Does stockpiling oil push prices up? Or is it a wise man's cushion?

Do strategic reserves drive oil prices up or are they a smart move by governments? What are their impact on world markets? And how long would they last in an emergency?

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By  Nicholas Wilson Published  September 6, 2005

Politicians and some analysts are quick to say that record oil prices will not last. They argue that high prices will spur extra exploration and lead to the discovery of new supplies. They say demand will inevitably fall. They say new forms of energy will emerge. So why are some of the biggest nations on Earth stockpiling oil as never before? Why is the notion of a ‘strategic reserve’ so attractive? And what does it do to the market? The most noteworthy, the United States Strategic Petroleum Reserve (SPR), started in its current form in 1975 as a reaction to the oil shocks of the early 1970s. It was seen as a way of protecting the US against future energy problems. The oil is stored underground in salt caverns. The International Energy Agency (IEA) now demands that its members keep at least three months’ worth of imports as reserves, although this is not always strictly adhered to. One of the problems with accounting for strategic reserves in terms of days-forward-usage is that demand fluctuates. In the mid-1980s, the US SPR accounted for nearly four months of imports. Today, the SPR on its own — when full — is only worth around sixty days of imports. The other half of US stocks are commercially owned. Over time, the US SPR has ended up being divided into two components: a store of light crude with less than 0.5% sulphur content and a sour store with less than 1.99% sulphur content. It currently holds 727 million barrels of oil, and the stated aim of the current US administration is to fill it by the end of September. It was one of President Bush’s first moves as President after 9-11 to announce that the SPR would be filled “to maximise long term protection against oil supply disruptions.” “It’s as basic as simply protecting their energy security,” says Kevin Norrish, oil analyst at Barclays Capital in London. “The more they have in the reserve, the more secure they feel.” Over the years, the SPR has been used in times of possible shortage, or during price shocks such as those of the early 1990s that followed the war in Kuwait. Then, there were two drawdowns of US stocks, one by four million barrels as a test (four million barrels is the amount per day that can be pumped from it) and another of 17 million barrels in January 1991. Even in times when prices seem benevolent, compared to those we see now, the SPR was often used in another manner: as a political tool. For example, in 2000 the US released 30 million barrels of its then 570 million-barrel reserve when oil hit US $30. Not long afterwards, OPEC increased its production levels. This illustrated the other use for Strategic Reserves: not just as a store for emergency use, but as a tool for price leverage. Although it was not explicitly stated at the time, both the US and the European Union used their strategic reserves to lower prices. They both threatened to open their reserves in 2000. Only the US actually did, but this action forced Opec’s hand. It forced Opec to produce more and pull the price back. In those days, the cartel wanted to be in control of pricing: after all their members are the ones who end up being paid for production. So rather than see any political problems, and to divert any blame for high prices, Opec did increase production and the price duly fell. Rather than this being a major emergency, it was not after all, this was a political game. A strategic oil reserve has thus become a valuable tool in the pocket of a government. But that is only when there is extra, untapped output to force onto the marketplace. Without any extra production, that use of reserves is nullified. So, historically reserves have been both an emergency fallback and a price weapon. However, times were different then. Now, with supply lines tight, strategic reserve use is starting to change. Whilst it could be a political and pricing tool again in the future, right now that ability is dwindling. The main strength of an oil reserve is reverting to its most obvious use. That is to protect against an immediate loss of supply. “Strategic reserves are not any kind of political tool at the moment,” Norrish said. “Producers are producing at their maximum and even if reserves could be used to influence anyone there is scarcely any space capacity to bring to market.” The absence of any supply cushion in the current market means that using a strategic reserve, without a definite crisis, will not affect pricing in any meaningful way. Even if the Bush administration released reserves from the SPR onto the US market, a process that takes around 13 days, it would only be a very short-term fix. Kevin Norrish agrees saying “the idea that filling up strategic reserves puts upward pressure on prices is absolutely incorrect. In terms of global daily consumption, the amount diverted to reserves is absolutely minute. What’s more, prices react to events that are unforeseen, not planned out. Prices change due to immediate factors, ones happening today, not to long-term plans.” Unlike the situation in 2000, there is very little extra external production capacity to force onto the market place. Also, oil-producing nations are not keen on seeing prices rise so high that a recession occurs. They want a balance of the highest price possible without a recession that would kill demand. In this regard, the interests of the US and those of Opec have actually become closely aligned. The only other way that America uses its SPR is to ‘exchange’ oil, basically to lend it to oil refinery operations in times of crisis. This was evident last autumn with the effects of Hurricane Ivan. After the tempest had passed, much of the US production in the Gulf of Mexico east of Louisiana was shut down. As a result, commercial companies, including Shell and Conoco Phillips, needed oil for their refineries. If a refinery actually ‘runs out’ of oil it can be bad in terms of maintenance in the same way as a car engine running out of petrol. As a result, the SPR loaned 5.4 million barrels of oil out to keep commercial supplies intact. But it is not just the US that is filling its reserves. Last year, China announced that it was set to create its own. In fact, four of them. The first to be built is in Zhenhai and will be followed by three more in Dalian, Huangdao and Daishan. When they are finished, alongside other smaller commercial stocks present in the country, it will give China around one month’s worth of imports. This is still far smaller than the US SPR, however, whose reserves, coupled with other commercial stores, equate to around four months of imports. Now, India has also decided that it too needs an oil reserve in case of supply downtime. In the past two decades, India’s consumption has risen dramatically. Previously, 70% of its daily needs could be met from its domestic production. Now, only around 30% of its daily requirements come from its own wells. The terrible fire at the Bombay High rig is a case in point as to how vulnerable India is to domestic production shortfalls. “Before, both India and China were not major importers, but that has changed,” confirms Norrish. “In case of interruptions in supply, countries that import a lot of their oil need to bulk up their reserves. China has been planning its strategic reserve for a long time. As those countries become dependent on imports, it is basic sense to try and minimise any possible shortfalls in supply.” With both China and India, another reason behind the desire for a strategic reserve is the ability of their governments to lever the domestic price. Their reserves will enable the government to buy itself time, in the face of supply shocks or price rises. In US, of course, the price is generally set by the ‘free market’. Filling strategic reserves, as is happening now, does put some pressure on prices, however. It tends to force them to the upside and has undoubtedly added to price pressure in recent months. But looked at in context, even the entire 727 million barrels in the US SPR is only around eight days of global consumption. “Looked at as part of the big picture, the amount in all the different resources is tiny, it’s nothing,” says Norrish. “The size of the buffer that strategic reserves represent is so small, just a few days cover, that they will only be useful in times of real emergency.” The basic reason behind the growth in international strategic reserve levels is at heart a simple one. The days when it could be used as a political tool, to confront Opec or to massage prices seem to be a thing of the past. With supply cushions gone and the market tight, the basic reasons for strategic reserves are to insulate countries against future oil shocks. The fact that they are being increased in size by various governments sends a message to the market: a message that the future of oil is replete with risks, volatility and uncertain outcomes. Ones that only a hefty store of oil can insulate against.

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