When the U.S. and 27 other member countries of the International Energy Agency (IEA) announced on June 23 that they would release 60 million barrels of crude from reserves, prices of the U.S. benchmark West Texas Intermediate quickly fell US$5 to roughly US$91 a barrel, after reaching three-year highs above US$112 in the spring of 2011.
As the first release from the U.S. Strategic Petroleum Reserve (SPR) since the aftermath of Hurricane Katrina in 2005, and only the third in the history of the IEA, it shocked many traders and analysts who believed the market was sufficiently supplied with oil. Saudi Arabia and its allies pledged to increase production by some 1.5 million barrels a day, after the Organization of Petroleum Exporting Counties’ failure to reach a new production agreement at its meeting on June 8.
The surprise release of oil reserves from the U.S. and other oil consuming countries may be the first in a series of attempts to drive down crude prices, but the effort likely won’t keep a lid on the market for long. Instead, it may herald a period of price volatility that would deter needed investment in the infrastructure that could boost supply.
A recent study by Robert Pollin and James Heintz of the University of Massachusetts’ Political Economy Research Institute states the uprisings in the Middle East and North Africa have not prevented a rise in oil output, noting that global crude production rose to 87.9 million barrels a day during the protests in the first quarter of 2011 from 87.6 million in the last quarter of 2010.
Yet the IEA said it was releasing the oil to make up for 132 million barrels of Libyan crude that had been lost due to fighting there, and was expected to remain off the market for the rest of 2011. It said the new oil supply would take some time to come to market, so there was an "immediate requirement" for more oil amid a threat of a "serious market tightening."
Some analysts have questioned the IEA, saying the market had already adjusted to the disruption of Libyan supply. The move was also criticized by business groups and some analysts as a politically motivated attempt to jump-start the sluggish U.S. economy at a time when monetary and fiscal policy have run out of room to spur growth and U.S. President Barack Obama seeks re-election in 2012.
Continued economic pressure may result in repeated attempts by the U.S. and other countries to hold down prices at a time when OPEC producers have limited capacity to pump more oil, and when high oil prices are holding back global growth. "There’s a pretty good possibility of them following up on this," says John Shages, a former Department of Energy official who oversaw the SPR under then-U.S. President George W. Bush, and is now Principal of the consulting firm Strategic Petroleum Consulting LLC.
No Quivers Left
Shages argues that the Obama administration has seized on oil prices as the last remaining tool with any chance of stimulating an economy that continues to struggle with paltry job growth and a still-depressed housing market.
With official short-term interest rates already near zero, the Federal Reserve’s quantitative easing program ended, and no fiscal help expected given the federal government’s yawning budget deficit, oil price seems to be one of the few economic factors still open to intervention.
"They don’t have any other arrows left in their quiver," Shages says. "With a year and a half to the election, if you are going to do something big to the economy, you had better get started now."
The release came the day after the Federal Reserve cut its forecast for U.S. economic growth this year to 2.7-2.9% from 3.1-3.3% in April, prompting speculation that the two announcements were coordinated.
Any use of the SPR is bound to have a political dimension. With gasoline prices down around 40 US cents a gallon from an April peak near US$4, consumers are already feeling some relief as a result of the SPR release. From the perspective of the White House, that is likely to outweigh the oil industry’s disapproval of the move.
The SPR release may have been partly an effort to make the oil price more truly reflect supply and demand, squeezing out a speculative premium that can distort true market conditions, as happened in 2008 when speculators were blamed for the WTI price hitting a high of US$147 a barrel.
"That had no relationship to the supply situation," Shages notes, adding that now, the White House is keen to limit the influence of speculators in its effort to keep prices down. "There’s nobody in this administration that loves speculators."
According to Pollin and Heintz’s study, speculation in futures markets — as distinct from supply and demand — drove up the U.S. average price of gasoline by 83 US cents a gallon in May to US$3.96. An average American two-car family spent US$82 in May because of a "speculative premium," most of which was paid to large-scale speculators in the commodities futures markets.
Their study suggests the influence of speculation on petroleum prices has grown sharply with the volume of oil futures trading. The level of crude oil futures contracts changing hands on the New York Mercantile Exchange is now 400% greater than it was in 2001 and has grown 60% just in the last two years. The growth reflects the entry of major banks such as Goldman Sachs and UBS, whose significant resources are able to influence market prices, the study noted.
OPEC Era Ending?
Since the June announcement had a decisive, if short-lived, effect on the market, Shages and other analysts suggest the U.S. government in particular and the IEA in general are in a good position to repeat the move, deterring speculators from betting against the authorities. "I don’t think you would have to do it that long before you broke the psychology of speculators," he says.
If futures speculators are less inclined to bid up prices because of the prospect of reserves entering the market, that will also affect how spot prices behave, Heintz tells Arabic Knowledge@Wharton. "If you don’t have that expectation story as part of their psychology, there is no real way that the futures market is going to influence the spot market," he says.
But such expectations, if in operation, can overwhelm supply and demand as influences on the market. "When you do have the speculative dynamic, that expectation can be the primary driving force," Heintz says.
In considering further reserve releases, the consuming countries are also motivated by the knowledge that for the moment, OPEC doesn’t have enough spare capacity to pump enough new oil to stop oil price spikes.
"We think that SPR reserves will be used to attempt to fill OPEC’s shoes," says Robert McNally, a former energy advisor to President George W. Bush and now president of The Rapidan Group, a consulting firm. "They will face enormous pressure to do this again and again."
Saudi Arabia, as OPEC’s leading producer, can no longer play its traditional role as central banker to the oil market because it has not made sufficient investment in its production infrastructure to boost capacity to levels where it has the power to smooth price spikes, McNally says.
McNally argues that the Saudis have only 1.5 million to 2 million barrels of spare capacity, or less than half of the 4.5 million barrels that OPEC, which pumps 40% of the world’s oil, should have if it wants to control prices. "Saudi Arabia can no longer stabilize prices," he says. "We are now witnessing the end of the OPEC era of price control."
OPEC’s diminished influence over oil markets is caused partly by its internal divisions, clearly illustrated by the inability of members to agree on new production quotas at the June 8 meeting, the first in more than 20 years to break up without agreement. The meeting ended after six nations, led by Iran, blocked a Saudi initiative to increase output by 1.5 million barrels a day to make up for lost Libyan crude and to aid the U.S. economic recovery.
Saudi Arabia was so irritated by the refusal of Iran and Venezuela to agree on a new quota that it said privately that it was considering thinking about punishing Iran by flooding the market with oil, Shages notes.
With OPEC less able to control the market, and the U.S. and Europe anxious to stimulate growth, prices are now likely to fluctuate between the top end of consumers’ comfort zone and a floor that would probably prompt production cuts by Saudi Arabia and others.
The resulting price volatility would fuel an uncertain business climate, deterring investment in energy, including the renewables that would reduce dependence on fossil fuels. "Ironically, western governments will miss OPEC, or at least the relative price stability it tried to provide," the Rapidan Group wrote in a recent commentary.
McNally predicted that consuming countries will want to keep WTI below US$110 a barrel and Brent no higher than US$120. Producers, who at least retain the ability to cut production if prices fall too low, are likely to do so if WTI prices drop much below US$90 a barrel, he predicts.
"OPEC can maintain a price floor by cutting supply," the Rapidan Group added in its commentary. "But insufficient spare capacity will deprive it of the power to impose a ceiling."
Asian Growth Overwhelms
Whether consuming countries can manipulate reserves to keep prices in their desired range will depend on economic growth and the consequent level of demand. "They can probably defend these levels for some time," McNally says. "If there is a recession, it would be longer."
World oil production has recently kept up with increasing demand, particularly from India and China, according to the study by Pollin and Heintz. In the first quarter of 2011, output rose 2.5% compared with the first three months of 2009, and ahead of a 2.4% increase in output over the same period.
Proven oil reserves rose in 2009 to 43 years of supply at current rates from 36 years in 2000, and the highest level for 30 years, the authors say. "There is no evidence to suggest that the current short-term jump in oil prices could be tied to long-term shortages in oil supply."
David Greely, head of energy research at Goldman Sachs, is among analysts who contend though that surging growth in many Asian economies is likely to overwhelm the ability of either consumers or producers to keep prices down.
Greely predicts WTI prices will rise to US$130 a barrel in early 2012 and to US$140 by the end of the year, and top producers won’t be able to halt the trend. "Saudi Arabia will have trouble producing over 10.5 million barrels on a sustained basis," Greely says. "OPEC’s biggest producer is now pumping about 9 million barrels a day.
Any further attempt by consuming countries to use reserves to control prices will be subject to diminishing returns, Greely adds. "You can’t do this for ever. The more you run down inventories, the more vulnerable you are to supply disruptions."
He also played down the size of the June 23 release, saying that only 40 million of the advertised 60 million barrels was actual oil. The rest was achieved by lowering stock-holding obligations on some IEA member countries.
Investment bank Barclays Capital increased anxiety over a tightening market on July 5 when it raised its 2012 forecast for Brent crude by US$110 to US$115 a barrel, saying it believes the impact of Libya on the oil market will be "prolonged" regardless of the outcome.
Phil Flynn, senior energy analyst at PFG Best, a financial markets trading firm, called the reserves release a "legitimate" exercise that was designed not to manipulate prices, undermine OPEC, or attack speculators, but to ensure the continued operation of European refineries that are dependent on Libyan crude.
WTI closed at US$96.89 a barrel on the New York Mercantile Exchange on July 5, up from US$91.16 on June 24, the day after the IEA intervened. "They should have released a lot more if they wanted to control prices," Flynn notes.