The Strategic Petroleum Reserve drawdown

The International Energy Agency announced on Thursday that its 28 member countries had agreed to release 60 million barrels from their combined strategic stockpiles. The U.S. plans to contribute half of this total, all in the form of sweet crude. Thirty million barrels represents about 10% of the U.S. strategic petroleum reserve of 293 million barrels of sweet crude oil, and about 4% of the entire 727 million barrels stockpiled in the U.S. SPR.

To think through the effects such a move might have, suppose that there were no changes in production or private inventories. The two million barrels per day released from the IEA program would represent 2.3% of the 87 million barrels per day currently being produced globally. If for illustration we assume a short-run price elasticity for oil demand of 0.1, the result would be a 23% decrease in the price for the month of July, after which the price would return to its previous value.

That of course is not what's going to happen, because it would make no sense for anyone to sell oil for 23% less in July than you could get for it in August. If oil is cheaper in July than August, you'd want to buy more of that cheap oil in July, store it, and sell it back at a profit in August. If it were completely costless to store oil and if there were no urgency to sell it now rather than later at the same price, the outcome would be that the release from the public SPR would be matched by an equivalent increase in private inventories with no effect at all on the price.

But that's not what's going to happen either, because it's not costless to store oil and because with constant prices and positive interest rates it's always better to sell now rather than later. The actual effect we'd expect from a one-time release from the SPR would be a more modest effect on the price spread out over a longer period of time, with much of the initial release going into private inventory and eventually being sold back out of private inventories. For example, suppose the 60-million-barrel release results in an extra 10 million barrels ultimately being consumed over each of the next six months. The resulting flow (333,000 b/d) would represent about 0.38% of daily supply, which again using the 0.1 elasticity would be predicted to keep the price about 3.8% lower than it otherwise would have been for a period of about 6 months or so. That price decrease would be front-loaded, with the biggest impact in the first month, and the price gradually rising back to its original level after six months.

When the SPR release was announced on Thursday, the price of Brent fell 6.1% and West Texas Intermediate was down 4.6%.

Some traders may anticipate that there will be further SPR releases. The Libyan conflict has been estimated to have taken about 1.5 mb/d of light, sweet crude off the market. The IEA described the SPR release as intended to "help bridge the gap until sufficient additional oil" is produced by oil-producing countries. If the gap still needs bridging a few months down the line, perhaps potential oil buyers anticipate that Thursday's announcement is just the beginning.

Jim Brown sees the IEA move as a miscalculation, arguing that most of that lost Libyan production is not going to be restored even if Libyan leader Muamar Gaddafi were immediately removed, that much of the advertised increase in Saudi production may go to their own consumption, and that Chinese consumption has continued to increase despite the disruptions in North Africa. Speaking of which, the Chinese might see a temporary drop in prices as an opportunity to add to their own SPR. To the extent that happens, we're getting back to the no-effect scenario.

Another possibility is that prices were heading lower anyway, and all the IEA move did was to help them jump to an appropriate level more quickly. This is how I would interpret the claim that speculation was a factor keeping oil prices higher than they otherwise would have been, and seems a more plausible rationale for the move than the temporary bridge story.

In any case, the deed is now done, and the IEA has run an interesting experiment for us in how oil markets function. But I would recommend against further SPR sales, regardless of the final outcome of the current effort. The reason is that I see the long-run challenge of meeting the growing demand from the emerging economies as very daunting, and in my mind is the number one reason we're talking about an oil price above $100/barrel in the first place.

A one-time release from the SPR, or even a series of releases until the SPR runs dry, does nothing whatever to address those basic challenges.