Shrinking the Strategic Petroleum Reserve

• Selling oil from the Strategic Petroleum Reserve as part of the Congressional budget compromise raises serious questions about the SPR's future role.
• Shrinking the SPR without first bringing its coverage into line with 21st century needs risks strengthening OPEC's hand. 

Last month's Congressional budget compromise included plans to sell 58 million barrels of oil from the US Strategic Petroleum Reserve, beginning in 2018. That decision raises serious questions. The world has changed enormously since the SPR was established in the 1970s, but the realignment of such an asset for the 21st century deserves a full strategic review and debate. Leaping ahead to treat the SPR like an ATM  seems unwise on multiple grounds.

My initial reaction was that the sale would result in the US government effectively buying high and selling low. However, using the last-in, first-out (LIFO) accounting common in the oil industry, the SPR release during the 2011 Libyan revolution should have removed any barrels purchased as prices surged past $100 per barrel (bbl) to over $140, prior to the financial crisis. The oil now slated to be sold in 2018-25 was likely injected between December 2003 and June 2005, when West Texas Intermediate crude oil averaged around $44/bbl. The Treasury should at least break even on these sales, allowing us to dispense with judging the trading acumen of the Congress and focus on the strategic aspects of this decision.

It is also true that the combination of revived US oil production and lower domestic petroleum demand effectively doubled the notional import protection that the SPR provides. That has made policy makers comfortable enough with the coverage the reserve provides to consider shrinking it. Yet as Energy Secretary Moniz  and a growing body of experts have concluded, the SPR's present configuration is inadequate to deal with whole categories of plausible oil-supply disruptions.

Today's SPR consists entirely of crude oil stored in caverns near the major refining centers of the Gulf Coast, to which it is connected via pipelines. However, while crude oil imports into the Gulf Coast have fallen dramatically, the long-term decline of oil production in Alaska and California has forced West Coast refiners to import 1-1.5 million bbl/day of oil, including more than half of California's crude supply, much of it from OPEC producers. In the event of an interruption of those deliveries, and under current oil-export restrictions, getting SPR oil from Texas and Louisiana to L.A. and San Francisco would pose enormous logistical challenges.

We have also learned that natural disasters such as hurricanes Katrina and Rita in 2005 and Superstorm Sandy in 2012 affect refinery operations, as well as oil deliveries.  A crude oil SPR is of little value if its contents can't be processed into the fuels that consumers and industry actually use.  The newer Northeast heating oil and gasoline reserves were intended to address that limitation, though on a much smaller scale.

It is thus fair to say that the SPR established in the Ford Administration and filled by the next five US presidents to a level now equivalent to 137 days of US crude oil imports is not diverse enough in its composition or locations, and too big for our current needs. If we could count on a continuation of cheap, abundant oil for the next two decades, selling off some SPR inventory wouldn't create problems. However, the purpose of such a reserve is to mitigate the risks of uncertain and inherently unpredictable future conditions and events. That should be factored into any decision to shrink it.

We don't have to look far to find reasons to suspect that oil prices might someday be higher and more volatile--perhaps as soon as the 2018-25 legislated sales period--or to worry that oil supplies from the Middle East might become less secure. Consider the consequences of the oil price collapse that began over a year ago. Low oil prices have indeed put pressure on the highly flexible US shale sector, where production is now expected to drop by around 500,000 bbl/day by next year. The impact on large-scale, long-lead-time capital investments in places like Canada, the North Sea and Gulf of Mexico has been even more profound. Over $200 billion of new projects and exploration activity have been deferred or canceled. Unlike shale, most of these projects could not be revived quickly if prices rebounded.

As production from existing fields declines without replacement, the current global oil surplus will dissipate, bringing the market back into balance. However, that balance is likely to be more precarious than before, since last fall's strategic shift by OPEC to protect its market share instead of managing prices entails the depletion of OPEC's "spare capacity." That means that in a future crisis, Saudi Arabia and other OPEC producers will have little flexibility to increase production to make up for lost output elsewhere.

Barring an unforeseen reduction in global  oil demand, the scenario that is beginning to take shape fits the  pattern of risks that the SPR was originally intended to address. It includes the prospect of rising US oil imports, increasing reliance on OPEC, and the threat posed by ISIS in the world's oil "breadbasket".  In that light it is hard to justify reducing the size of the SPR without a clear plan for making the remaining volume more effective at shoring up future vulnerabilities in US energy security.

In their haste to reach a deal, Congressional negotiators may also have overlooked some SPR-related alternatives that could generate revenue without draining inventories. These might include allowing other countries to buy into the reserve by means of "special drawing rights," or simply selling long-dated call options backed by the SPR, to be settled in the future by delivery or cash, at the government's discretion.

Taken together, there are ample reasons for the next Congress and administration to revisit the SPR sales provisions of the 2016 budget deal, before they go into effect.

A different version of this posting was previously published on the website of Pacific Energy Development Corporation

The Keystone Rejection and the Shift Back toward OPEC

Although the International Energy Agency's latest warning of future energy security risks doesn't mention the Keystone XL pipeline, it provides important context for assessing President Obama's decision turning down that project's application. The IEA's newly issued global energy forecast indicates that if oil prices remain low until the end of the decade, it "would trigger energy-security concerns by heightening reliance on a small number of low-cost producers," a polite way of referring to OPEC. The Keystone verdict could help reinforce that shift.

I've devoted a lot of posts to different aspects of the Keystone issue. In a post last year on the State Department's Final Supplemental Environmental Impact Statement, I pointed out the pipeline's relatively modest potential to affect climate change, with a range of incremental greenhouse gas emissions (GHGs) equating to 0.02-0.4% of total US emissions. Even if the full lifecycle emissions of the oil sands crude it would have transported were included, they would still not have exceed around 0.3% of global CO2-equivalent emissions. For these and other reasons, I have consistently concluded that the decision would be made on political, rather than technical grounds, consistent with the symbolism the project has taken on with environmental activists during this administration.

Whether the Keystone rejection is attributable mainly to domestic political considerations or to positioning in advance of next month's Paris climate conference is a minor distinction. As the editors of the Washington Post put it, the distortion and politicization of the issue "was a national embarrassment, reflecting poorly on the United States’ capability to treat parties equitably under law and regulation." If the IEA's assessment of the trends underlying today's low oil prices is correct, we may come to regret last Friday's ruling for other reasons, too.

Recall that last year's oil-price collapse had two principal triggers: surging US oil production from shale deposits in Texas, North Dakota and several other states, and a decision by OPEC to forgo its historic role as balancers of the global oil market and instead to produce full out. The latter explains why oil remains below $50 per barrel, even though US shale output is now retreating.

Yet while shale production is expected to rebound once prices start to recover--whenever that might occur--the same cannot necessarily be said for conventional non-OPEC production from places like the North Sea and other high-cost, mature regions. Oil companies have canceled or deferred over $200 billion in exploration and production projects, while existing oil fields accounting for more than 10 times the output of US shale will continue to decline at rates of perhaps 5-10% per year.

The combination of all these factors sets the stage for a future oil market very different from what we've experienced in the past few decades. If OPEC and particularly Saudi Arabia assume the role of baseload, rather than swing producers, the price of oil will be set by the last, most expensive barrels to be supplied. That would constitute a much more normal market than one that has been dominated by OPEC production quotas, but it would also lack the margin of 3-5 million barrels per day of "spare capacity" that OPEC has typically held in reserve. That is a recipe for increased risk and volatility ahead.

If this comes to pass, the result might not be an exact re-run of the oil crises of the 1970s. The global economy is much less reliant on oil than it was four decades ago, especially for electricity generation, which as the IEA points out will increasingly come from renewable sources. However, oil will remain indispensable for transportation for many years. In a global oil market again dominated by OPEC, additional pipeline-based supplies from a reliable neighbor like Canada would be highly desirable, and the US Strategic Petroleum Reserve, which the Congress just voted to shrink in order to raise a couple of billion dollars of revenue, could become a lot more valuable.

The decision to reject TransCanada's application for the Keystone XL pipeline was ostensibly made on long-term considerations related to climate change, but it reflects a short-sighted view of energy markets. In that light, the President's conclusion that Keystone "would not serve the national interests of the United States" seems very likely to be revisited by a future US president.