So Just What is the Strategy of the Strategic Petroleum Reserve?

Today’s WSJ online has a short piece quoting Daniel Yergin counseling against tapping the Strategic Petroleum Reserve in response to Mideast turmoil. Yergin argues that it is desirable to keep the stockpile untouched as a hedge against the possibility of worse disruptions in the future. Insofar as commercial storage is concerned, economic theory highlights two factors that are relevant in determining the optimal timing of adding to or drawing from inventories. My forthcoming book goes into these factors in detail.

The first is that it is optimal to draw down on storage in response to adverse supply shocks that are expected to be transitory. This means that current supply is below expected future supply, making it less desirable to hold inventories to meet future consumption needs. Well-functioning markets move things from where they are relatively abundant to where they are relatively scarce. A temporary supply shortfall means that the present has become more scarce, relative to the future, making it desirable to shift some consumption from the future to the present. When some inventories are available, this intertemporal shift can be achieved by drawing down on stocks.

In contrast, supply shocks that are expected to persist should have minimal impacts on storage decisions as such shocks do not affect supply today relative to what is expected in the future. Since scarcity today relative to future scarcity isn’t affected by a highly persistent shock, there is little or no need to change inventory to move consumption from the future to the present.

The second factor is uncertainty about fundamentals. Inventories are in part a hedge against uncertainty about future demand and supply conditions, a buffer against adverse supply or demand changes in the future. An increase in uncertainty about future supply increases the precautionary demand, leading to an increase in inventory holdings. This is the factor that Yergin emphasizes, and which I analyze in detail in chapter 5 of the forthcoming book.

In the current situation these considerations are in conflict. It is likely that the effect of the effect of the loss of Libyan production will be relatively transitory as this production will be brought back on line when the situation, which appears to be reaching a climax, stabilizes, and because other suppliers, notably Saudi Arabia, have pledged to expand output. This would tend to cause a decline in inventories. On the other hand, the risk of future supply disruptions—not excluding major disruptions in Saudi Arabia—has increased dramatically. This would tend to lead to an increase in inventories.

Movements in the forward curve suggest that the first effect is dominating. The contango in WTI has declined and Brent has also moved into a backwardation. The WTI curve has become slightly humped at the short end. Such moves are associated with declines in inventories.  That said, the effect of the increased uncertainty has probably led to smaller stock drawdowns.

The foregoing relates to commercial storage decisions. SPR is not operated on a commercial basis. That said, it would probably make sense to take commercial considerations into account when making storage decisions, if only to reduce the cost to the taxpayer. The fact that SPR is not operated on commercial principles, but is a political animal with difficult to predict decisions likely has some feedback effects on commercial storage decisions; with respect to politics, some, such as MA Rep. Markey, are calling for the SPR to release supplies into the market. Commercial storers have to take into account their expectations about SPR actions when deciding how to make their own storage decisions.

It would seem to be very hard to predict what SPR will do given its political-military nature. Clarifying SPR’s operational methodology would assist private parties to make rational storage decisions that would assist in reducing price volatility.

About Craig Pirrong 223 Articles

Affiliation: University of Houston

Dr Pirrong is Professor of Finance, and Energy Markets Director for the Global Energy Management Institute at the Bauer College of Business of the University of Houston. He was previously Watson Family Professor of Commodity and Financial Risk Management at Oklahoma State University, and a faculty member at the University of Michigan, the University of Chicago, and Washington University.

Professor Pirrong's research focuses on the organization of financial exchanges, derivatives clearing, competition between exchanges, commodity markets, derivatives market manipulation, the relation between market fundamentals and commodity price dynamics, and the implications of this relation for the pricing of commodity derivatives. He has published 30 articles in professional publications, is the author of three books, and has consulted widely, primarily on commodity and market manipulation-related issues.

He holds a Ph.D. in business economics from the University of Chicago.

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