Overwhelmed by Barrels
I was late getting to yesterday's Wall Street Journal, or this item would have been Thursday's blog topic. The editorial page featured this item (subscription required) by Professor Steve Hanke of Johns Hopkins University concerning the impact on oil markets of the Administration's decision to continue filling the Strategic Petroleum Reserve (SPR). He asserts that this policy has added $10.00 per barrel to the price of oil. After following this topic for months, I must say that this is easily the most blatantly exaggerated assessment I've seen of the impact of the SPR fill, hinging on a fundamental misunderstanding of how the oil markets work.

You may recall that in previous blogs I had initially defended the SPR addition policy (see posting of February 17), which takes about 130,000 barrels per day out of a 15 million barrel per day physical market in the US. More recently, I concluded that suspending additions would be a good idea (see posting of May 19), but for very different reasons than Dr. Hanke claims.

The problems with his analysis start with the role that inventories play in the oil markets. While changes in inventory certainly influence prices, this does not happen in the way Dr. Hanke suggests, in terms of "the economics of storage", but rather by what those changes imply about trends in the supply and demand for oil. The notion that SPR additions "crowd out" commercial stocks in any physical sense is absurd. A more defensible conclusion would be that a larger SPR reduces the incentive for holding commercial stocks, but this only works over the long run, not on a week-to-week basis.

Dr. Hanke goes on to suggest that crude oil prices for current delivery, or "spot" prices, should normally be lower than prices for future delivery, or "futures". In fact, this state of the market, called "contango", occurs sporadically and normally only as the result of a current oversupply of physical oil.

In fact, Dr. Hanke's justification for his claim of a $10.00 per barrel SPR premium seems to rest entirely on the evidence of the market's response to the first President Bush's announcement of an SPR release coinciding with the onset of the Gulf War. As someone who was trading oil products in London that day, I can tell you that the conversation in the market had little to do with changes in inventory and everything to do with the prospect that a volume of oil greater than that produced by Kuwait would turn up in the market if the SPR were tapped, and that the risks of a wider regional war had diminished. (I freely admit that the price drop caught me and many other traders by surprise.)

Ultimately, it appears that Professor Hanke has made the classic mistake of an academic analyzing market data and arriving at a logical but erroneous conclusion, entirely divorced from market realities and, in this case, possibly clouded by politics. The only subject on which we seem to agree is the desirability of modernizing the entire concept of strategic oil storage.