US strategic oil reserve release justified

London, 28 June 2011

President Obama's decision to order the release of oil from the Strategic Petroleum Reserve (SPR) has triggered protests, mostly from purists and market participants with inventory or long positions. But the decision to release emergency stocks, in conjunction with other members of the International Energy Agency, appears a sensible and conservative use of the stockpile very much in line with its purpose.

Opponents of the release suggest it is somehow a misuse of the SPR and the reserve should be kept for genuine emergencies. In fact, the release fulfils all the legal conditions and the intent of Congress when it established the stockpile.

The 1975 Energy Policy and Conservation Act (EPACT) states the purpose of the SPR is "reducing the impact of severe energy supply interruptions" (42 USC 77 6201). It establishes three conditions for release: "(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" (42 USC 77 6241 (d) (2)).

The recent release clearly satisfies conditions (B) and (C) and it arguably satisfies condition (A) as well. There is no doubt rising prices contributed to the abrupt slowdown in growth in the United States during Q2 2011 and further rises threatened to trigger a prolonged slowdown. Condition (C) is easily satisfied.

Prices for Brent rose 33 percent in the first five months of the year (a pretty severe increase in a short time) and most observers have pinned blame on the loss of Libyan exports -- though some also blame speculators and inchoate fears about instability spreading across the Middle East. Condition (B) is satisfied.

The question is whether the interruption of Libyan exports qualifies as a "emergency situation" within the meaning of EPACT -- a "significant reduction in supply" of "significant scope and duration" -- and therefore meets condition (A).

Opponents imply the loss of output is not large enough and the SPR should only be used in response to a much larger loss of production. In fact there has been a significant loss. While pre-crisis Libyan exports may not have been large (1.3 million barrels per day) the loss has been total and prolonged and now amounts of 132 million barrels, nearing 2 days of global production. Far more output has been lost, for longer, than after Hurricane Katrina, the last time stocks were released.

It is not clear if opponents think that release was also a mistake. Opponents suggest only a big supply interruption should qualify for a stock release -- perhaps the loss of output from Iran (3.7 million barrels per day) or Saudi Arabia (9-10 million barrels per day). But such large losses have never occurred in the 35 years of the reserve (except possibly in the first Gulf War and in that case Saudi Arabia made up the shortfall).

Opponents seem to imply the SPR should be kept for the sort of disruptions that do not actually occur -- and not used for those that do. While SPR releases can be effective alleviating fears about shortages in the face of a small interruption (evidenced by the collapse of the Brent timespreads last week) they would not be much use in the face of a large interruption since the market would quickly worry about its exhaustion.

CONTEXT OF OUTPUT LOSSES

The challenge for opponents is to specify conditions under which releases would be justified. In principle, it should be possible to define a rule governing releases setting a threshold -- but should it be loss of 1 million barrels per day, 2 million, 5 million or 10 million? Such thresholds are arbitrary and need to be modified by context.

Presumably a release rule would take into account factors such as spare capacity, inventories, whether the crude lost could be readily replaced from other sources, and whether other producers were willing and able to make up the shortfall.

The current release appears to satisfy these conditions. Libya's light sweet crude is hard to replace from other sources; while Saudi Arabia can increase output it cannot readily supply the same quality of oil. The adequacy of global capacity and stockpiles is disputed, but the persistent backwardation in Brent clearly suggests many market participants are worried, and are pushing for bigger stockpiles to be held to compensate.

Some release opponents have claimed the release is not justified because commercial stocks are ample. But that argument is not consistent with the Brent backwardation and ignores the fact what matters is not actual stocks but the market's desired level, which is itself a function of uncertainty and expectations.

It seems likely Obama's decision would meet any plausible automatic rule that took into account contextual factors.

PERVERSITY, FUTILITY, JEOPARDY

In his analysis of the arguments opponents use to disparage policy action, changes or interventions, economist Albert Hirschman identified three common arguments: perversity (it will have the opposite effect to the intended one); futility (it won't work anyway); and jeopardy (even if it works it will damage some other objective that policymakers want to attain).

Opponents suggest the release is futile because it shifts inventories from government to commercial stockpiles; because the government will have to buy back oil later to rebuild the SPR; or because the release is small and temporary and will not affect underlying supply tightness in the medium term. But the shift in Brent spreads suggests the strategy was a success in its own terms in easing fears about near-term shortages.

There have been suggestions the effects will be perverse because investors will start to worry the drawdown in government stocks will leave the market more vulnerable to disruptions in future (tapping America's insurance policy, as the American Petroleum Institute put it in a press release).

In a linked argument, some argue supplying the market from government stocks reduces the incentives for the private sector to maintain its own stocks, since it reduces the ability of owners to benefit from periodic shortages, again heightening volatility in the long-term. But there is no actual evidence for these assertions and it likely misunderstands the nature of stock building.

The problem with the futility, perversity and jeopardy arguments is that they apply even more forcefully in the case of a large supply disruption. If it is not rational to release stocks in response to a "small" outage like Libya it would be even less rational to release stocks in response to a "big" outage like Saudi Arabia.

Why have the government stocks at all if there are no conditions under which it would be reasonable to release them? There is no doubt the market could have cured the prospective shortage of crude without intervention. But given limited elasticities of demand, and fixed supply, the only way the market could be rebalanced on its own would have been through price increases and recession. It is hardly surprising the president chose to order a stock release in the hope of achieving a less painful adjustment path.

The intervention may or may not work, and it will outrage market purists, but it is not obviously worse than the Fed's quantitative easing and low interest rate strategies, of Keynesian demand management. All those policies can be criticised -- though a majority of economists, politicians and voters probably endorse them.

It is possible to oppose the SPR release on consistent intellectual grounds, but it remains a minority and extreme laissez-faire view.

Ends --

The views expressed here are his own.