base pricing on the relationship between the release and the market.

In short, the release becomes the trading focus. It is merely absorbed into the calculus after a few trading sessions, but it does not change the underlying dynamics of how the market determines the price.

This occurs for a very simple reason.

An SPR release will very marginally change the supply of crude. The 60 million barrels released last summer only represented less than 18 hours in global usage.

But it does nothing to offset either demand or how the market approaches it.

Fundamentally, this is not a supply side problem. An SPR release Band-Aid will have limited impact, even for the politicians who control it.

Second, coming in from the outside does nothing to change the market conditions actually prompting the price rise.

The pressures continue to build, leading to a steady rise in both oil and oil product prices. Releasing oil from the SPR does nothing to temper these developments.

A nation practicing centralized planning – for example, China, Cuba, or the old Soviet Union – could attempt to curb such factors by decree.

But open-market systems can hardly resort to such means.

Prices are not aberrations.

Like a rising body temperature, prices tell us something. Free market approaches have to deal with the causes… not the symptoms.

We are experiencing a number of causes for the current price appreciation that an SPR release cannot offset.

One of these is geopolitical.

And driving that factor is the rising tension with Iranian supply as we move closer to the July 1 date for a complete European embargo of Iranian oil.

All Eyes on Europe Once More

And something else happened yesterday, an event overshadowed in the media by the SPR debate.

The Belgium-based Society for Worldwide Interbank Financial Telecommunication (SWIFT) said it would comply with a European Union order to disconnect designated Iranian financial companies from its messaging system, effective March 17.

The SWIFT system is used by banks around the world for interbank transfers.

The move virtually cuts off Iran from processing revenues from its global oil sales and will further cripple the Iranian economy. There will certainly be a response from Tehran with the rising tension resulting further increasing oil prices.

The U.S. government can’t do anything about it.
And no SPR release will be able to offset what’s coming in the market.

This is going to be a very bumpy ride.

Good thing we know how to profit along the way and protect ourselves from what’s coming.

Sincerely,

Kent

[Editor's Note: Politicians, newspapers, and TV networks are getting it wrong when it comes to a very important question: What underlying factors are affecting oil prices?
That's why people all over the world are turning to Kent.

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  1. terry
    March 16th, 2012 at 13:48 | #1

    IMO iran is probably using oil revenews to fund their geo political and nuclear operations by being able to buy know how and/or hardware and pay for it with dollars instead of iranian ryiads or whatever is their money. This is a very, very serious problem and exists with S Arabia as well. These trouble makers probably have more dollars than we do! With no end in sight!

  2. Tib Csabai
    March 16th, 2012 at 19:31 | #2

    I am appaled at the implication the “US government can’t do anything about the rise in prices.” This is preposterous!

    The US government’s illegal sanctions on Iranian oil is the sole cause of this price spike. If the US would like to see the price of oil drop, it would happen almost immediately after the sanctions are rescinded.

    So please, let’s not propogate phony propoganda here, especially in such a lengthy missive. Instead, let’s focus on how we can make money in the oil patch.

  3. Rob Davis
    March 16th, 2012 at 21:00 | #3

    We are currently shipping more refined gasoline out of our country than we are using. To me that speaks volumes about oil companies. As well as our current shortage. This is just corporate price gouging period. The Government is looking into electric vehicle stations across the country. Could this be a ploy to bolster the electric automobile? We also have the largest natural gas inventory in the world.With a simple conversion to current and future automobiles we would be paying under $2.00 a gallon. For over a 100 yrs.

  4. Ed Nichol
    March 16th, 2012 at 21:36 | #4

    @terry
    If those “trouble makers” wanted to have nukes, they would simply buy them. All the aggravation at our airports is political since for a small fee ( $50.00 ) you can put just about anything on a plane bound for downtown London, New York, or Paris. Look around. We doing all this grief to ourselves.

  5. Ed Nichol
    March 16th, 2012 at 21:41 | #5

    Kent
    Are there graphs that track together basic production costs and price of oil from different suppliers? It might take the magic away from that good old $5 dollar Texas crude and give the chart readers a clear reason to weep.

  6. eric taylor
    March 17th, 2012 at 00:56 | #6

    Obama is talking about the need for a comprehensive energy policy
    here in Chicago, but likens the Washington D.C. support for it as
    non existent among the antiquated partisan politicians in Washington.
    At least Obama is aware of this need, lame duck though he be. You
    cannot get too far ahead of the people, if you are to be an effective
    leader, and as you know most of the political representatives in a
    Corporate run government have to lick boots. The Republicans wouldnot
    close the oil tax loopholes last year, as an example, whose revenues
    could be used for preferential energy investments elsewhere. You have
    to manage by objectives, and we obviously have a hamstrung government.

  7. Chuck S
    March 18th, 2012 at 01:42 | #7

    What we REALLY need for petroleum reserves is more US oil wells.

    As for the SPR, I think we need to max it out because of the threat of Iran messing with the Straits of Hormuz. This will supply us for a while while dealing with Iran. Also, Iran may be less likely to act if they know that we’re not completely vulnerable.

  8. March 19th, 2012 at 01:15 | #8

    I am not sure where the SPR is geographically located in the US. But can the government not release the reserve now to bring down the prices and replenish it with US/Canadian crude that’s backed up due to lack of pipeline on guaranteed volume / lower price contract? At least that way, we’ll be paying ourselves (so to say) to replenish the SPR. It may require thinking outside the (oil industry) box.

  9. enthusceptic
    March 21st, 2012 at 13:09 | #9

    All the talk about US gasoline prices is myopic, for 2 reasons:
    First, gasoline is much more expensive in the USA than in much of the world. In developing Colombia gasoline is twice as expensive as in super-rich Norway! All taxis in Colombia use NG.
    Anywhere in the world it’s possible to enable a car to run on NG. Mr Davis has got the point, and when the auto makers do…

  10. enthusceptic
    March 30th, 2012 at 10:53 | #10

    You are of course right, Rob. I have understood that for you in the US gasoline prices are much more important than in many other countries. Taxis in Chicago and many other places run on NG, so why not your vehicle? You even get to keep your gasoline tank, and can you can use gasoline if you run out of NG. The NG is in a different tank.

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