Thursday, July 24, 2008

Leveraging the SPR

Election-year politics and prudent energy policy do not mix well. The combination is even worse when the election cycle coincides with a genuine energy crisis, and both parties seek to curry favor through short-sighted proposals aimed at producing votes, rather than BTUs or kilowatt-hours. We saw this earlier in the year with suggestions by Senator Clinton and Senator McCain to suspend the federal tax on motor fuels for the summer, and we are seeing it again in calls by the Speaker of the House and others to release oil from the Strategic Petroleum Reserve to drive down fuel prices.

It's remarkable how quickly the debate over the Strategic Petroleum Reserve (SPR) has shifted from halting additions to it, to draining it. The former was eminently sensible, in light of the cost of the program and the possibility that diverting small quantities of light, sweet crude into storage was having a disproportionate impact on the price of all oil. The balance of risks strongly favored suspending additions to the SPR; quite the contrary is true for using SPR oil to create a brief, convenient slump in the oil market, while diverting attention from the more serious discussion of increasing supply and reducing demand--both sides of which would be harmed by a non-emergency release from the SPR.

Make no mistake: the current SPR is a relic of the energy crisis of the 1970s that merits serious re-thinking about its fundamental purpose and the best way to achieve it in a very different economic and geopolitical environment. It is also possible to conceive of ways in which oil in the SPR could be used to speed up the contribution of production from new oil fields, once they are identified and under development, via SPR vs. reservoir exchanges. However, such considerations are quite different from simply dumping SPR oil into the market--volumes that under the policy passed by this Congress could not be replaced as long as oil remains expensive--for no purpose other than to provide some relief at the gas pump, where prices are already likely to fall by another 25-35 cents per gallon, based on the past week's drop in the crude oil and gasoline futures markets.

The problems with releasing SPR oil now are straightforward. Inventory is not production. The proposed draw-down is not sustainable, while the production that new drilling could add would contribute to our energy supplies for a generation. Moreover, oil prices are a classic stock-and-flow system, reflecting the current balance between actual supply and actual demand, and the difference between actual inventory and desired inventory. Although the flow of SPR oil into the market would create a temporary glut and drive down the price of oil for prompt delivery, the subsequent lower inventory levels--even for an emergency back-up such as the SPR--could result in even higher prices after the release program ended than before it began. At the same time, this signal--not just from lower current prices but also from the demonstrated willingness of the government to use the SPR to manipulate the market--would deter new energy projects, including those for alternative fuels that are more attractive when oil prices are high, while impeding our transition to more efficient vehicles.

The world has changed in many ways since the SPR was first opened, and some of those changes make it even more essential for the US to have quick access to large volumes of oil in extremis. Among other things, our net oil imports have doubled since President Ford signed the SPR into law in 1975. Although oil prices remain high, supply still meets demand. Yet it is far too easy to envision plausible scenarios in which that would not be the case, involving terrorism, expanded conflict in the Middle East, or the effects of Peak Oil. In any of those cases, we might find that the SPR's current 160 days of supply at its 4.4 million barrel per day maximum delivery rate are not nearly as ample as they seem.

Aside from expediency, the theory behind releasing SPR oil now is based on a flawed narrative involving a bubble in oil prices. If the evidence were clear that supply and demand would balance at a much lower oil price, and that speculators were responsible for a large fraction of the current oil price, then I could support using a brief release from the SPR to crush speculation. The reality appears much different. Oil prices have fallen since this debate started, largely because of the extraordinary reduction in demand that high prices and a weak economy have triggered--and not because the market sees a realistic prospect of a SPR release this year. Oil is trading today below $125 per barrel for delivery in September 2008, as well as for delivery in December of 2010, 2011 and 2012. That could change tomorrow, due to some event, but it suggests that the impact of speculation is more like the foam in a glass of beer than a steadily-inflating bubble. The interests of the nation would be better served by a Congressional commission on re-engineering the SPR for the 21st century, than by Congressional legislation to fritter away this $88 billion asset in the pursuit of short-term goals.

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