SPR drawdowns trigger law of unintended consequences

Afghanistan itself currently bears no relevance to the oil market. As the concentric circles of responsibility for the Sept. 11 attack (or "terrorism," defined more broadly) expand beyond Afghanistan's borders, however, the possibility of a disruption to oil supplies grows. The threat to oil supplies falls into two categories.

The first is the self-embargo phenomenon in which an Islamic oil producing state, such as Iraq, cuts its exports. A self-embargo or the cessation of exports could raise oil prices at a time when the US economy is struggling with a recession. Most analysts agree that this use of the "oil weapon" is outdated in a market with spare capacity, spot market-linked prices, and substantial codependence between the world's producers and consumers.

The loss of market share and revenue to Iraq is just not worth it. Even so, Iraq has shown over the last couple of years that it is willing and ready to stop exporting for a month or more to underscore its views vis a vis the UN Security Council and existing economic sanctions.

Notably, the recent passage of UN Security Council resolution 1382, which extended the oil-for-aid program but set the stage for future changes to the sanctions regime, did not trigger an Iraqi embargo. Next June's review of the oil-for-aid program will be far more controversial as the aforementioned changes are negotiated. Depending on the outcome of those negotiations, Iraq, in protest, could again stop exporting.

The self-embargo phenomenon can also be viewed more broadly in terms of cracks in the coalition. If US military action broadens beyond Afghanistan, Islamic countries currently cooperating with the US might publicly, if not privately, distance themselves from the US campaign. This could take the form of anti-US rhetoric, denial of US access to military bases, or perhaps a more subtle change in oil policy among disapproving oil producing countries.

It is one thing to allow oil prices to fall in the wake of the Sept. 11 attacks and amid fears of a US recession. It is a far different thing to allow prices to stay low while public opinion within countries shifts from sympathy for the US as victim to antipathy for the US as aggressor.

In short, the current antiterrorism coalition is a fragile meeting of the minds between vastly different countries that include many oil producing countries. To the degree the coalition deteriorates over time, the tolerance for low oil prices among its producing members could also deteriorate.

Other threats

The second category of threat to oil supplies is the direct action of the coalition (or a fragment of the coalition) against oil producing states. US President George W. Bush has repeatedly made two points: The US campaign will target states that support terrorism from this day forward, and every state is either with or against that campaign. This means that countries who were formerly known as rogue states can elect to support the antiterrorism efforts or not. If they do, then apparently they are not targets, regardless of their previous record. This seems to be the logic that has made Sudan an indirect partner in the coalition.

Moreover, the closure of Iran's border with Afghanistan and Iran's overriding opposition to the Taliban appear to have kept the focus off Iran. Likewise, Libya's extradition of the Lockerbie bombers, albeit after many years, probably keeps Libya off the target list for the time being. With these three producing countries temporarily off the list of state sponsors of terrorism, Iraq remains very conspicuous.

In the meantime, the anthrax scare in the US has only heightened interest in bioterrorism. Following the US announcement of five countries (Iran, Iraq, Libya, North Korea, and Syria) that are developing biological weapons, Iraq's biological weapons capabilities are under even more scrutiny. The resolve of the Bush administration to address biological weapons portends a tougher US policy regarding Iraq.

If military action were taken against Iraq, its exports would be taken off the market, as tankers are prohibited from loading at Iraq's Persian Gulf port, Mina Al Bakr. Pipeline shipments to Turkey and Syria would be vulnerable to deliberate or accidental interruption.

In sum, the worldwide campaign against terrorism, led by the US, does have the potential to directly or indirectly threaten global oil supplies. For this reason, the US Strategic Petroleum Reserve is once again an issue for discussion.

SPR history

When the International Energy Agency was set up after the 1973 oil shock, its primary function was emergency preparedness. The role of government strategic stocks as a tool of emergency preparedness was encompassed in the International Energy Program that IEA would administer in the event of a supply disruption.

The gist of the IEP was a three-pronged response, led by a supply allocation plan that would force IEA members to share oil if the imports of one or more members fell below a predetermined level.

The allocation of supplies would be accompanied by demand restraint imposed by the national governments. The drawdown of strategic reserves was then a last resort if the first two steps failed. What is important about the IEP is that the emergency response was focused on volume replacement. The response was triggered when imports fell. Absent the import trigger, no collective response was forthcoming.

The Iranian revolution of 1979 was a test of sorts for the IEP. Iranian production fell by 40%, and crude oil prices more than doubled. The supply allocation component of the IEP, however, was never triggered because imports did not fall enough, as stocks at sea and alternative supplies made up the difference.

Governments, however, did implement wide-ranging demand restraint policies. Indeed, these government policies shifted US power plant input from oil to natural gas and nuclear in the years that followed. Even with demand restraint and alternative supplies, however, crude oil prices surged. And they stayed high as consumers stocked up, fearing more unrest in the Middle East.

Because oil trade was still largely conducted under fixed prices, the rising stocks did not have a dampening effect on spot prices on the fringe of the market. Policy-makers realized that the emergency was not a volume problem. It was a price problem. The system they had set up to replace volume did nothing to mitigate price.

High prices, in turn, had a profound impact on the global economy. Global economic growth, which had averaged 4.6% in 1978, fell to 3.8% in 1979, 2.3% in 1980, and 2.2% in 1981 and bottomed out at 1.1% in 1982. Obviously the countries of the Organization for Economic Cooperation and Development needed to rethink their emergency preparedness in the oil sector.

Many things changed in the mid-1980s, but the most important was the emergence of spot and futures pricing as an alternative to fixed prices. As more and more of the world's oil trade fell under spot or spot-linked pricing, the ability of the market to reallocate supply to meet demand only grew.

The existence of a price mechanism meant that oil crises could and should be viewed through the lens of price and not volume. Many analysts even went so far as to say that there was no such thing as shortages, only high prices. Given time, the market would reallocate supply to eliminate imbalance. This view was underscored by the 1985 move by Saudi Arabia to abandon the role of swing producer in Organization of Petroleum Exporting Countries. The resulting surge in production as each member made a bid for market share highlighted the world's excess crude oil production capacity and the speed at which it could be brought into the market.

By 1984, the administration of President Ronald Reagan and the IEA had already determined that strategic stock draws, rather than supply allocations or demand restraint, should be the first line of defense in an oil emergency. Following an identifiable supply disruption, an early and large release of government strategic stocks would calm the markets and prevent or temper high prices that could harm the economy.

The 1990-91 Persian Gulf crisis presented yet another test of emergency preparedness. Iraq's invasion of Kuwait and the subsequent cessation of production by both countries seemed a textbook opportunity for the use of strategic stocks. Third quarter 1990 crude oil prices doubled in the fourth quarter, even though Saudi Arabia and other countries immediately increased production in a market that was already very well supplied prior to the Aug. 2 invasion.

The administration of President George H.W. Bush did not draw down the SPR until January and then only as a complement to the start of the air war over Iraq. The combination of the drawdown and the overwhelming and quick success of the air war led to a $10 drop in oil prices. Many economists believe, however, that the price collapse was too late to prevent a US recession that may have, in fact, cost President Bush his reelection in 1992.

The reasons the Bush administration did not use the SPR sooner are unclear. People in the administration documented much of the period of Aug. 2, 1990, to Jan. 17, 1991, and no clear overriding principle emerges that explains the decision not to exercise the "early release" option. Contributing factors, however, include:

• The concern that the disruption could be deeper or longer if the conduct of the war went poorly. In other words, save the reserve in case it is more urgently needed later on. Other countries would make up the shortfall in the meantime.
• The apparent misreading of futures market backwardation, which was interpreted to mean that the market thought prices would fall in the future.
• The apparent reference to the original purpose of the SPR to replace volumes lost. Since other producers had made up the shortfall, this was not a volume problem. This view seems to run completely counter to the mid-1980s adoption of the early release principle designed to mitigate the economic effects of high prices.

In sum, history has provided two bona fide energy crises in which to use strategic reserves. In 1979, the guiding principle of volume replacement and the focus on supply allocation and demand restraint rather than reserve drawdown prevented the (then small) reserve from being used. Private sector stocking and perceived tight overall production capacity, however, kept crude oil prices high and ultimately damaged the global economy.

In subsequent years substantial resources were made available to build the US and other national reserves. In fact, the US, Japanese, and German reserves, which accounted for the lion's share of government-held strategic stocks, equaled only 150 million bbl in 1979. By the time of the Iraqi Invasion of Kuwait in 1990, the combined reserves of the US, Japan, Germany, and South Korea had swelled to 880 million bbl. Obviously, the policy-makers thought strategic reserves were a good idea. They also recognized that price mitigation might be more important than volume replacement.

This point was lost on the first Bush administration in 1990, however, when it elected not to use the SPR as prices rose. Prices remained high for a full 3 months, even though alternative supplies were forthcoming from Saudi Arabia. This is a key point. In both 1979 and 1990, alternative supplies came onto the market after the disruptions (albeit faster in 1990 than 1979).

In 1979, market uncertainty led to stocking and kept prices high. In 1990, market uncertainty and a stock draw led to backwardation in the futures market, discouraged stock-building, and kept prices high. In both cases, even though the wellhead shortfall was made up, market concerns about stability in the Persian Gulf kept prompt prices high.

The noncrisis years

The administration of President Bill Clinton added yet another wrinkle to the SPR debate. If the SPR could be used in a crisis to temper prices, then why not use it to temper prices even absent a crisis? This view characterized the Clinton approach. Indeed, during 1992-2000, there were three drawdowns of the SPR, and yet there were no energy crises (defined here as sudden and substantial crude oil supply disruptions).

The first drawdown was essentially a revenue-raising plan. The US government sold 5 million bbl of crude oil in early 1996 to raise $100 million to defray the cost of shutting down the Bayou Choctaw SPR site at Weeks Island, La.

The second drawdown started out as yet another revenue-raising plan. Indeed, as part of the 1996 budget bill, the government intended to raise $227 million by selling crude oil from the SPR. Shortly after announcing this plan, however, the Clinton administration urged the Department of Energy to accelerate the plan in order to temper surging gasoline prices.

At the time, crude oil prices were very high. The futures market had become steeply backwardated (i.e., prompt prices were higher than future prices) as the oil industry anticipated Iraqi acceptance of the UN oil-for-aid plan, which would trigger the resumption of Iraqi exports. With the market backwardated, crude stocks remained lean because companies did not want to stock up in a market in which they could not protect the future value of the stock. With lean stocks, prompt crude prices remained high.

In addition, 1996 was only the second year of processing reformulated gasoline (RFG). Because RFG is harder to make than conventional gasoline, it carried a high premium during the spring as refiners built supplies. At the same time, refinery outages exacerbated the gasoline strength.

All of these factors contributed to high pump prices and public complaints. The Clinton administration saw the chance to kill two birds-tempering gasoline prices and raising money for education-with one stone, selling 13 million bbl of crude oil.

After that, many members of Congress saw the SPR as a tool for easing high retail fuel prices and combating what was publicly perceived as deliberate price gouging by oil companies. Indeed, in fall 1999, Sens. Charles Schumer (D-NY) and Susan Collins (R-Me.) introduced legislation that would authorize the president to draw down the SPR to counter high retail prices resulting from "anticompetitive behavior." The legislation failed, but it underscores the extent to which the SPR had transformed from a pillar of US emergency preparedness into a tool of political opportunism.

The final and most recent drawdown in SPR's history was a 30 million bbl drawdown in fall 2000. This decision was strongly supported by Vice-Pres. Al Gore during his election campaign when he called for a drawdown to ease heating oil prices. It is very hard not to see this as an election year misuse of an important strategic asset.

Unintended consequences

By mid-2000, heating oil supplies were unusually tight because refiners had pushed hard to make gasoline in the first year of Phase II RFG. Prices for the marginally harder-to-make Phase II RFG gasoline were very high all year. Refiners had maximized gasoline production at the expense of heating oil production, and as the summer came to an end, heating oil supplies were lean.

An SPR drawdown, however, was not the appropriate response. By drawing down the SPR, crude prices would fall. This, in turn, would lower NY harbor heating oil prices, closing the arbitrage window with Europe and the US Gulf Coast.

As expected, the SPR drawdown, which began in October 2000, lowered New York harbor heating oil prices and short-circuited the price mechanism. This prevented the New York harbor price from rising high enough above Rotterdam prices to attract the needed foreign barrels.

With coincidentally high shipping costs, the arbitrage did not open enough to cover the cost of shipping until December. This finally triggered a surge of imports in January. At the same time, the New York harbor price was not high enough relative to US Gulf Coast prices to cover the cost of shipping incremental volumes to the East Coast in the required Jones Act tankers.

In short, the unintended consequence of the third SPR drawdown was that the price mechanism was prevented from pulling the needed barrels into the Northeast. Even though the wholesale price fell in New York harbor, the price paid by the consumer remained high as supplies remained scarce. In this case, the SPR drawdown did not mitigate high prices. It did quite the opposite; it prolonged them.

SPR: political tool

In many respects, the 2000 SPR drawdown marks the culmination of years of divergence from the SPR's original emergency preparedness mission. There was no identifiable supply disruption. Crude oil prices were high, but they had been high for several months, so there was no identifiable crude oil price disruption.

As in 1996, the SPR was used to address petroleum product prices rather than crude oil prices. Finally, during the 1990s, the idea that oil companies were intent on price gouging in their retail markets had permeated the political debate on use of the SPR.

In sum, the SPR was no longer a tool of crisis management, but an instrument politicians used to counter the perceived threat to the consumer (and hence the economy) of big and not-so-big oil.

The more the use of the SPR diverges from its original purpose, the more it is likely to yield unintended consequences. As a political tool the SPR is very clumsy in the oil market. Without a clear disruption that yields a distinct and potentially long-term imbalance in the market, the use of the SPR in the guise of an "invisible hand" is foolhardy.

The oil market is big and fast-moving, and it represents the activities of thousands of players. The efficiency of the price mechanism in such an unfettered market is legendary. Indeed, it is almost impossible to use the SPR in an undisrupted market without the result of unintended (and counterproductive) consequences.

Lessons

This review of the historical use or nonuse of the SPR should yield some guidance for today's potential oil crisis. The easiest way to organize the lessons learned over the last 20 years is to examine them in terms of mission, strategy, and tactics.

The mission of the SPR harkens back to its roots. It is a government-owned and segregated reserve and a critical component of the nation's emergency preparedness. For this reason, the recent decision to fill the SPR to its 700 million bbl capacity is appropriate.

There must be an oil crisis, however, to use it. An oil crisis is an identifiable and substantial disruption to crude oil supplies. Make no mistake, even though consumers buy petroleum products and not crude oil, three quarters of the price of those products comes from the price of crude underlying product prices.

Because the SPR stores crude oil, it is best used to affect crude oil markets. If petroleum product supply disruptions were of concern, then a product reserve (like the Northeast heating oil reserve) would be far more effective.

Given the mission of responding to a crude oil supply disruption, however, the strategy should not focus on volume replacement. It should focus on the price impact of the supply disruption. Alternative suppliers or private sector stock draws can often make up supply shortfalls. This brings us to the central dilemma of the SPR. The 1979 and 1990 crises yielded several months of high prices even though alternative supplies were forthcoming. If used, the SPR could have played an important market-calming role.

Policy-makers seeking price mitigation, however, walk a fine line between "calming" the market by showing that there is sufficient crude available-and they are willing to deploy it-and yielding the unintended consequence of short-circuiting the price mechanism and preventing the market from equilibrating. This dilemma is magnified in political debate, pitting the advocates of free markets against the advocates of interventionist government.

Tactics of a drawdown

By focusing on price and not volume, the policymaker is forced to examine the actual or expected market reaction and the potential for unintended consequences. Having said this, many still advocate an early and large release of the SPR in a real energy emergency. If the supply disruption is so big that it will not be easily replaced in the global market, then an early release is definitely worthwhile. In this case, an SPR drawdown should be a coordinated effort on the part of the countries with government-held segregated stocks-the US, Japan, and South Korea.

If the disruption is smaller, a timely review of the immediate and expected market reaction is essential. If the early release option has been ruled out, then a more holistic approach, integrating strategic stock draw with demand management, may be in order depending on the expected duration of the original disruption.

The use of the IEA 90-day stocks held by companies is unclear and untested but could be part of the integrated approach. However collaboration proceeds, the paramount objective should be to understand the market impact. What will be the drawdown's impact on supply, demand, and price? How will market participants react?

Each oil crisis will necessitate a different kind of response. In today's oil market, as we consider the impact the war on terrorism may have on oil supplies, it is likely that, if there is a supply disruption, it will be a large one. This means the early release option should be on the table. Not only would it augment existing crude supplies from alternative suppliers and temper prices, it would reiterate the point that the US is indeed waging the war on many fronts.

The author

Sarah Emerson joined Energy Security Analysis Inc. when the oil consulting practice was launched in 1986. Since then she has become a principal in the firm and currently oversees daily ESAI operations, specifically directing the oil practice. Emerson has developed many of ESAI's tools for analyzing the oil market and forecasting oil prices. She has conducted industry studies, regularly publishes articles in the energy trade press, and coauthored the monograph, Storage in the International Oil System, published by the Economist Intelligence Unit. Emerson received her BA from Cornell University and her MA from the Johns Hopkins University Nitze School of Advanced International Studies.