Pick one: SPR or recession
(Note: Commentaries do not necessarily represent the ASPO-USA position.)
In a Brookings Institution presentation in early 2009, UCSD economist James Hamilton suggested that the government think of using the US Strategic Petroleum Reserve (SPR) to counter high oil prices. Although the suggestion failed to gain traction at the time, recent upheaval in the Middle East is once again putting the future of the SPR back on the agenda. Should the reserve be drawn to cool oil prices which have surged on the back of lost Libyan crude output? I must admit I was somewhat cool to the idea when Hamilton published his Brookings paper, but his suggestions often prove prescient and therefore deserve closer examination. Indeed I became much more convinced when I saw a Federal Reserve presentation on short term oil prices, which largely concluded that the institution has little insight into short term oil price movements. Given the potential impact of oil prices on the economy, the Fed does not have the luxury of such ignorance.
The SPR was established in 1975, after the first oil crisis, with the purpose of providing a critical petroleum reserve to the US which could be drawn in the event of war or embargo. This seems sensible enough. A large and militarily critical power like the US should avoid being held hostage to energy exporters like the Gulf states and Russia. But the oil-price spikes of 2008 show that oil prices can substantially damage the US economy even without hostile acts by other countries.
The SPR holds 727 million barrels of crude oil, about 40 days of US consumption and 70 days of oil imports. In addition, the US has about 1.1 billion barrels of commercial crude oil inventories. All in all, the US has sufficient domestic crude oil stocks to cover about six months of imports. But it is one thing to hold such reserves, another to deploy them.
As we look forward at Douglas-Westwood we see a greater than 50% probability of an oil shock by 2013; indeed, given recent high oil prices, the US could find itself back in recession by summer. Notably, when crude oil consumption has exceeded 4% of GDP, the US has typically fallen into recession - in some cases in as little as 30 days, and generally not more than six months. Crude consumption as of April 22 stood at 6% of GDP, well in excess of the historical threshold.
In light of this, should the SPR be activated as a price-moderation tool?
Interestingly enough, many in Washington are opposed. These objections are largely ideological: that governments should not manipulate market prices as a matter of principle; that such a capability would permit more misguided, incompetent, or corrupt meddling; that interfering would garble market signals and, in effect, confiscate upside earnings of those who bet long in markets; and that it would not help anyway. All of these objections may be legitimate, but given the stakes, a deeper look would seem warranted.
Begin with price manipulation. Oil is believed different from other commodities, say, copper or coal. Neither of these is associated with economic traumas; no one has ever heard of a ‘copper shock’ or a ‘coal shock.’ Oil is special in that other economic activities depend upon it. Without an automobile, most Americans cannot get to their jobs, schools, or stores. Therefore, oil is arguably unique, and when its price rises too high, an oil shock devastates the US economy. Therefore, the manipulation of oil prices - beyond a certain threshold - could indeed be justified if it prevented a recession.
Could market manipulation obscure price signals? In a demand-driven model, absolutely. If the government establishes a too-low price for, say, televisions, then fewer televisions will be manufactured and sold. However, oil shows every sign of being supply-constrained. Why do we think this? From 1995-2004, oil and gas companies invested $2.4 trillion in upstream exploration and production activities, and the oil supply increased by 12.3 million b/d, about 15%. From 2005-2010, the pace of investment picked up, again $2.4 trillion, but now in only six years, rather than ten. And the oil supply not only failed to increase, it declined. Thus, high oil prices from 2005 did not elicit additional supply. Market signals were ineffective. Further, most incremental oil supplies - Alaska, gas-to-liquids, shale oils, oil sands, deepwater offshore, pre-salt Brazil and others - are all viable at $65 or less. Therefore, $125 oil is unlikely to elicit a materially greater response than, say, $85 oil. While price manipulation may adversely affect economic activities with an elastic supply response, in the case of oil, prices are so high that they can be reduced without endangering oil production, on the one hand, while mitigating macro-economic risk, on the other.
US Crude Oil Expenditure as a Percent of GDP
Source: EIA monthly data, NBER, BEA, Bloomberg, Douglas-Westwood analysis
Would market manipulation expropriate producers like the oil companies? Undoubtedly it could limit the maximum upside. But the Great Recession is not warmly remembered in Houston, either. Uncontrolled oil prices are not free; they lead to recessions, and the profits earned in hot markets may be ceded during downturns. And psychologically, recessions are unpleasant. They create stress and uncertainty, even for those who have retained their jobs. Companies are entitled to advocate their own interests. But policymakers need to keep the bigger picture in mind.
Then there is the fear that any designated SPR decision-making body could be incompetent and politicized. This is certainly a risk, and many in the oil industry believe the Administration‘s energy policy team lacks sufficient depth or interest in oil, and frankly is committed to shutting down the industry to the extent possible. As such, pro-energy factions distrust Washington to install appropriate leadership to guide any possible deployment of the SPR. With the rise of a Republican-controlled House, this risk is diminished. But clearly, the institutional setting and leadership of any body setting SPR strategy need an appropriate framework, which involves competent persons with industry experience, at a minimum.
Finally comes the criticism that it would not help anyway, that oil price reflects market fundamentals, and a short-term intervention is bound to fail. But is this right? Just three months ago, the EIA was confidently asserting that there was plenty of spare capacity. And indeed, in its March Short Term Energy Outlook, the EIA shows 4.1 million b/d of spare capacity - almost all of it in Saudi Arabia. Are fundamentals then driving oil prices, or is it merely a fear premium associated with turmoil in the Middle East and the loss of Libya‘s output? If it is the latter, then does it make any sense to risk an oil shock merely on principle?
Or perhaps the Saudis will withhold production. The difference between $90 a barrel - a sustainable level for the US - and recent oil prices of $125 a barrel is $300 million per day in increased oil revenues to Saudi Arabia. Procrastinating for just three days is worth a billion dollars to Saudi Arabia. Is there a mortal on the planet who could resist such temptation? Can we reasonably expect the Kingdom to act so decisively against its own interest? On the other hand, if prices continue to increase, Saudi Arabia in a short time will come to be seen by public as a price gouger, loathsome, and an enemy of the people of the United States. In such an event, Saudi leadership may find, in the event of domestic uprising, that public opinion in the US will not countenance the protection of the Saudi ruling family, regardless of the inclinations of the US Administration. So how should we manage our relationship with Saudi Arabia?
Indeed, do we even have a thesis on oil markets and recession? If so, where is that housed in the government? Who is the government expert coordinating oil markets, economic management, and oil diplomacy? Does the function even exist?
I fear it does not, for the simple reason that there is no institution designated to manage oil-shock risks. Under Secretary Chu, the Department of Energy is more interested in electric cars than oil shocks and, in any event, lacks the muscle to address macro-economic considerations and drive policy. The Federal Reserve has both the intellectual firepower and institutional capacity to drive policy, but it does not control the SPR, nor does it have an institutional oil markets capability. Indeed, the Fed does not appear to have a firm thesis about oil markets. Thus, we hear detailed discussions on quantitative easing and whether it should be continued or suspended subject to a series of indicators; but the Fed is all but mute in the face of a possible oil shock, a far more menacing threat to the economy. Has the Fed prepared a budget or macro-economic outlook assuming an oil shock in the coming months? Does the Fed believe the global economy can be held together with oil prices on current trends? If oil prices are virtually unsustainable with 4 million b/d of spare capacity, what will they be when capacity runs out in 2012 or 2013? Has the Federal Reserve suggested revisions to the national budget in this light? Or is it leading us blindly into the next recession just as it did with housing and subprime mortgages in the last?
And if the SPR were deployed, what should be the means? How many barrels should be sold? For how long? At what price? How will we know if we are succeeding? How should we coordinate with other holders of oil reserves like the EU and China? Should we coordinate at all or go it alone? How should we coordinate with Saudi Arabia? Do we ignore them or collaborate?
The issue is not merely one of deploying the SPR. It is one of creating a capability to understand oil-market dynamics and react appropriately to protect the economy. These may involve interfering with markets, and consequently proper safeguards should be installed to insure sound management and limit intervention to only those periods when the economy is materially at risk.
But these steps are easily accomplished. There is no reason to fatalistically accept the inevitability of an oil shock unprepared and in ignorance. We can do better than that.
In the end, decision-makers need to understand that oil markets will likely blow up the global economy again, and soon. It may occur as soon as the summer, or perhaps later. But when the oil shock and the companion recession arrive, voters will surely hold politicians accountable, just as they did in 2008.
Steven R. Kopits heads the New York office of Douglas-Westwood, energy business consultants. The firm assists energy service providers with market research, strategy development and commercial due diligence.