The Politics of Oil

07/08/2011 7:30 am EST

Focus: MARKETS

Elliott Gue

Editor and Publisher, Energy and Income Advisor and Capitalist Times

While there may be a rationale for releasing oil from the Strategic Petroleum Reserve, it's largely a political game in the US and Europe, notes Elliott Gue of Personal Finance.

On June 23, the International Energy Agency (IEA) announced that it would release 60 million barrels of oil held in strategic government reserves over the next 30 days, a pace of roughly 2 million barrels per day.

These reserves are oil held in storage as a supply cushion, in the event of an emergency or prolonged supply disruption.

Of the 60 million barrels to be released, the US will sell 30 million barrels over the next month from its Strategic Petroleum Reserve (SPR). The remainder will be spread out among the remaining 23 members of the IEA.

Disruptions to Libyan oil exports, because of the country’s civil war, have tightened the supply picture in the EU. Even if the conflict is resolved, it will take time for Libya’s oil exports to return to 1.5 million barrels per day. Operators must rebuild the country’s infrastructure, and evacuated foreign oil workers will need to relocate to the country.

The supply disruption stemming from Libya’s civil war is the sort of emergency that these IEA petroleum reserves were created to address.

But the timing of this announcement caught oil markets by surprise, and sent crude prices tumbling by as much as 5% in the immediate aftermath of the news.

At first blush, 2 million barrels per day of oil supply isn’t much, in the context of a market of almost 90 million barrels per day. But this is a meaningful quantity of oil when you consider:

  • the Libyan supply disruption amounts to 1.5 million barrels per day
  • total global spare capacity—the amount of oil that could be brought on stream by OPEC, but is not currently under production—stands at about 4 million barrels per day

The oil market's supply-demand balance is tight, so a relatively small shift in supply can have a real impact on prices.

The IEA’s plan to evaluate the effectiveness of this move in a month's time also should help cap prices for the balance of the summer, because it leaves the door wide open to further releases from strategic inventories if prices fail to respond.

And don't forget that oil prices, alongside other major commodities, had already slipped after a prolonged stretch of weaker-than-expected economic releases. Prior to this development, I had called for oil prices to trade sideways at best because of economic weakness.

However, over the intermediate and long term, this news is extremely bullish for crude oil, and underpins my view that the global market is far tighter than most investors imagine. I still expect crude oil to top its early 2011 highs by late 2011 or early 2012. Here are some points to consider…

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The timing of this move is political. President Obama's approval ratings have undeniably been hit by rising oil and energy prices. The truth is that global oil prices are for the most part beyond the control of any President, but the person in office—Democrat or Republican—gets to take credit for a good economy, and gets blamed for a poor economy.

The most important thing is that the president wants to appear to make an effort to lower oil prices, to support economic growth and reduce unemployment. The desire to be proactive is undoubtedly a factor in the administration's shifting opinion of deepwater drilling in the Gulf of Mexico.

President Obama also wants to be seen as helping Americans at the pump ahead of summer driving season. Never forget that 2012 is an election year in the US. Even if the SPR release provides only a temporary respite for consumers, this move may allow the Obama administration to take some credit for the recent drop in retail gasoline prices in the US.

Europe needs this more than the US. Although US oil prices are up year-over-year, EU oil prices have been pushed up by the crisis in Libya. This is particularly true of Italy, the country that purchases the most oil from Libya.

Unlike Europe, the US also enjoys advantages in the form of less onerous regulations, a better domestic supply outlook, and ultra-cheap natural gas prices.

The coordinated US-IEA response looks like it may have been driven partly by EU governments’ desire to keep prices down this summer and cool inflation, a major concern for the European Central Bank.

Also, remember that several EU nations have scheduled elections over the next couple of years. This move could provide the incumbent parties with a boost at the polls.

The oil market is tighter globally than anyone wants to admit. In the IEA's most recent Oil Market Report (OMR), the agency predicted that global oil demand in 2011 will rise by 1.3 million barrels day compared to 2010 levels—that's on top of an increase of 2.8 million barrels per day in 2010.

According to the report, production from non-OPEC nations will increase by about 560,000 barrels per day, roughly half of the amount it grew in 2010. (Non-OPEC supply growth has been revised of late, because of weather-related disruptions to US production.)

That leaves almost 750,000 barrels per day of additional demand that needs to be met through either existing inventories of crude in storage, or more OPEC production. And OPEC's production capacity is already stretched by the loss of Libyan output.

To make matters worse, we're entering a seasonally strong period for demand. The IEA stated that global oil demand will increase by 1 million barrels per day between the second and third quarters of this year alone. This is due to the seasonal ramp in supplies that coincides with the summer driving season in the Northern Hemisphere.

Projections from the IEA and the US Energy Information Administration showed that without significant additional OPEC supplies, global commercial oil inventories would decline sharply through the summer due to the ramp-up in demand. Global oil inventories will have thinned substantially by the fourth quarter.

In short, the decision to release 60 million barrels of oil from global reserves is partly a political move designed to bring down oil prices ahead of the summer driving season. That may work over the next few weeks.

But the more important point is that it reflects how tight the global oil market has become. Meeting global oil demand growth will require an unacceptable decline in global spare capacity.

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