Integrating China's SPR

Last week the Wall Street Journal reported on a meeting between the head of the International Energy Agency (IEA) and a vice chairman of China's National Development and Reform Commission (NDRC), discussing how the country's new strategic petroleum reserve might be coordinated with those of the developed countries. They also apparently talked about the speculation, figurative and literal, that has surrounded China's strategy for filling its SPR tanks. I hope the conversation included some of the lessons that the IEA's member countries, including the US, have learned about this strategic tool. It would be even better if it were clear that China is not merely replicating an outdated approach from the 1970s, but designing an oil backup mechanism that is truly suited for the realities of the early 21st century.

In this country, since the early 1980s we have seen our SPR grow from its original 250 million barrels to its current level of 689 million, on its way to a targeted 1 billion barrels. During the same period, however, commercial crude oil inventories have declined by 6%. When viewed in terms of days' supply, the latter trend is even more pronounced, falling from an average of 30 days in 1982 to 22 days in 2006. While some of this decrease is probably attributable to changes in inventory strategies relating to accounting rules and supply-chain management, the existence of a large government-held inventory has likely contributed to this trend, even if only by reducing the risk of being caught short in an emergency, and thus relieving companies of the need to hold extra inventory in their own tanks. The experience of previous releases of SPR oil to alleviate market tightness, rather than actual supply disruptions, has further reduced the perceived speculative benefit of holding inventory.

Based on my own observations, I'd offer our Chinese colleagues the following advice on the subject, keeping in mind that their political-economic system is quite different from ours:

• The closer SPR oil is to the refineries that would use it, the more valuable it is. The first line of defense is a refinery's own storage, and as China's refineries expand to meet growing demand, they should be provided with adequate tankage to accommodate inventory beyond that strictly required for operational efficiency.
• An SPR that combines centralized and dispersed storage is less vulnerable to terrorism and natural disasters than one entirely comprised of large central repositories.
• Make sure that accounting systems do not penalize refineries for holding additional inventory. Consider offering incentives for maintaining an onsite strategic reserve, equal to some set number of days' operation.
• When planning the scenarios under which SPR oil might be released, be sure to include disruptions in domestic supply, including major pipeline breakdowns or oilfield disasters. Over the life of an SPR, these are at least as likely as a disruption of imports. That means ensuring that the infrastructure is in place to distribute oil to any facilities vulnerable to this risk.
• Avoid the temptation to influence the market, internally or externally, through reserve releases or altered timing of reserve additions. This will be especially tempting in a country in which the prices of petroleum products do not always reflect world levels. It is one thing to subsidize consumption financially; it is quite another to use emergency stocks for this purpose.
• Consider diversifying China's SPR to include some level of emergency products inventory. Crude oil is useless in an emergency that knocks out a large number of refineries, as the US learned after Hurricanes Katrina and Rita.

All in all, the conversation between Monsieur Mandil and NDRC Vice Chairman Chen is good news. China's economic growth, and the accompanying rapid growth in its oil imports, puts it on the same side of the supplier-consumer relationship as the EU, Japan and the USA. At a time when OPEC is expanding both its membership and its future production potential--based on its dominant reserves position--it is entirely appropriate that the largest factor in recent world demand growth begin to coordinate energy policies with the IEA, and perhaps even join it at some point.