Shrinking the Strategic Petroleum Reserve

• Selling oil from the Strategic Petroleum Reserve as part of the Congressional budget compromise raises serious questions about the SPR's future role.
• Shrinking the SPR without first bringing its coverage into line with 21st century needs risks strengthening OPEC's hand. 

Last month's Congressional budget compromise included plans to sell 58 million barrels of oil from the US Strategic Petroleum Reserve, beginning in 2018. That decision raises serious questions. The world has changed enormously since the SPR was established in the 1970s, but the realignment of such an asset for the 21st century deserves a full strategic review and debate. Leaping ahead to treat the SPR like an ATM  seems unwise on multiple grounds.

My initial reaction was that the sale would result in the US government effectively buying high and selling low. However, using the last-in, first-out (LIFO) accounting common in the oil industry, the SPR release during the 2011 Libyan revolution should have removed any barrels purchased as prices surged past $100 per barrel (bbl) to over $140, prior to the financial crisis. The oil now slated to be sold in 2018-25 was likely injected between December 2003 and June 2005, when West Texas Intermediate crude oil averaged around $44/bbl. The Treasury should at least break even on these sales, allowing us to dispense with judging the trading acumen of the Congress and focus on the strategic aspects of this decision.

It is also true that the combination of revived US oil production and lower domestic petroleum demand effectively doubled the notional import protection that the SPR provides. That has made policy makers comfortable enough with the coverage the reserve provides to consider shrinking it. Yet as Energy Secretary Moniz  and a growing body of experts have concluded, the SPR's present configuration is inadequate to deal with whole categories of plausible oil-supply disruptions.

Today's SPR consists entirely of crude oil stored in caverns near the major refining centers of the Gulf Coast, to which it is connected via pipelines. However, while crude oil imports into the Gulf Coast have fallen dramatically, the long-term decline of oil production in Alaska and California has forced West Coast refiners to import 1-1.5 million bbl/day of oil, including more than half of California's crude supply, much of it from OPEC producers. In the event of an interruption of those deliveries, and under current oil-export restrictions, getting SPR oil from Texas and Louisiana to L.A. and San Francisco would pose enormous logistical challenges.

We have also learned that natural disasters such as hurricanes Katrina and Rita in 2005 and Superstorm Sandy in 2012 affect refinery operations, as well as oil deliveries.  A crude oil SPR is of little value if its contents can't be processed into the fuels that consumers and industry actually use.  The newer Northeast heating oil and gasoline reserves were intended to address that limitation, though on a much smaller scale.

It is thus fair to say that the SPR established in the Ford Administration and filled by the next five US presidents to a level now equivalent to 137 days of US crude oil imports is not diverse enough in its composition or locations, and too big for our current needs. If we could count on a continuation of cheap, abundant oil for the next two decades, selling off some SPR inventory wouldn't create problems. However, the purpose of such a reserve is to mitigate the risks of uncertain and inherently unpredictable future conditions and events. That should be factored into any decision to shrink it.

We don't have to look far to find reasons to suspect that oil prices might someday be higher and more volatile--perhaps as soon as the 2018-25 legislated sales period--or to worry that oil supplies from the Middle East might become less secure. Consider the consequences of the oil price collapse that began over a year ago. Low oil prices have indeed put pressure on the highly flexible US shale sector, where production is now expected to drop by around 500,000 bbl/day by next year. The impact on large-scale, long-lead-time capital investments in places like Canada, the North Sea and Gulf of Mexico has been even more profound. Over $200 billion of new projects and exploration activity have been deferred or canceled. Unlike shale, most of these projects could not be revived quickly if prices rebounded.

As production from existing fields declines without replacement, the current global oil surplus will dissipate, bringing the market back into balance. However, that balance is likely to be more precarious than before, since last fall's strategic shift by OPEC to protect its market share instead of managing prices entails the depletion of OPEC's "spare capacity." That means that in a future crisis, Saudi Arabia and other OPEC producers will have little flexibility to increase production to make up for lost output elsewhere.

Barring an unforeseen reduction in global  oil demand, the scenario that is beginning to take shape fits the  pattern of risks that the SPR was originally intended to address. It includes the prospect of rising US oil imports, increasing reliance on OPEC, and the threat posed by ISIS in the world's oil "breadbasket".  In that light it is hard to justify reducing the size of the SPR without a clear plan for making the remaining volume more effective at shoring up future vulnerabilities in US energy security.

In their haste to reach a deal, Congressional negotiators may also have overlooked some SPR-related alternatives that could generate revenue without draining inventories. These might include allowing other countries to buy into the reserve by means of "special drawing rights," or simply selling long-dated call options backed by the SPR, to be settled in the future by delivery or cash, at the government's discretion.

Taken together, there are ample reasons for the next Congress and administration to revisit the SPR sales provisions of the 2016 budget deal, before they go into effect.

A different version of this posting was previously published on the website of Pacific Energy Development Corporation

ISIS Threatens Iraq's Oil Upside

• Even if its threat to Iraq's oil exports can be contained, the newly asserted "Islamic State of Iraq and Syria" has altered the political risk of projects there.
• That could hamper future production that was expected to be a major factor in meeting growing oil demand later this decade.

Last month's blitzkrieg advance of Al Qaeda spinoff ISIS in northwestern Iraq rattled global oil markets and politicians. Oil prices have risen by only a few dollars, reflecting the remoteness of the current threat from Iraq's main producing region and validating OPEC's recent characterization of the global oil market as "adequately supplied." Yet even as the rebel offensive appears to stall, the escalation of risk in Iraq and its neighbors could affect geopolitics, oil supplies and fuel prices for the rest of the decade.

Iraq currently exports around 2.7 million barrels per day (MBD) of oil, or 7% of global oil exports. It is effectively the number two producer in OPEC. Having recovered beyond pre-war levels, Iraq's oil industry has been growing, while Iran's exports are constrained by international sanctions and Libya's output has become highly erratic following that country's revolution.

In the International Energy Agency's latest Medium-Term Oil Market Report Iraq accounts for 60% of OPEC's incremental production capacity through 2019 (see chart below) and nearly a fifth of all new barrels expected to come to market in that period. This is a more conservative view of Iraq's growth potential than in previous scenarios, but it still leaves Iraqi oil, together with " tight oil" in the US and elsewhere, as the bright spots of the IEA's supply forecast.

Following ISIS's capture of Mosul in northern Iraq, the Heard on the Street column in the Wall St. Journal painted a stark picture of how the destabilization of Iraq could limit investment in the country's oil industry, truncating its expansion. That would increase longer-term oil price volatility and make investments elsewhere more attractive, not just in North American tight oil but also in energy efficiency and alternatives to oil.

Warning signs seem ample. The "Islamic State in Iraq and Syria" might never capture Baghdad or directly threaten the giant oil fields of southern Iraq that are reviving with help from international firms like BP, ExxonMobil and Shell. However, ISIS's actions in the territory they now control, and the fears they incite across a much larger swath of Iraq, are sparking renewed sectarian violence and prompting foreign companies to evacuate personnel. This undermines the IEA's medium-term forecast, which despite being "laden with downside risk" will apparently not be revised in light of recent events. It also raises the potential for jumps in nearer-term oil and petroleum product prices.

It is noteworthy that oil prices haven't gone up significantly, as they did when Libya's revolution began. From February 15 to April 15, 2011 the price of UK Brent Crude jumped 22%.  Iraq's troubles added about 5% to the Brent price, some of which has already dissipated. However, average US gasoline prices are $0.21 per gallon ahead of their level for the same week last year, in part because tensions in Iraq and elsewhere have forestalled the typical post-Memorial Day price drop.

The market's relatively muted response could change abruptly if the Iraqi military suffered further setbacks at the hands of ISIS and its allies, or if ISIS turned its attention to the oil infrastructure of central and southern Iraq. They attacked the country's largest refinery at Baiji, north of Baghdad, and I have seen conflicting reports of its current status.

As several analysts have noted, anything that threatened the country's oil exports, most of which pass through the Gulf port of Basra, could send oil prices substantially higher. That's because other supply outages have reduced usable spare production capacity elsewhere--oil that isn't now being produced but could ramp up quickly--to less than 4 MBD, a narrower margin than in several years. Even if lost Iraqi output were made up by Saudi Arabia and the UAE, the further contraction of spare capacity would drastically increase price volatility and boost oil prices from today's level, until Iraq's exports--or Iran's--were restored.

Nor would booming domestic oil and gas-liquids production, which is surely helping to hold down global oil prices, insulate US consumers from increases at the gas pump. The oil that US refineries process and the products they sell are still priced based on the global market. If Brent crude spikes, so will US gasoline and diesel. That would have less impact on the US economy than in the past, when imports made up a much higher share of supply, but shifting money from the pockets of consumers to those of oil company shareholders is rarely popular.

An Iraq-driven oil price spike would affect politics and geopolitics, too. An unstable Iraq makes it more difficult to maintain the sanctions pressure on Iran, particularly if the US and Iran ended up coordinating their responses  in Iraq. It's even harder to envision a consensus on keeping  more than 1 MBD of Iran's oil bottled up if oil prices returned to $150/bbl.

That could also complicate the debate over exporting US crude oil, already a tough sell for politicians who came up during the era of energy scarcity. As a practical matter, if exports began while prices were rising sharply for other reasons, convincing US voters that the two factors were unrelated would be challenging. A full-blown oil crisis in Iraq or the wider Middle East would likely result in the idea being tabled for an extended period.

It's tempting to view the success of ISIS in seizing territory on both sides of the Iraq/Syria border as a temporary outgrowth of Syria's civil war. If that were the case, the situation might revert to the status quo ante, once the Iraqi army--with some outside help--mopped up ISIS.

Even if this genie could be rebottled, however, the aftermath of the Iraq War and the "Arab Spring" revolutions is exerting  great stresses on the post-World War I regional order, overlaid on 13 centuries of animosity between Sunnis and Shi'ites.  An accident of history and geology has made this area home to much of the world's undeveloped conventional onshore oil reserves. Can its stability be restored with a few deft military and diplomatic moves, or might that require a complete rethinking of boundaries and nations, as recently suggested by the foreign affairs columnist of the Washington Post?

A different version of this posting was previously published on the website of Pacific Energy Development Corporation.