An SPR bazooka and the central bank of oil

In a perfect world of crude pricing, there would exist a mechanism to soak up excess length when prices were low, and add length into the market when prices were high.

In the world of money, this is called a central bank, with a dual mandate of keeping inflation low and employment as full as possible. There is no central bank for crude oil. But if there were, its dual mandate would be a price floor for producers and a price ceiling for consumers.

And let’s be clear here: this would be a price floor for US shale oil producers, say high enough to insure they keep producing, and a price ceiling for US gasoline consumers, say low enough that they don’t stop driving.

(Oh who knows, say a minimum of $70/b for producers and a maximum of $4.50/gal for gasoline.)

The only entity out there with enough liquidity to actually enforce this kind of a mandate is the US Strategic Petroleum Reserve. As of the week ended March 14, US Energy Information Administration data showed there was almost 700 million barrels of oil sitting idle in strategic storage, just waiting for a purpose.

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At present the market has two principal forces on constant watch: Saudi Arabia and China.

Saudi Arabia, as a “swing producer”, can almost be relied upon to adjust its production in order to target a certain price band. One can argue that the Saudi’s have been very effective at this, and here we are sitting right around $100/b. Sure that works for them, but what about New Jersey drivers?

More recently, the swing consumer clearly has become China. While everyone watches Chinese supply and demand very closely, much of the data remains opaque and hard to forecast.

The bottom line is neither of these market dynamics can be counted on to ease volatility, let alone backstop the dual mandate of a central bank of oil.

And while a futures contract has really always been the free market’s best attempt at serving this “mandate,” it is prone to speculation as well as painful booms and busts that can be as hurtful to the economy as they can be helpful.

Back in 2010, Rice’s Amy Myers Jaffe and Mahmoud El-Gamal wrote in Oil, Dollars, Debt and Crises that some force was needed to counter the business super-cycle. Something must step in to spark investment when prices were low, and curtain booms before they turned into bubbles.

Left to themselves, markets often correct and price is truly king, but then again, the corrections often wreak havoc and after all, volatility has a positive connotation to precious few out there. Most of them are options traders.

Obviously, this something Jaffe et al were looking for still does not exist, and there is little hope that either Saudi Arabia or China can be called upon to regulate a global market.

Step into the arena, SPR.

A recent test sale of a 5 million barrel cargo of sour SPR crude has been seen by some as a warning salvo across Russia’s bow. Whether or not that was the case, the writing is on the wall.

With this in mind, could we really say that prior to this, leaving SPR crude idle served any purpose at all?

With 700 million barrels in its holster SPR crude could be offered into the market, with precision, to counter any tenders from companies — and countries — that need to be brought to heel.

Say a South Korean refiner wants to purchase a VLCC cargo of crude from a country that is currently not playing ball with US foreign policy.

A low-ball offer of SPR crude to the rescue.

“If you have a bazooka in your pocket and people know it, you probably won’t have to use it,” former US Treasury Secretary Hank Paulson famously said.

It is obvious that SPR sales are of a similar caliber.

Further, with all the talk of possible exports of US crude, why not start with the 200-300 million barrels of light, sweet SPR crude, as veteran oil economist Phil Verleger suggested in his weekend newsletter.

“Within a year or two if not months, the government will decide to sell this oil to willing buyers,” Verleger said. “They will almost certainly be located overseas. Thus, for one or two years, the United States will be putting SPR light sweet crude into the world market.”

“No less of an ‘authority’ than IEA Executive Director Maria van der Hoeven has asserted that these reserves serve no useful purpose for the United States,” he writes. However, that is not clear, as IEA officials said van der Hoeven has stated her views that strategic stocks should only be used for supply disruptions.

(Ed. note: Changes have been made from the original publication to clarify Van Der Hoeven’s views, following communication with the IEA.)

In much the same vein Verleger sees an important role for the SPR in its ability to influence markets. Traditionally purchases of crude by the US government to be injected into the SPR, for emergencies, are often ignored when in fact they should be considered consumption, Verleger said.

“This distinction is important,” he said, noting that in the next ten years, increased demand will be offset by SPR liquidation.

“These sales will, in essence, negate consumption,” he said.

And this is where the rubber really meets the road.

Verleger says: “Alternatively, strategic stock sales can be seen as a new supply source of oil that might otherwise have come from OPEC or Russia.”

In the end, it is daunting to imagine a Washington bureaucrat in charge of the SPR bazooka. When to threaten it, when to trigger it…all of this will depend on the Administration in the White House. And among many counter-arguments, this is probably the most convincing.

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Comments

  1. Bill Loveless at March 29, 2014 9:21 am

    Thought provoking piece, James. Well done!

     
  2. Bob Schafer at March 29, 2014 7:49 am

    My opinion is that the article should mention that the 700 million bbl SPR only represents about 8 days of global consumption. The point about trusting/not trusting the politicos is well taken. One can assume they would only foul up the stewardship.

     
    • John Kingston at March 29, 2014 8:30 am

      True, but comparing the SPR to global consumption is a fairly meaningless comparison. The entire world is not going to shut off its oil taps; the problem would come if a certain key player found itself unable to produce or export in a short period of time. A strategic reserve, when it’s set up, needs to have a number that the government can say: that’s enough. That number has been 90 days of net imports. The US is way, way over that.

       
  3. Bill Braunig at March 28, 2014 7:53 am

    Great article. I enjoyed reading it very much.

     
  4. Simon Jacques at March 27, 2014 11:54 pm

    Verleger shows the SPR in its capacity to influence markets.
    Market is taking note, U.S Gov could hoard strategic commodities and use direct interventions to modulate Prices and Domestic & Foreign Policy.

    The ugly part is that Gov would have to print dollars to hoard Barrels and decide who are winner/losers.

    Central Banking, is Appealing for people believing in big government and in a lesser role for Markets.

    Simon

     

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