-- John Kemp is a Reuters market analyst. The views expressed are his own --
By John Kemp
LONDON, March 7 (Reuters) - The U.S. government should keep all its options open for dealing with oil market impact of the chaos in Libya, including a sustained release of crude stocks from official reserves, coordinated with other OECD countries.
Constructive ambiguity is the best way to counter the risk of a speculative bubble.
Established by the Energy Policy and Conservation Act 1975 (EPCA) following supply disruptions caused by the Arab oil embargo of 1973-74, the U.S. Strategic Petroleum Reserve (SPR) is the largest in a network of worldwide strategic stocks of crude and products held by member countries of the International Energy Agency (IEA).
The agency’s founding treaty obliges members to hold emergency petroleum reserves equivalent to least 90 days of the previous year’s net imports.
The U.S. SPR currently holds 727 million barrels of crude from a mix of domestic and foreign sources in giant salt caverns at four locations along the Gulf Coast (Bayou Choctaw and West Hackberry in Louisiana, and Big Hill and Bryan Mound in Texas).
Current SPR holdings are sufficient to cover around 70-75 days worth of net crude and product imports, but commercial crude and product stocks would cover another 110 days, so the United States is comfortably in compliance with IEA obligations, even if stocks are not officially held for strategic reasons.
The U.S. Energy Policy and Conservation Act (codified at Title 42 Chapter 77 of the United States Code) authorised the creation of a reserve of up to 1 billion barrels, though actual storage has never approached this level, and the SPR is currently operating close to its physical capacity (42 USC 77 Section 6234).
Crude may only be released and sold following a presidential finding that “drawdown and sale are required by a severe energy supply interruption or by the obligations of the United States under the international energy program” [IEA mandated stock releases] (Section 6241 (d)(1)).
The presidential determination must include three findings: “(A) an emergency situation exists and there is a significant reduction in supply which is of significant scope and duration; (B) a severe increase in the price of petroleum products has resulted from such emergency situation; and (C) such price increase is likely to cause a major adverse impact on the national economy” (Section 6241 (d)(2)).
Smaller releases up to a maximum of 30 million barrels in total spread over no more than 60 days can be authorised to meet the adverse impact of smaller-scale disruptions including domestic shortages (Section 6241 (h)).
Outright releases, unilaterally or as part of coordinated measures with other IEA members have been rare. The IEA authorised coordinated releases in 1991 in response to the Gulf War and again in 2005 following hurricanes Katrina and Rita.
Temporary sales to help refiners cope with logistical problems, coupled with a commitment to replace borrowed oil within a specified duration, with additional barrels as an “interest payment”, have been more common. The United States used the SPR on 10 separate occasions in the decade leading up to 2009 to provide temporary relief to refiners, according to the IEA, employing a sale-and-buyback system.
The purpose of strategic stocks and conditions under which they should be released remain unclear and controversial. EPCA does not provide much guidance. In the congressional statement of purpose prefacing the law, it merely states the object is “to provide for the creation of a Strategic Petroleum Reserve capable of reducing the impact of severe energy supply interruptions” (42 USC 77 Section 6201).
Severe energy supply interruption can be interpreted to cover a number of situations.
At one end of the spectrum are severe physical disruptions (owing to war, revolution, embargo, or natural disaster) which leave sufficient oil supplies unavailable at any price, and harm the ability to project military force or lead to severe domestic rationing and widespread disruption to the economy. Release in such circumstances is uncontroversial.
At the other end are minor physical disruptions or imbalances between supply, demand and inventories that do not threaten physical availability, but push up prices substantially and threaten significant economic harm. Release in such circumstances is fiercely contested. Opponents argue intervention is a mistake and the government should rely on price increases to ration demand and incentivise more supply.
Purists (supported by much of the oil industry) argue releases should be authorised only in cases where physical supply is at risk, not merely surging prices and economic damage. The problem is that EPCA conflates the two meanings of supply security -- physical and economic. Two of the three conditions for release refer to prices and economic conditions. Congress clearly contemplated the president would take a view about economic dangers posed by rising prices.
The IEA’s position is complicated. The agency opposes using stocks to try to blunt price spikes. “To use the reserves for price management is dangerous and would fail ... a policy of releasing oil to counteract high prices would add an additional source for speculation,” IEA Director for Energy Markets and Security Didier Houssin told the U.S. Senate in May 2009.
If the IEA had ordered the release of stocks in response to soaring prices in 2004 "the market [might have] worried that the stock draw was reducing our strategic reserves and providing a negative incentive to invest in new supplies or improve efficiency, making the fundamental supply/demand situation even worse," according to Houssin (here).
IEA and industry objections to using the SPR to mitigate purely economic disruptions or manage price rises seem to break down into several categories:
(a) Strategic stocks will be quickly exhausted if they are released to meet a fundamental supply-demand imbalance (such as excess demand growth) rather than a temporary disruption (a hurricane-related shortfall or closure of the Strait of Hormuz).
(b) Releasing stocks blunts price signals and delays adjustments needed to bring supply and demand back into balance.
(c) Deploying stocks in response to rising prices would politicise the reserves as governments and interest groups lobbied for releases to mitigate the impact on voters, businesses and consumers.
The U.S. government position is no clearer. The Energy Department has described the SPR as the "first line of defence against disruption in critical petroleum supplies", a deterrent to hostile cut off of oil imports and providing economic security. But the department has been cool to the idea of releases in response to purely economic concerns or acting as a price regulator (here).
The chaos in Libya sits somewhere in the middle of the spectrum between physical danger and pure price spike. Some production has been lost. There is no risk of the United States running out of oil, but loss of Libyan output might (at a stretch) satisfy the first release condition. There clearly has been a severe increase in prices (condition 2). Higher prices could pose a danger to the recovering economy (condition 3).
If disruption is seen as a temporary problem (albeit lasting several months) or one of perception rather than reality (driven by speculators rather than real shortage) an SPR release in coordination with other countries would seem like a useful measure to calm the markets. If so, the federal government should invoke its strategy of “early use in large quantities”.
If the loss of Libyan output is permanent or likely to be very extended, releasing stocks would do nothing but delay necessary adjustment. It might not even achieve a sustained price reduction.
But whatever the decision, the U.S. government should maintain and cultivate strategic ambiguity about its intentions and what price level (if any) would trigger a stock release. Maximising uncertainty about stock releases is a good way to ensure a range of views prevails among market participants, reducing the risk of a bubble, and ensuring prices move in line with fundamentals.