Buying High

An article on oil prices in yesterday's Washington Post reminded me that the federal government has resumed purchasing crude oil to inject into the Strategic Petroleum Reserve (SPR.) Whether this involves paying cash for crude or swapping it for barrels the government receives as royalty-in-kind, the net result is less crude available for delivery to refiners, at a time when commercial oil inventories are shrinking globally and prices are in record territory. The 70-100,000 barrels per day going into the SPR hardly seems sufficient to drive up prices by the $15/barrel we've seen since August, but that doesn't mean the psychology of the market is unaffected. It's also a terrible deal for taxpayers.

My long-time readers know that I regard the present SPR as an outmoded relic of the energy crisis of the 1970s. It has served a useful purpose during crises, but it has also discouraged industry from holding larger inventories closer to where actual demand occurs. All of this could be rectified, and I've made that case before. If we are stuck with the current SPR for the foreseeable future, though, the question becomes how it ought to be managed. I haven't changed my view that it shouldn't be used by the government to dampen oil prices in non-crisis periods. The releases in 2000 to moderate heating oil prices were well-intended but shouldn't have occurred. However, that's not the same thing as saying it makes sense to pay record high prices to fill the SPR, since there's no guarantee that the oil would be sold for a higher price later.

Look at how volatile oil prices have been this year. They've ranged from a momentary high yesterday of $89/barrel to a low of $50.48 on January 18. While plenty of traders expect oil to go even higher, I would not want to bet my home or my 401-k against seeing prices dip below $60 some time next year, even if the long-dated oil futures are currently around $75 all the way out to 2015.

Given this kind of volatility, what would be a reasonable course for a government that ultimately intends to acquire an additional 205 million barrels of oil to reach the stated 1 billion barrel target? Well, if the government only bought oil when it was below $60/barrel, it might still be able to reach its target, but at substantially lower cost. If such a policy had been in place this year, the roughly 3 million barrels purchased since August would have had to be deferred, at a savings of up to $60 million. Such a mechanism would also function as a sort of soft floor price, without the pitfalls of a tariff-based floor, while still providing some of the reassurance that investors in renewable energy are seeking.

As an old oil trader, I know that the actual details of such an arrangement would be more complicated than that simple description above. You can't gear up to put oil into the SPR on a moment's notice, to capture some blip in the market. But I would also bet that the DOE could hire a suitable US-based trading company to manage the purchasing process along these lines and deliver the oil within a suitable window, for a fee that would look minuscule compared to the effective premium we're paying right now to top up the SPR during a price spike.