Friday, April 11, 2008

Calling A Halt

The management of the nation's Strategic Petroleum Reserve has long been a bone of contention between Congressional Republicans and Democrats, with the former tending to support the administration's fill-at-any-price strategy and the latter generally supporting a more interventionist approach. Senator McCain's call yesterday for a halt to SPR additions, until oil prices are lower, signals an important shift. If the government followed his suggestion, the results might be more dramatic than anyone expects, because of the limited size and nearly unlimited leverage of the domestic market for light, sweet crude oil.

Yesterday's posting, which was cited in today's WSJ Environmental Capital blog, looked at how oil trading has changed in the last couple of decades, focusing on the tremendous growth in the influence of the New York Mercantile Exchange's West Texas Intermediate (WTI) crude oil futures contract. Because it is the largest and most transparent oil market in the US, it has provided a handy reference point for traders transacting deals for physical oil, often with very different properties of sulfur, specific gravity, and other characteristics. The typical structure of an oil deal now involves an agreed premium or discount to the prevailing WTI price over an agreed period, often related to the time that a cargo of oil is loaded, or a pipeline shipment delivered. So while the global oil market has expanded to some 85 million barrels per day (MBD), with US refineries consuming on average 16 MBD of that, the price for a surprisingly large proportion of those barrels is set by a domestic light sweet crude futures market that is backed by only a few million barrels per day of physical oil: the domestic oil production and suitable imports connected by pipeline to the Cushing, OK delivery point for WTI.

Since current SPR additions are only 0.07 MBD (70,000 bbl/day), how much effect could foregoing them have on oil prices? Measured against 85 MBD, virtually none, but that's not the relevant comparison. What really counts is the Mid-continent light sweet crude system, consisting of pipelines going into and out of storage at Cushing, serving a number of inland refineries, including five sweet crude refineries in Oklahoma with a combined capacity of 0.5 MBD. Thus, while the volume of "paper barrels" traded on the "Merc" can mount into the hundreds of millions of barrels per day, the physical market underpinning them is orders of magnitude smaller. Anyone doubting the disproportionate impact of that system on crude prices need only look back one year, when Cushing was full and the value of the WTI "marker" was in doubt, with the WTI price consistently below that of its UK Brent cousin.

With its three current royalty-in-kind swaps consisting of 58% sweet crude grades, according to a DOE spokesman I contacted this morning, the government has a 40,000 bbl/day lever with which to nudge the balance point of the physical WTI market by reselling the oil that would otherwise go into the SPR. Because that still only amounts to a few percent of actual WTI deliveries, I wouldn't expect the market to drop by $10/bbl. But when you add the psychological impact of the government shifting its stance from buyer to seller--a net swing of 80,000 bbl/day--I wouldn't be surprised to see a change in the speculative logic driving oil ever higher. That ought to knock off at least a few bucks per barrel, while dampening the market's exuberance going forward.

As with climate change, we now see all three remaining presidential candidates signaling a break with the present SPR strategy, starting next January. Unlike climate change, it wouldn't require a change of heart or ideology on the part of the administration to shift from its policy of continuing to fill the SPR above 700 million barrels to putting the government's royalty oil back into the market. That could be done with the stroke of a pen and would be greeted warmly on both sides of the aisle, and by most Americans, with the possible exception of a few hedge fund or commodity fund managers. If it turned out to have no effect, the government could quietly resume SPR additions once its sales contracts ended. With every dollar increase in WTI adding $4 billion per year to our trade deficit and 2 cents per gallon at the gas pump, that looks like a low-risk, high-reward strategy to me.

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