Date: 04/04/22
Author: Kent Moors, Ph.D.
At the end of last week, crude oil prices were declining faster than at any point in the last two years. By Friday’s close of trade (2:30 pm Eastern for oil and other commodities), both major benchmarks were accelerating a move downward.
WTI – West Texas Intermediate, the standard for futures contracts cut in New York – had recorded a decline of 6.38 percent for the current rolling week daily average (adding the most recent closing value, deleting the earliest), a much more pronounced 13.48 percent dive for the monthly equivalent. Brent – the most often used international yardstick set daily in London – posted retreating figures of 7.26 and 11.4 percent, respectively.
Some of this decline was a result of a pause in ongoing hostilities from the Russian invasion of Ukraine. But two other factors contributed to the reverse. First is the possibility of Iranian oil moving back into the market, along with Washington discussions of additional supplies from Venezuela. Second is the Biden Administration’s decision on Thursday to tap the Strategic Petroleum Reserve.
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All of this is unfolding against a backdrop signaling that the price was too high to begin with. Here, I use my Effective Crude Price (ECP), a proprietary algorithmic addition that calculates the actual market price of crude oil once shorts, derivatives, artificial supply moves, and other outliers are removed. There is always something that offsets a true reading. That is, the market never provides a pure ECP reading.
Nonetheless, ECP has consistently indicated a published crude oil price that is much higher than what the underlying market factors would warrant. The latest run concluded this weekend still registered ECP figures lower than those flashing on your TV screen. WTI came in at $84 a barrel; Brent at $87. That is 15.5 and 16.7 percent, respectively, below the posted market price.
Now some of this spread is a result of continuing concerns over Russian supply draining from trade following Western sanctions and increasing European commitments to cut dependence on Moscow for energy. Additionally, the rising tide of Civil War in Libya is reducing expected available supply.
On the other hand, OPEC+ (OPEC plus primary outside producers headed up by Russia) increased supply of 432,000 barrels a day will hit in May, along with some indicators that various member states are already tacitly exceeding volume limits.
Recall that the acceleration in oil prices has nothing to do with a corresponding rise on global demand. This is all about the geopolitical risk factor’s effect on supply. And when it appears that hostilities are abating so also does the upward pressure on prices.
The second factor is injected by observers but has little of an immediate impact. There does seem to be some movement in returning to the JCPOA (Joint Comprehensive Plan of Action) framework agreement. JCPOA was signed by Iran, the five permanent member of the UN Security Council (the US, UK, France, Russia, and China), Germany, and the EU in 2015. It provided for a pullback in Iranian moves toward nuclear arms in return for the ending of Western and UN sanctions against Teheran.
Trump unilaterally withdrew the US from JCPOA in 2018, but all other members continued to abide by the provisions until Iran began again to purify fuel last year. Resumption of the accord would allow a large amount of Iranian crude back into the market, a development that would certainly introduce a significant downward pressure on oil prices.
The corollary on this situation is the ongoing American talks with Venezuela about renewing supply. Now Washington has been in opposition to the Maduro administration in Caracas for some time, even briefly sponsoring an ill-thought-out parliamentary opposition during the Trump era.
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As that crisis has receded in public view of late, there has been an interesting quiet pullback of US enforcement of sanctions against Caracas, and an even more intriguing allowance of both increasing Venezuelan crude exports and imports of lighter oil (needed to mix with the heavy oil extractions from the Orinoco basin). Some of these latter consignments are from Iran.
Until recently, knowledgeable folks in my network have concluded that, in the absence of any genuine alternative, Washington has concluded keeping the current Maduro government afloat is preferable to an economic meltdown that would prompt a bloody insurrection casting the region into turmoil.
These days, some believe the situation can be turned to provide the US market some ready additional sourcing of lower-priced oil. Yes, we can meet the demand requirements using more pumping from domestic fields. But that will be at a higher price and result in additional costs at the pump.
Remember, in a democracy, gasoline prices vote.
All of the talk surrounding Iranian or Venezuelan crude coming into the market makes for some creative discussions. But this will have nothing to do with the current pricing situation. Any renewal of JCPOA or additional Caracas crude remain medium-term outliers. Neither will have more than a modest impact on pricing, and only then in the calculus used by traders in setting futures contracts more than six months out.
That leaves the decision to tap the SPR.
I discussed the nuances of the move on Friday in my weekly market reviews for Sigma Trader and PRISM Profits members. In an extended analysis, I wrote then that:
The White House has announced a decision to release up to one million barrels of crude from the national Strategic Petroleum Reserve (SPR) each day for the next six months. The up to 180-million-barrel move is expected to be paralleled by a between 30- and 50-million-barrel total from reserves held by other allies.
There is already considerable misinformation circulating about the impact of this action. Therefore, today I have decided to explain what the SPR does in addition to the likely impact of this recent decision.
The announced move is by far the largest drawdown in the 50-year history of the SPR. However, even if the total commitment of 180 million barrels is extracted it would account for less than 30 percent of what the SPR currently holds (some 605 million barrels) and less than 25.3 percent of its capacity (714 million barrels).
Additionally, when there are drawdowns – such as the 50 million barrels removed last November or amounts taken in the past to offset losses of volume resulting from hurricanes, other natural disasters, or major oil product pipeline bottlenecks (the most recent being acute processed oil product, especially diesel, shortfalls in the Northeast) – the SPR can be replenished via additional purchases from domestic producers.
Concerns now being addressed by some talking TV heads that taking too much out will adversely impact the system’s ability to serve as a strategic buffer simply do not understand how the SPR operates. If necessary, the volume taken is simply replaced with oil bought from US producers … and at premium prices. This last aspect explains why there is little opposition from American operating companies each time the SPR is tapped.
Created in 1975 after the Arab oil embargo, the SPR comprises four “salt dome” locations in the Gulf of Mexico region near to the preponderance of American refinery installations. After the embargo was imposed in October 1973, the price of a barrel of oil increased some 400 percent, gasoline prices spiked, and the US faced its first fuel shortage since World War II.
It is intended to “alleviate the effects of unexpected oil supply reductions.” According to regulations as explained by the US Energy Information Administration (EIA), oil can be released from the SPR under four conditions: emergency drawdowns, test sales, exchange agreements, and nonemergency sales.
Emergency drawdowns and test sales are relatively rare. The most recent emergency drawdown occurred in 2011 in response to production disruptions in Libya, and the most recent test sale occurred in 2014. The SPR has released crude oil under exchange agreements 13 times since 1996, most recently after Hurricane Ida. In these exchange agreements, crude oil is released to private companies and repaid in kind by specified dates with additional barrels, similar to monetary interest on a loan.
Congress has also authorized nonemergency sales of SPR crude oil to respond to lesser supply disruptions or to raise revenue for the US Treasury. For example, the Fixing America’s Surface Transportation Act, passed in 2015, and The Bipartisan Budget Act of 2018 collectively called for the sale of more than 160 million barrels of crude oil from the SPR in Fiscal Years 2022 through 2027.
The last time a SPR tap resulted from geopolitical tensions occurred during the 1991 Gulf War.
Once extractions are called for by the US President, it takes about 13 days for the oil to go out for delivery. That means the first of the daily barrels involved in the current action will hit the market near mid-May.
Will it have an impact in reducing prices at the pump? Probably, but not by much. Putting the matter in perspective, the 1 million barrels a day will comprise about 5 percent of daily US oil consumption (according to government figures for 2021 that amounted to a little less than 19.8 million barrels a day).
When we were last faced with a drawdown, I made the following comments in Classified Intelligence Brief (“Why Releasing Oil from the SPR is Not a Solution,” Classified Intelligence Brief, November 26, 2021):
In the current example, this is an all too transparent attempt to meet one of the main ingredients in rising inflation. After all, with supply chain disruptions meaning just about everything associated with the holidays is going to be costing more, it would seem a good idea to reduce the price of driving to shop for all of that.
There are basic reasons why the SPR release will fail. One is the aggregate [of US and allied releases] amounts to little more than half a day of global demand. My demand estimate is a bit lower than those of the International Energy Agency (IEA) or the US Energy Information Administration (EIA). Still, my global demand figure comes in at slightly more than 104 million barrels a day.
Another shortfall is that the amount will be released over several weeks. The US 50 million, for example, will not be available for 13 to 14 days after the decision is made. There is a similar time delay for other nations involved in the move.
However, the most important reason reminds me of the last time I was personally dealing with this matter. That was in 2011, the Obama Administration was releasing a smaller volume from the SPR in league with a consortium of 26 other countries. The issue then was rising prices coming from lower overall crude supply in the international market. That, in turn, was resulting from a civil war in Libya.
I was at the time in Athens advising the Greek Finance Ministry in the depths of a debt crisis. A part of that was processing information surfacing that derivative paper cut on Greek debt was being used as collateral in European-based crude oil futures contracts.
I was pressed into commenting on the impending Obama SPR release while at the same time trying to avoid being drawn into a widening Greek political mess. After all, I was not there to blame some paper cutters on the Continent for the depths of a financial morass largely of Greece’s own making. Unfortunately, the minister I was advising threatened to do so at a press conference anyway with a statement that began “As we have just been advised by Dr. Moors…”
So much for my global reputation.
I dodged the bullet, but what I reminded the media then still holds now. It is the single biggest impediment to using reserve releases as a main weapon against rising oil prices and the single most misunderstood element in the pricing process.
It is all about how crude oil prices are set. This involves the difference between futures contracts (or “paper” barrels) and the genuine oil commodity in trade (the “wet” barrels).
Normally on any given day, there are far more paper than wet barrels in trade. That is because the future contracts are entered into as an investment. The holder seeks to make money on the difference between what she paid for the contract and what it commands when it is sold prior to expiration. The holder has no interest in owning the underlying oil itself.
Meanwhile, the wet barrel involves real oil being bought made available to real end users in the market. As the expiration of the futures contract (that is, as the date for the sale of the physical oil) approaches, market players on both sides will utilize a series of options and other derivatives to arbitrage the two prices (paper and wet) so that they converge on the sale date. The more volatile the market environment, the more difficult the arbitrage becomes.
Most of the setting of oil prices, on the other hand, is a function of the paper barrel (the futures contract). And that results in the maker of that contract having to be especially attuned to where the price of the underlying oil is going. She will also utilize options to hedge against possible losses should the underlying price swing more than expected.
Here is the key to why SPR releases will have only very short-term and marginal impact. The released volume from reserves is factored in on the supply side when the cutter of the futures contract determines the target price of the contract.
The trader will normally price a contract pegged to the expected cost of the next available barrel. If the supply/demand dynamic is moving prices up, the trader will emphasize the pricing spread to the expected cost of the most expensive next available barrel (since that is the direction in which the greatest threat to her profits is moving) and set a contract strike price accordingly. Should the trend be in the other direction, the trader weighs more heavily toward the least expensive next available barrel. Once again, call and put options are used to narrow possible losses.
The important point – in today’s discussion of how SPR releases impact market price as well as my discussion of what happened in 2011 – is this. As soon as an SPR release is made it is no longer an outside force on market dynamics (as a threat of the release had been). It is now part of the volume on the physical supply side itself.
For the SPR to have a longer impact, there must be recurring releases. Otherwise, the trader reverts to the earlier contract formula used, ignoring the SPR altogether. The reliance on reserves does nothing to change the underlying pricing mechanisms in the market. It simply introduces an artificial outlier that disappears as soon as there is an end to the release(s).
As a symbolic gesture, an SPR release may reveal a government’s resolve. But as a genuine tool for reversing the price witnessed at the pump, it is a nonstarter.
OK, much of the above still applies. The outlier this time around involves the six-month length of time committed to the SPR drawdowns. Neither the market nor oil traders have been confronted by such a long period in the past. While this may well set a more ongoing cap on where those cutting futures contracts are prepared to put the price of crude, it is also not likely to have a decisive impact on appreciably bringing down the cost of gasoline.
Remember, all of this is impacting the supply side of the equation. Yes, there will be more crude volume available for processing. But unless OPEC+ chooses to expand upon its already declared increase of about 432,000 barrels per day set to hit next month, there will be little genuine impact at US gasoline pumps aside from the restraining of further major increases.
Dr. Kent Moors
This is an installment of Classified Intelligence Brief, your guide to what’s really happening behind the headlines… and how to profit from it. Dr. Kent Moors served the United States for 30 years as one of the most highly decorated intelligence operatives alive today (including THREE Presidential commendations).
After moving through the inner circles of royalty, oligarchs, billionaires, and the uber-rich, he discovered some of the most important secrets regarding finance, geo-politics, and business. As a result, he built one of the most impressive rolodexes in the world. His insights and network of contacts took him from a Vietnam veteran to becoming one of the globe’s most sought after consultants, with clients including six of the largest energy companies and the United States government.
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