Wednesday, February 27, 2008

Quit While We're Ahead

The nation's Strategic Petroleum Reserve is back in the news. The Senate Committee on Energy and Natural Resources, chaired by Jeff Bingaman (D-NM) is holding hearings on the management of this program by the Department of Energy, focusing on its policy of continuing to fill the reserve, regardless of price. Senator Byron Dorgan (D-ND) has introduced a bill that would suspend SPR additions until oil prices are significantly lower. With the SPR approaching its maximum capacity, and with oil prices having crossed the $100 mark, a time-out seems appropriate, in order to ensure that the SPR does not contribute to the high energy prices that are fueling inflation, rather than acting as a moderating influence.

Conceived in the 1970s, the SPR has provided an insurance policy in case of a serious disruption in the global oil market upon which the US relies for its oil imports, which have more than doubled since the SPR opened in 1975. Although SPR oil has been loaned to refiners on numerous occasions, it has only been released via sale during perceived crises, including the Gulf War and after Hurricane Katrina. When President Bush took office in January 2001, the SPR inventory stood at 541 million barrels (MB). Since then, this administration has added a net 157 MB of oil, including 49 MB in 2002, when the price of WTI averaged $26.15/bbl, another 37 MB in 2003 ($30.99) and 2004 ($41.47), and 27 MB (at roughly $53,) prior to Katrina in 2005. Since then, purchases for the SPR have been running at a slower rate, with 7.7 MB injected during 2007, when oil averaged $72.41/bbl.

In retrospect, most of those additions look like a good investment, though since oil prices started rising in 2003, they have been controversial. While they certainly contributed to the pressures that have caused oil prices to triple since the end of 2003, that contribution has been relatively minor, weighed against the growth of China, a war in Iraq, chronic unrest in Nigeria, and the deliberate impairment of the Venezuelan oil sector. But although the contemplated fill rate of 125,000 barrels per day (bpd) constitutes only 1.25% of US oil imports and 0.3% of global oil trade, it abets the psychology of a market speculating that even higher prices lie ahead. Although a policy of buying predictably, whether prices were low or high, had its merits in the past, that policy has run its course in terms of the marginal benefits of any further additions.

As of last week, the SPR stood at 96% of its maximum capacity of 727 million barrels. At its maximum drawdown rate of 4.4 million bpd, the difference between 96% and 100% would only be one week of supply, at the end of 23 weeks. In any crisis severe enough to cause us to drain the SPR at its maximum sustainable rate for 5 months, it's hard to envision one week making much of a difference; however, it makes a difference now, by implicitly validating a bullish view of prices and competing with refiners' purchases. Any contribution by the SPR program to higher oil prices only compounds the forces driving wholesale inflation to levels we haven't seen in decades.

While I would like to see the next administration undertake a comprehensive review of the entire SPR strategy, the question today is much simpler. Is it prudent for the government to continue buying oil at an all-time record price, or should it take a breather while the market sorts itself out? If oil is still trading over $100 in six months, the DOE could resume buying, without having lost anything meaningful to our security--energy or otherwise. And while no one can be sure that suspending the SPR fill would dampen the market's enthusiasm for $100 oil, it surely can't hurt.

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