Paul Horsnell

Research Associate

Paul Horsnell, is Global Head of Commodities at Standard Chartered Plc. He was previously Managing Director and Head of Commodities Research at Barclays Capital, the investment banking division of Barclays Bank plc. Dr. Horsnell joined Barclays Capital in 2003 from JPMorgan where he was Head of Energy Research. Prior to that, he was Assistant Director for Research at the Oxford Institute for Energy Studies and a Research Fellow in Economics at Lincoln College, Oxford University. He is the author of Oil in Asia, and (with Robert Mabro) Oil Markets and Prices: The Brent Market and the Formation of World Oil Prices. He holds a degree in Philosophy, Politics and Economics, and a doctorate in Economics, both from Keble College, Oxford.

Contact

WP_Query Object
(
    [query] => Array
        (
            [post_type] => publications
            [posts_per_page] => -1
            [meta_query] => Array
                (
                    [0] => Array
                        (
                            [key] => author
                            [value] => 14537
                            [compare] => LIKE
                        )

                )

        )

    [query_vars] => Array
        (
            [post_type] => publications
            [posts_per_page] => -1
            [meta_query] => Array
                (
                    [0] => Array
                        (
                            [key] => author
                            [value] => 14537
                            [compare] => LIKE
                        )

                )

            [error] => 
            [m] => 
            [p] => 0
            [post_parent] => 
            [subpost] => 
            [subpost_id] => 
            [attachment] => 
            [attachment_id] => 0
            [name] => 
            [static] => 
            [pagename] => 
            [page_id] => 0
            [second] => 
            [minute] => 
            [hour] => 
            [day] => 0
            [monthnum] => 0
            [year] => 0
            [w] => 0
            [category_name] => 
            [tag] => 
            [cat] => 
            [tag_id] => 
            [author] => 
            [author_name] => 
            [feed] => 
            [tb] => 
            [paged] => 0
            [meta_key] => 
            [meta_value] => 
            [preview] => 
            [s] => 
            [sentence] => 
            [title] => 
            [fields] => 
            [menu_order] => 
            [embed] => 
            [category__in] => Array
                (
                )

            [category__not_in] => Array
                (
                )

            [category__and] => Array
                (
                )

            [post__in] => Array
                (
                )

            [post__not_in] => Array
                (
                )

            [post_name__in] => Array
                (
                )

            [tag__in] => Array
                (
                )

            [tag__not_in] => Array
                (
                )

            [tag__and] => Array
                (
                )

            [tag_slug__in] => Array
                (
                )

            [tag_slug__and] => Array
                (
                )

            [post_parent__in] => Array
                (
                )

            [post_parent__not_in] => Array
                (
                )

            [author__in] => Array
                (
                )

            [author__not_in] => Array
                (
                )

            [ignore_sticky_posts] => 
            [suppress_filters] => 
            [cache_results] => 1
            [update_post_term_cache] => 1
            [lazy_load_term_meta] => 1
            [update_post_meta_cache] => 1
            [nopaging] => 1
            [comments_per_page] => 50
            [no_found_rows] => 
            [order] => DESC
        )

    [tax_query] => WP_Tax_Query Object
        (
            [queries] => Array
                (
                )

            [relation] => AND
            [table_aliases:protected] => Array
                (
                )

            [queried_terms] => Array
                (
                )

            [primary_table] => wp_posts
            [primary_id_column] => ID
        )

    [meta_query] => WP_Meta_Query Object
        (
            [queries] => Array
                (
                    [0] => Array
                        (
                            [key] => author
                            [value] => 14537
                            [compare] => LIKE
                        )

                    [relation] => OR
                )

            [relation] => AND
            [meta_table] => wp_postmeta
            [meta_id_column] => post_id
            [primary_table] => wp_posts
            [primary_id_column] => ID
            [table_aliases:protected] => Array
                (
                    [0] => wp_postmeta
                )

            [clauses:protected] => Array
                (
                    [wp_postmeta] => Array
                        (
                            [key] => author
                            [value] => 14537
                            [compare] => LIKE
                            [alias] => wp_postmeta
                            [cast] => CHAR
                        )

                )

            [has_or_relation:protected] => 
        )

    [date_query] => 
    [request] => SELECT   wp_posts.* FROM wp_posts  INNER JOIN wp_postmeta ON ( wp_posts.ID = wp_postmeta.post_id ) WHERE 1=1  AND ( 
  ( wp_postmeta.meta_key = 'author' AND wp_postmeta.meta_value LIKE '%14537%' )
) AND wp_posts.post_type = 'publications' AND (wp_posts.post_status = 'publish' OR wp_posts.post_status = 'acf-disabled') GROUP BY wp_posts.ID ORDER BY wp_posts.post_date DESC 
    [posts] => Array
        (
            [0] => WP_Post Object
                (
                    [ID] => 27994
                    [post_author] => 1
                    [post_date] => 2000-10-01 13:48:55
                    [post_date_gmt] => 2000-10-01 12:48:55
                    [post_content] => On 22nd September, President Clinton announced that 30 million barrels of oil would be released from the US Strategic Petroleum Reserve on a swap basis. Rather than selling the oil, as it had in 1990, the Department of Energy (DOE) would receive offers based on the volume of replacement oil to be put into the SPR between August and November 2001.

We believe that the SPR release has proved to be unfortunate for four main reasons. First, the release has been handled in a clumsy fashion. Secondly, it did not provide the best value for the DOE and the US taxpayer, and by offering a large hidden discount offered oil traders the possibility of locking in large profits. Thirdly, it was not in any way appropriate for the objective which the release was, at least in public statements, intended to achieve. Finally, it has confused the issue of what the SPR is actually for, and it has at least temporarily blunted the effectiveness of SPR release for the purpose for which it was intended. We consider these separate aspects in the four sections that follow.

1. Operational Flaws

On 4th October, the DOE announced that it had received enough bids to award the full 30 million barrels of SPR oil that was on offer. At first sight, this appeared to be quite a triumph, as many within the industry had questioned whether the full allocation would be taken up. After all, the market has been suffering from a shortage of heating oil, while crude oil availability has not really been a problem in the USA. However, the doubts set in when the list of takers was released. Eight of these eleven companies are well known oil traders or oil refiners. Three are somewhat more surprising, indeed selecting them before seeing any letters of credit seems incomprehensible. Euell Energy is a small Colorado based pipeline company, while Lance Stroud and Burhany Energy are totally unknown. To confirm that they are complete outsiders, an internet search on either Lance Stroud or Burhany Energy brings up nothing of relevance, which is, to say the least, unusual for any company with any degree of oil market experience. A total of ten million barrels, one-third of the whole SPR release, was then awarded to companies whose credentials in the context of such an operation was open to considerable question. Sure enough, on 12th October Euell Energy's award was forfeited when it failed to produce letters of credit. Lance Stroud and Burhany Energy were given more time to produce letters of credit, but on 14th October the Lance Stroud bid was also forfeited. Burhany Energy also failed to produce letters of credit. However, as they managed to pass transfer of their bid to Hess Energy, that bid stood. Bids for a total of 23 million barrels were then cleared to move to completion. The remaining 7 million barrels have been reopened for bidding, with a closing date of 23rd October and probable delivery in December. The first transfer out of the original tranche began on 14th October, with Morgan Stanley receiving, and rapidly trading on, the first part of their allocation. Lance Stroud Enterprises is a one person operation operating out of a New York apartment. Burhany Energy was incorporated just two months ago and has no oil experience. How did these companies get onto the list in the first place? Why did the DOE apparently make no background checks? One could argue that allowing all bids in the first round is simply a reflection of the desirability of encouraging free enterprise. Opportunity should exist for all, and there should be no list of the acceptable elite. Indeed, the administration has argued precisely that. According to White House spokesman Jake Siewert, "It's capitalism at work". If the process had been an auction for surplus Army office equipment I would tend to agree, after all one needs little experience to resell a photocopier. However, this was an auction for crude oil. It is difficult, indeed nearly impossible, for an outsider to handle the transfer of large amounts of crude oil without the benefit of any experience or any reputation. Counterparty risk is extremely important in the oil industry, and the original DOE list included rather a lot of it. The principle of exclusion for government auctions according to minimal thresholds is not a new one. When it comes to auctioning leases for crude oil exploration and development in federal areas, the government's Minerals Management Service maintains a list of approved bidders. Yet, when it came to an auction with a fair greater political profile, it appears that not even the most basic of criteria were applied. I would have no wish to stop Lance Stroud becoming a new Rockefeller within the natural cut and thrust of capitalism. I would, however, suggest that he cut his teeth on something less ambitious within oil trading before moving on to SPR oil. The basic sine qua non of oil trading is that the first reaction of your potential trading partners should be something other than "Who?". It is course possible that the DOE had decided to trade off one embarrassment for another. Perhaps it was thought better to announce that all the oil had been awarded and then to rescind one-quarter of it, rather than to have to announce that not enough suitable bids had not been received. Perhaps it was thought that the triumph of allocating all the oil would get big headlines, while the forfeits would get little attention. Whatever the reasoning, the whole process was lurched into a state of some disarray by the failure to make even the most basic of checks. However, the major problem behind the SPR auction is not the selection of companies of dubious suitability. The major problem is the reason why those companies were bidding in the first place. They bid because the SPR auction offered the possibility of an almost riskless cash bonanza. In seeing that, the three small companies moved faster and more intelligently than many established traders, and one must say that they therefore showed some of the most important skills to succeed in oil trading. They had done their numbers and seen the potential. As we demonstrate below, that potential proved to be in reality a windfall of just below $100 million. The real surprise of the SPR auction is that the DOE was prepared to give so much money away in order to move the oil into the marketplace.

2. Financial Naivety and Hidden Discounts

The release of SPR oil provided the chance of a risk-free cash windfall for the winners. We would estimate this handout to be at the very least $93 million, had all the initially accepted bids actually stood. The mechanism for this transfer works as follows. The taker of the oil would receive it by the end of November 2000, and then would have to provide replacement oil within a year. They would be exposed to the risk of a price fall before they took the oil, and a price rise before they replaced it. However, both risks can be hedged, and a guaranteed riskless profit locked in. Assume that the delivery from the SPR was expected in the first three weeks of November. The nearest futures contract trading at that time will be December 2000. The closing price on the New York Mercantile Exchange (NYMEX) on October 4th, (the day of the award), for December 2000 delivery was $31.24 per barrel. On the same day, November 2001 delivery closed at $28.21 per barrel. If all the SPR barrels were hedged in this way, the profit locked in would be the difference between 30 million barrels at the December 2000 price, and 31.56 million barrels (the total award to be returned to the SPR) at the November 2001 price. This results in a profit of $47 million. In addition to this $47 million, the traders receive money when they sell the oil on, or alternatively if they are also refiners they benefit from not paying cash now for the oil they are using. We must therefore add one year's interest payments to the traders' benefit. In the note at the end of this comment we value the average barrel of oil involved in the SPR release at 74 cents below the NYMEX light sweet crude oil contract. On the October 4th selling prices, (which the traders would have locked in through hedging), the value of the oil was therefore (31.24-0.74)*30 million = $915 million. Assuming a 5 per cent return on capital then adds a further amount of close to $46 million, and thus takes the total windfall up to $93 million. This a bare minimum figure, as a good trader could have achieved more favourable prices than we have used, particularly if they had taken the risk that they would get SPR oil and put the hedge in place before the announcement of bids on 4th October. Given that the conventional wisdom in the industry was that the DOE would have trouble allocating all the oil, that risk does not seem too large to have taken. To move the oil, the DOE was thus prepared to transfer at least $93 million to traders. In effect, they were prepared to discount the oil by more than $3 per barrel, which is to say the least generous. Of course, by arranging the release as a swap arrangement rather than a straightforward sale, the extraordinary degree of discounting could more easily be hidden. However, the size of that discount is also very apparent if we consider quantities. The DOE's discounting led to it accepting bids that added up to as little as 31.56 million barrels for ultimate replacement into the SPR. They would have done better, from the point of view of the US taxpayer, by simply selling SPR oil and then buying oil back in one year. We can illustrate this as following. Using the derived discount of SPR oil from the futures price, above we derived a value of $915 million on 4th October. Assuming that this capital achieved a 5 per cent return over the year, and dividing the total by the November 2001 delivery price as of October 4th, (which the DOE could have locked in by hedging) minus the SPR quality adjustment, produces the figure of exactly 35 million barrels. The DOE could then have achieved the same result, but added 5 million barrels instead of 1.5 million barrels to the SPR without incurring risk. They forfeited the opportunity of getting an extra 3.5 million barrels. Valuing those 3.5 million barrels at the November 2001 price as of October 4th, (i.e. the price that could have been locked in) minus the quality adjustment, produces another value for the DOE's total discount. Our previous calculation put it at $93 million. Using this alternative 'foregone quantity' measure produces a comparable figure of $96 million. On both calculations the DOE are seen to have in effect discounted the oil by more $3 per barrel, on one calculation by $3.10 and on the other $3.20. By using the swap mechanism they had in effect put the true size of the discount somewhere where auditors are less likely to pick it up. Had the DOE decided to take risk and believed that NYMEX prices one year from now will be lower than $28.21, then they might have expected to have done even better in terms of replacement quantities. In the event, the DOE has actually taken on risk with regard to replacement of SPR oil. The bids from the companies contained bonus percentages, which stipulated the extra bonus oil the SPR would receive should prices have fallen by next year. As these details have not been made public, it is impossible to quantify them. However, it is impossible that they would have resulted in the SPR receiving more oil in the case of price falls than if the DOE had mounted the operation themselves, or at least it would have not been commercially rational for a company to make such a bid. The above shows that the discount is in fact totally transparent when the calculations are made. It has, however, certainly not been presented so transparently in coverage of the SPR auction to date. One does however suspect that if the original announcement of successful placement by the DOE had included the admission that a discount of more than $3 per barrel compared to the fair market value had been given, then some pertinent questions would have had to be answered.

3. The Impossibility of the Stated Objective

The SPR release was designed to reduce the impact of potential heating oil price spikes in the US northeast. According to Energy Secretary Bill Richardson, 'We need to make sure that American families keep warm this winter'. As rhetoric it may sound laudable. The problem is that SPR release can not have any appreciable effect on heating oil availability in current circumstances. To increase the availability of heating oil by providing more crude oil would simply require that refiners produce more heating oil. The problem is that US refiners are already at close to full capacity, and hence there is virtually no slack within the system to produce more. One could add that spare space within the key oil product pipelines to the northeast is extremely limited, so it might be difficult to transport the oil even if it could be produced. If there was any theory behind the release, it would be that providing SPR oil would reduce the price of crude oil relative to that of oil products, increase refinery profitability and hence provide an economic signal to refine more oil. It has failed because that signal was already there, refiners were already maximising production. The refining industry has for a long time been an extremely low return business, and therefore one should not begrudge them the potential for increased profits that SPR release provides. On the other hand, a government strategy which is designed to increase heating oil quantities but instead just leads to changes in profits can hardly be thought of as a success. The connection with heating oil availability seems even stranger when we consider the DOE's own idea of the overall impact of SPR release. According to the Winter Fuels Outlook 2000-1, published by the Energy Information Administration (EIA) of the DOE, 'EIA estimates that average distillate stock levels this winter will be about 3 to 5 million barrels above where they would otherwise have been had the President not ordered a swap of 30 million barrels of oil from the Strategic Petroleum Reserve (SPR)'. The logic behind this is that the SPR release will lead to a displacement of 20 million barrels of oil imports that would have come into the USA. The 3 to 5 million barrels of heating oil stock increase is the, rather optimistic, expected yield of heating oil from the remaining 10 million barrels, (the yield of US refineries for all oil distillates was about 25 per cent in September). One could argue that in a backwardated crude oil market, (i.e. where prompt prices are above those for future delivery and hence where companies have no incentive to hold excess crude oil inventory), when refiners had no spare capacity to refine more, the provision of 30 million barrels of SPR oil would reduce imports by a full 30 million barrels and not the EIA's 20 million barrels. To force an extra 10 million barrels through the refining system over a month requires capacity utilisation rates to rise by what might seem a trivial 2 per cent. However, the capacity utilisation rate at the time of the release announcement was already 97.5 per cent. The EIA quote together with our earlier analysis then implies that the US government is willing to transfer nearly $100 million to traders in order to attempt to increase heating oil inventories by just 3 to 5 million barrels. We believe that in the best possible case the increase would be just 2 million barrels. Those barrels then begin to look extremely expensive. At current prices, they would cost $40.50 per barrel on the wholesale market, and then the tax payer would be paying a further $46.50 per barrel through our calculation of the SPR auction transfer to traders. If we were to take at face value the government statement that the SPR release was intended to increase heating oil availability, then we would have to conclude that the result is just 2 million barrels that in effect would cost the US economy $87 per barrel. To put the 2 million barrels volume in context, US total distillate inventories for the second week of October stand 30.1 million barrels lower than they did in 1999. The expected SPR improvement makes very little impression on this, even if it actually managed to increase inventories by the full 3 to 5 million barrels. The absurdity of giving away so much to achieve so little is illustrated by the following. For the amount of the transfer given to traders in the SPR auction, the DOE could have gone to Europe, bought 2 million barrels of heating oil, transported it across the Atlantic and then given it away to consumers absolutely for free. Absurd of course, but no more expensive and producing no less extra volume of heating oil than what was actually done. In reality, it appears that the government intended the SPR release to serve more of a political purpose than an oil market purpose. Note the size of the release. The gap between heating oil inventories at the time of the release announcement and the levels from one year ago was 30 million barrels. The choice of 30 million barrels for the SPR release, rather than any other amount, then appears suspicious. It looks all too tempting to try to run through public opinion the fallacious argument that heating oil was 30 million barrels down on 1999 so the government released 30 million barrels of oil to cover for it. The heavy hand of political expediency seems to be at work, for, as the EIA's report shows, the DOE itself was in doubt that SPR release would be of little usefulness in terms of its stated goal.

4. Bad Timing

The SPR release has created considerable confusion as to whether the purpose of the SPR has changed. The justification for the release in terms of heating oil availability implies micro-management of the oil market. If we accept that the official justification was just a smokescreen, and on the basis of the previous section we must, we have to conclude that the SPR has been used for a combination of internal US political reasons, and as an attempt to directly manage world oil prices. The question is then raised as to the extent to which the USA wishes to become an overt participant in the determination of prices. A precedent has now been created that the active use of the SPR is a valid policy instrument far beyond the SPR's original supply security aims. As such, that is a dangerous precedent. At times such as the present, when OPEC members and the USA all wish to take some of the heat out of the market, it may not appear too problematic. It is, however, not at all difficult to imagine circumstances under which the US view would conflict with the OPEC view. The possibility of the USA, through use of the SPR, attempting to counteract the impact of OPEC policy decisions would take us into untested, and potentially hazardous waters. The use of the SPR may just prove to be an aberration brought on by the proximity of the US elections. However, it has muddied the waters sufficiently to raise questions over what precisely the role of the SPR now is. It has shown that the SPR will be released when it is politically expedient to do so. Creating such uncertainty over something as potentially far-reaching as US oil policy can not be helpful in terms of returning the market to any form of longer term stability. In attempting to reduce price volatility, the US government may have achieved the reverse, simply by generating such a large zone of uncertainty for other policy makers and for the market in general. The SPR was intended to ameliorate supply crises, not as a buffer stock to be used to affect prices. If the US administration had known that within three weeks of the SPR announcement the Middle East situation would have deteriorated, one suspects that they would have preferred to hold back on release until it was more important to do so. Using the SPR for an objective for which it was neither intended nor capable of achieving might seem rather unfortunate given the circumstances. Foresight was impossible, but the danger of early and inappropriate use has been illustrated. The SPR release has been largely ineffectual in terms of any impact on crude oil prices. The idea of having a SPR for supply crises is that its use should be able to change the dynamics of the market significantly. That is why the reserve is so large, indeed at current prices about $17 billion of federal funds are locked up in the SPR. However, in this case the SPR has been used for peak-shaving the oil price at a time when crude oil availability is not the source of the primary oil market problems. As a result, the SPR release has had no decisive impact, and has not changed the underlying market signals. In particular, the release did not permanently remove price backwardation, the feature of prices that had been responsible for keeping inventory cover low. The impact of the SPR release on the price level was soon lost in a welter of other factors, particularly the fears surrounding the Middle East situation. The rumours of the announcement of the SPR release came close to the expiry of the October 2000 crude oil contract on NYMEX. This was probably not a coincidence, as the timing had the effect of magnifying the apparent effect of the announcement. The headline figure became that SPR release had driven prices down from $37 to $30. This is something of an exaggeration, which comes from comparing prices for October with those for November, when the former was trading $2 above the latter. To gauge the effect of SPR release one must compare like with like, i.e. just consider the prices for November delivery. A better calculation is then as follows. The November contract closed on the 20th September at $35.24. We will use that as the pre-release price, given that the $1.12 fall to $34.12 on the 21st September, the day before the announcement, was largely due to anticipation of the release. Its lowest closing price occurred on 28th September at $30.34. The maximum fall was then just $4.90. However, soon it became clear that SPR release had done nothing to help the heating oil situation. Inventory cover was still alarmingly low, and no new dynamic within the market had been set in play that might alleviate the situation. Prices began to rise again. By the end of 11th October, the day before the Middle East situation deteriorated, the price stood at $33.25, just $1.99 down from the pre-SPR release price. After that point, prices started to move with great volatility, driven by news headlines. Three weeks after the original announcement, the impact of the SPR release had become an indiscernible echo rather than any decisive intervention. The difference was that now a potentially severe Middle East crisis was beginning to unwind. We would argue that the earlier release of the SPR has blunted the ability of any immediate new SPR announcements to moderate prices. The SPR is, for practical purposes, the only effective instrument that the US government has in the oil market beyond strong-arm diplomacy. Having used it already for a purpose for which it is ill suited, it could be argued that its credibility has been undermined. In 1990, the announcement of a limited SPR release drove prices down by $15 immediately, and then kept prices down. In 2000, the impact has been limited to less than $5, and evaporated within three weeks. The SPR remains a powerful tool, which, given the current uncertainties, could conceivably be needed for its original purpose within the near future. However, its effect on the oil market arises primarily, at least in the short term, from its impact on market psychology. The psychological impact of a weapon can not be anything but reduced and distorted when it has already been used so recently and so ineffectually. When, in addition, a huge uncertainty has been created as to what the American oil weapon is actually for, how often will be it be used, who is it aimed at, and who could it be aimed at, then the overall impact is not a constructive one. NOTE : Valuing SPR Oil The notice of tender for the SPR auction detailed that a total withdrawal of 30 million barrels would be achieved by accepting bids of up to 30 million barrels for crude of West Hackberry Sweet, 30 million of Bryan Mound Sour, and 20 million of Bayou Choctaw Sour. The average API gravity and sulphur contents of the three blends are as follows ; The bids received consisted of 24.95 million barrels of West Hackberry Sweet, 3.05 million barrels of Bryan Mound Sour, and 2 million barrels of Bayou Choctaw Sour. The chemistry of blending oil is not a linear process. However, as an approximation for the average characteristics of oil in the SPR release, we can take the volume weighted characteristics of the separate blends. This produces an average quality for the release as being oil with an API gravity of 36.3 degrees, and a sulphur content of 0.48 per cent. To value this relative to West Texas Intermediate (WTI), we use the quality adjustments as laid down in the SPR tender as being those to be used for deviations of actual quality from the stated quality of each blend. These adjustments were 15 cents for each degree of API gravity, and 10 cents for each 0.1 per cent of sulphur content. The main component of the deliverable crude oils for the NYMEX light sweet contract is WTI. The quality of WTI is typically about 40 degrees API and 0.3 per cent sulphur content. We therefore value the SPR crude oil at WTI - 74 cents, (of which 56 cents is due to its lower gravity and 18 cents its higher sulphur content). [post_title] => The Strategic Petroleum Blunder? [post_excerpt] => [post_status] => publish [comment_status] => closed [ping_status] => closed [post_password] => [post_name] => the-strategic-petroleum-blunder [to_ping] => [pinged] => [post_modified] => 2000-10-01 13:48:55 [post_modified_gmt] => 2000-10-01 12:48:55 [post_content_filtered] => [post_parent] => 0 [guid] => https://www.oxfordenergy.org/wpcms/publications/the-strategic-petroleum-blunder/ [menu_order] => 0 [post_type] => publications [post_mime_type] => [comment_count] => 0 [filter] => raw ) [1] => WP_Post Object ( [ID] => 28000 [post_author] => 1 [post_date] => 2000-05-01 00:00:50 [post_date_gmt] => 2000-04-30 23:00:50 [post_content] => The broad details of how oil is priced in the world market have remained the same for more than thirteen years. Indeed, the current system has now survived for as long as direct setting of an administered price by OPEC did. The system itself may have been stable, but the past thirteen years have seen major changes in the underlying fundamentals of the oil markets, and also in the nature of oil trading. In the physical market, the pattern of world trade flows has changed. The US import gap has risen steadily, and now represents about of quarter of the volume of international trade in crude oil. Within that increase, the balance of US imports has shifted away from long-haul towards short-haul sources, and towards heavier crude oil. The Asian import gap has also risen sharply, while Europe's has contracted due to the steady increase in North Sea production. West African crude oil now occupies a pivotal position, and swings into all three of the main crude oil consuming regions according to market conditions. The changes in the physical market may have been profound, but the rate of change has been greater in oil trading. When producer countries first adopted market linked indexing as a pricing system, the NYMEX light sweet crude oil contract was only in its fourth year, and the current IPE Brent contract was still a year from fruition. Since then the volume of futures market trading has increased remorselessly, and the volume on informal markets such as forward Brent has declined. From being a novelty, futures have grown to be the dominant part of the trading system. Trade in absolute prices in spot markets was universal in the mid-1980s, now it is almost extinct and the role of price discovery in the market has moved to NYMEX and IPE. In general terms, the futures markets set the level of prices, and the physical markets set the differentials. Added to the above changes are the changes in the physical base of the main markets. In short, all three of the key world marker crude oils, WTI, Brent and, most severely, Dubai are in long term production decline. So, if the world has changed, if the nexus of trading is now the futures exchanges and if the production levels of the marker crudes are declining, does that mean that the current system of pricing crude oil is under pressure? Over the next decade or so, will it mutate through evolution, or by forceful change? Let us start with production levels. There is no unique answer as to how low production levels can go before the integrity of a market is threatened. As long as confidence is maintained, and as long as the narrowness of the production base does not lead to constant squeezes and distortion, a market can persevere. An extreme example of this is the market for Alaskan North Slope (ANS) delivered into the US Gulf. The major change in oil pricing mechanisms over the last decade has been the substitution of ANS by WTI in producer country formulae for exports to the USA. However, before this substitution occurred, the market had survived for some time with absolutely no traded physical base at all. California took an increasing proportion of ANS, and only a trickle was left to make the long journey into the US Gulf, and even that tended to be an internal company transfer rather than traded into the market. The quotation became based entirely on journalists' summaries of traders' perceptions of the price that ANS in the Gulf would be trading at, if there actually was any. It may sound bizarre, but this normally produced reasonable numbers. It is after all rather hard to squeeze a market that doesn't exist. The ANS market represents an extreme, but at least demonstrates that there is no critical lower limit on production. For WTI and Brent, production declines are in any case not of any magnitude sufficient to cause too much trouble over the next decade. The Dubai market is another story. For several years I have argued that Dubai has ceased to be a meaningful market, and has become increasingly distorted. The production decline only exacerbates the problem. What then of the idea of linking prices to futures market prices? When formula pricing began, there was a suspicion in the minds of some key producers about the nature of futures prices, and using Platt's quotations for the physical market implied a greater grounding in the physical market. The suspicions may have abated, but the most important numbers in the world oil trade remain the Platt's quotations for forward WTI and for dated Brent. In the case of the US market, there is no reason at all why NYMEX prices should not be used in formulae, indeed it would make little difference if they were. The NYMEX contract is a physical one, in that being a pipeline contract delivery can be made for the one thousand barrels volume of a single contract. What Platt's assess is the same thing, albeit in its informal forward rather than futures manifestation. The only major difference is the timing of the quote, with Platt's assessing WTI for time in the hour after the NYMEX close. One could argue that linking directly to NYMEX creates an incentive to manipulate the closing price in the frenetic last few minutes of trading, but that incentive already exists as an way of influencing the information available to the Platt's journalists. Direct pricing using futures prices would work in the USA, but would not represent any major change to the system. For Brent, however, matters are more complicated. A major feature of the Brent market is that it works extremely well as long as one does not think about it too hard. Physics may say that the bumble bee can not fly, but the bumble bee does not think about it. Financial theory would not produce a design like Brent, but Brent traders should also not think about it. The market has in general evolved more through chance than design, and IPE Brent is the one formal element within in interrelated mesh of markets. While EFP provisions can be used, the contract is not physical. It is cash settled as delivery can not be made for the standard contract volume in what is a cargo and not a pipeline market. In the USA, the futures market has supplanted the informal forward market. For Brent, the two markets are complementary, in that the futures market relies on the forward market to provide a physical grounding through the construction of the IPE index. In the USA, the near month NYMEX contract is as close as one can practically get to spot pipeline crude oil, given the logistics of pipeline scheduling. In that sense, there is no such thing as dated WTI. In Brent of course there is the problem of dated Brent. The Platt's quote for dated Brent directly or indirectly prices about two-thirds of all oil moving in international trade. Yet dated Brent is prone to chronic distortions: there is little reported trade, no trade in absolute prices as opposed to a differential, and the quote is leveraged by CFD market activity. One can not get away from the fact that the quote is often manipulated. By contrast, IPE Brent has a volume of trade around a hundred times greater, and is for all practical purposes just about impossible to manipulate sustainably. So, should the role of dated Brent be taken by futures Brent? The answer depends on how badly dated Brent is distorted. The logic of using dated Brent as an index is that with delayed pricing from time of loading, it guarantees competitiveness of long haul crude oil with short haul at the time of delivery to Europe. Moving away from this reduces that competitiveness, as the basis risk between futures and spot can be significant. On the other hand, if dated Brent is prone to wander off on its own due to distortions, then its use does not exactly pick up true spot values, and leaves both producers and refiners prone to frequent annoyance and discontent. By contrast, futures prices are highly transparent. In short, the best index is an undistorted dated Brent. Without that, to my mind both futures prices and distorted dated Brent prices are both less than ideal, but all in all one might as well use futures prices. A move to futures indexing has been in progress, advanced notably by the changes in Saudi Arabian pricing formulae for exports to Europe. However, one should be under no illusion that this represents a triumph for the market. It is a major defeat, in that it implies that self-regulation had failed in the area of pricing spot crude oil. The latter is a disaster in several ways, which is why I am always perplexed when significant oil companies distort the physical Brent market through a deliberate trading strategy. Perhaps the idea of trading as an independent and separate profit centre has just gone too far in some modern corporations. Ultimately, the power to make major changes in the oil pricing system rests solely with the major producing countries. Such changes are often discussed, and the price weakness of 1998 and early 1999 increased the depth and range of such discussions. Currently the policy of 'if it ain't broke don't fix it' still holds sway, and indeed the Saudi Arabian changes are to some extent superficial given that dated Brent still plays an explicit role. The current system can generate $30 per barrel for the producers, and it can generate $10 per barrel. The volatility in prices is related to the efficiency of output management, regardless of the system used. If the current system begins to creak, then producers have plenty of options for alternatives, and the change could be drastic. The onus is again put on major oil companies to behave responsibly, unless they wish to hasten the move back to at least a semi-directly managed method of price formation. The transition has happened several times in the past, and one should not assume that the oil market over the next decades will be immune to radical change. A version of this article first appeared in Pipeline, the magazine of the International Petroleum Exchange. [post_title] => Oil Pricing Systems [post_excerpt] => [post_status] => publish [comment_status] => closed [ping_status] => closed [post_password] => [post_name] => oil-pricing-systems [to_ping] => [pinged] => [post_modified] => 2000-05-01 00:00:50 [post_modified_gmt] => 2000-04-30 23:00:50 [post_content_filtered] => [post_parent] => 0 [guid] => https://www.oxfordenergy.org/wpcms/publications/oil-pricing-systems/ [menu_order] => 0 [post_type] => publications [post_mime_type] => [comment_count] => 0 [filter] => raw ) [2] => WP_Post Object ( [ID] => 28025 [post_author] => 1 [post_date] => 1999-06-01 00:00:09 [post_date_gmt] => 1999-05-31 23:00:09 [post_content] => Oil protectionism is back as an issue in the USA, specifically in the form of lobbying by smaller producers for an oil import tariff to help bolster the prices they receive. The true hallmark of a bad idea is that it never really goes away. When the idea is one that can serve as a totem, a flag to rally around in hard times, it becomes doubly dangerous. Then the argument becomes the following. Times are tough, something must be done, the government seems to be doing nothing, therefore we must save ourselves by getting them to do something drastic. The most obvious example of this is protectionism. It is hard to think of any industry that has lobbied for protectionism when business was going well, but easy to think of many that started lobbying when the climate began to turn icier. Given the above, it is perhaps not surprising that the low oil price environment of 1998 and early 1999 has left its own legacy of defensive items on the US energy policy agenda. The straightforward lobbying approach of "give us a tariff so we get more money" is somewhat too unsubtle to ever succeed. So, the problem for the protectionists is that they need to create a burning issue on which an oil tariff can ride as the obvious solution. The flag has then got to be somehow firmly attached to this cause, and preferably tied with a strong strand of xenophobia. Casting around, two mounts were found. One is a donkey, the other a thoroughbred with a pedigree dating back to Troy. The mule in this story has been the idea of accusing the major crude oil exporters to the USA of dumping oil and ruining the domestic oil industry. This has scored well in terms of getting the stars and stripes up the pole to gain public support, but has two main drawbacks. The first is that the government should not be happy about a process that immediately becomes quasi-judicial, and threatens to become a full long legal process against countries which, other things being equal, they would prefer to get along with. The second problem is that the dumping charge has absolutely no economic merit in this case. Dumping means to sell in a foreign market below the marginal cost of production. Crude oil exporters to the USA have not been selling at prices below their own marginal cost. If someone can produce something for a cost of $5 and sells it for $12, while some US production has a cost of, say, $13, then they are not dumping. They are just a lower cost producer. If some domestic oil becomes unprofitable at the prevailing world price then it is simply too expensive. It is an absurd idea to believe that exporters were happy about selling at low prices because it made life difficult for US producers. The cumulative loss of export earnings while prices were low was not exactly balanced by the effects of the often temporary shutting in of US stripper wells. In total, the protectionists' first mount has not proved to be ideal, but at time of writing it is still careering towards what one hopes is a fall at the first fence. However, should it clear that fence, the nag will run and run. What is proving to be a far more promising approach for the protectionists is the issue of oil import security. As a cause this has the history and the public's memories of the first oil shock going for it, and they can paint the picture of an America whose prosperity is vulnerable to the actions of foreign powers. As an issue it also comes with its very own Trojan horse. An inquiry under Section 232 of the Trade Expansion Act may not in itself sound very exciting. However, it was as the result of such an inquiry that oil import tariffs were imposed in 1975. Sanctions against Iran were also first imposed on the basis of a Section 232 report. And, conveniently for the protectionists, the US Commerce Secretary is currently undertaking another report under the section to determine if US national security is being undermined by the level of oil imports. If he concludes that it is, (and all previous Section 232 inquiries have reached that conclusion), then the President has authority to impact on the oil import regime should he wish to. Were it not then for the Commerce Secretary's current investigation, the oil import tariff question would have little steam. As it is, the issue still lurks in the wings. The first question to address is precisely what the USA is vulnerable to. A common answer is "the economy is vulnerable to supply shortfalls and sharp increases in the price of imported oil arising from dependence on oil from unstable regions". It sounds plausible, but can be dismissed on the basis of three propositions. Proposition 1 : Supply shortfalls are never made manifest The price of oil adjusts upwards and balances available supplies (including draws on inventories) with demand. There may be a period of dislocation while supplies reallocate, but no actual shortfall emerges. Proposition 2 : The price of all oil rises Domestic oil rises in price to the same extent as imports. In terms of the impact on the price index, it is not the proportion of imports that matters, but the total demand for oil. A country that is self-sufficient suffers the same immediate price impact as one that is not. The difference of course arises in longer term balance of payments effects, and whether the oil windfall accrues to domestic or foreign producers. However, these effects are not those which are normally brought to the fore as a security issue, and indeed they can be fairly limited for any short to medium term disruption. Proposition 3 : It does not matter who you import from Imagine that some catastrophe removed the entire exports of Libya and Iran from the world market. The USA has sanctions in place against both countries, and would not be directly impacted on. However, countries that do import Libyan and Iranian supplies would bid up the price of oil in the spot markets to make up the loss. The price of all oil rises, including that which the USA imports and that which it produces domestically. The impact is then the same, all that the pattern of imports determines is who will be the first to enter the spot market in strength. It follows that the often quoted measures of percentage dependence on OPEC or percentage dependence on the Middle East carry no useful information at all about potential vulnerability to shocks. The three propositions have force even before note is taken of the US Strategic Petroleum Reserve (SPR). This gives even more flexibility, and an associated power to directly limit price increases. It is a useful thing to have in a crisis, but it should be noted that the cost has not been trivial. When one adds up the cumulative operating cost plus the interest foregone on the capital tied up in the SPR, it begins to emerge as an insurance policy with a very expensive premium. It looks even more expensive when one considers that much of the oil was bought at high prices, and in current money terms these prices are higher than would be likely in anything but a crisis of full Armageddon proportions. An oil import tariff increases costs to US industry and consumers and reduces the competitiveness of US exports. These costs are born permanently, and are set against the potential, and we would suggest at best minimal, benefit of having lower imports should a crisis emerge. A very certain loss is being put against a very uncertain gain. An oil import tariff is not a good way to bolster the US domestic oil industry, should that be what the President wishes to do in the light of the, I fear inevitable, findings of the Commerce Secretary's report. However, when one weighs up the populist appeal of what, for much of public opinion, would be patriotic anti-foreign oil measures against that of more constructive supply side measures (which would be seen as either overly pro-oil or anti-environmentalist), a niggling fear arises that the protectionist cause may not after all be a totally hopeless one. And of course what may look now like an anti-dumping donkey may instead prove to be a very dark and dangerous horse indeed. [post_title] => US Oil Security and the Oil Import Tariff Question [post_excerpt] => [post_status] => publish [comment_status] => closed [ping_status] => closed [post_password] => [post_name] => us-oil-security-and-the-oil-import-tariff-question [to_ping] => [pinged] => [post_modified] => 1999-06-01 00:00:09 [post_modified_gmt] => 1999-05-31 23:00:09 [post_content_filtered] => [post_parent] => 0 [guid] => https://www.oxfordenergy.org/wpcms/publications/us-oil-security-and-the-oil-import-tariff-question/ [menu_order] => 0 [post_type] => publications [post_mime_type] => [comment_count] => 0 [filter] => raw ) [3] => WP_Post Object ( [ID] => 28041 [post_author] => 1 [post_date] => 1999-01-01 00:00:42 [post_date_gmt] => 1999-01-01 00:00:42 [post_content] => This comment first appeared in the International Institute of Strategic Studies Strategic Survey. The analogy between the strategic aspects of the development of energy in the Caspian region and the 'great game' of the competition between Britain and Russia for influence over the region is often drawn, with its allusions to high level bipolar superpower politics. However, while the label may be journalistically convenient, the parallels between the current strategic positions in the Caspian and their 19th century counterparts are on further examination extremely weak. The 'great game' was played out between two players in the context of what amounted to a complete power vacuum within the region. Today, the number of external players is large, their aims far more complex than the rather black and white imperatives of the great game, and we would argue that there is no longer such a convenient vacuum for the external players to fight over. Perhaps the major surprise to many observers concerned with the region since the fall of the Soviet Union, has been the robustness of the new Caspian states themselves. Most early analyses placed great stress on the competition for influence between Turkey and Iran, assuming that the new states would simply divide into blocks determined by the interaction of forces led by considerations of language groups and religion. Indeed, large sums of money were pumped into the area by concerned countries in explicit attempts to stop the formation of any area of direct Iranian influence. Other early analyses concentrated on the thesis of a fast return to complete hegemony by Russia, reinforced by the fact that all the transport, communication and economic logistics of the area had been carefully designed over the 75 years of the Soviet Union to run to the centre and not radially, and thus to frustrate the viability of independence and so dampen any centrifugal forces. In the event neither scenario has come true, the new states in many cases have been fast to exert independence and forge distinct national identities, and have proved extremely adept at playing other interests against each other, plying courses between Iran and Turkey, between the USA and Russia, and between China and the West. To give but one example, the composition of interests in Azeri oil consortia is no direct result of economic forces, but the result of a very deliberate weighing up of Azeri foreign policy interests. For reasons of space, we will not here summarise the physical logistics of Caspian oil and gas in terms of all of the proposed pipeline export routes. However, before considering some elements of the strategic positions of the major external players involved in the pipeline politics of the region, it is as well to put Caspian oil and gas within the context of the world market. In short, Caspian energy is very considerably less important than many political analyses have implied. There are three main reasons why it would be unwise to be carried away by the potential of this oil; namely size, cost, timing and marketability. Much of the inflation of the real importance of Caspian oil has derived from US State Department estimates that placed the potential ultimate recoverable reserves of oil in the region at around 200 billion barrels. By way of comparison, the combined original recoverable reserves of the two largest fields found after 140 years of exploration in the USA, (the Prudhoe Bay and East Texas fields), amount to 18 billion barrels. The size of the largest oil field in the world (The Ghawar field in Saudi Arabia) is 80 billion barrels. A giant field is usually defined as one with at least 0.5 billion barrels of recoverable oil, and the grand total of such fields ever discovered worldwide currently stands at about 370. The US State Department figures then imply that the Caspian area contains the equivalent of 400 minimum size giant fields, or 16 Prudhoe Bay fields, or two and a half Ghawars, all based on little more than pure speculation and political expediency. Within the oil industry the 200 billion barrels estimate is greatly derided, but it is that figure which recurs frequently in journalistic and political analysis, and that figure which has stoked up the general and political interest in Caspian energy exploitation. The implication of the figure is that the Caspian is a little smaller in scale as an oil province than Saudi Arabia. This leads in its most extreme form to the conclusion that the Caspian is in some way a potential substitute or means of heavily diversifying away from Saudi Arabia and the Gulf, with all its attendant implications for the direction of US foreign policy in particular. Despite their near universal quotation, the US State Department figures are generally perceived to be an order of magnitude away from reality. The current proved reserves of the Caspian area as of 1998 are estimated by the Oil and Gas Journal at about 8 billion barrels, and by the BP Statistical Review of World Energy at about 16 billion barrels. The consensus of oil industry forecasts as to the ultimate total recoverable reserves (i.e. including discoveries not yet made) tend to lie in the range of between 25 billion and 35 billion barrels. A better point of comparison is then the North Sea rather than Saudi Arabia, and the possibility of the Caspian serving as a major long term competitor and substitute for the Gulf then evaporates. Instead of the 16 per cent of world reserves the US State Department implies, the true figure is likely to be closer to 3 per cent. Our second proviso is the pure economics of Caspian operations. Caspian oil is extremely costly, with cost being inflated by the difficulties of moving equipment into the area, by the cost of pipeline construction, and most significantly by the transit fees payable to other countries on potential pipeline routes. Since the Gulf Crisis of 1990-1, oil prices have moved in a range between $10 and $25 per barrel. At the high end of this range, Caspian oil would provide good rates of return. At the low end, it would provide extremely poor rates of return, and any sustained period of low prices would see cause interest in the region wane and development timetables to slow. At the low end, gas development would become completely unviable. In early 1999 we are at the low end of the range, and the profit net of development costs, operating costs, pipeline construction costs and transit fees for currently active or proposed projects is derisory. Given the choice, international oil companies would allocate very little capital to the Caspian, were the lost cost reserves of the Middle East available to them. In this context the potential for the opening up of the Iraqi oil industry represents a major threat to Caspian energy given the latter's high cost. Iraq has far more oil than the Caspian, production can be increased on a far faster timetable, and it would be extremely low cost. To give but one parameter, Iraqi oil goes through Turkey with transit fees of less than $1 per barrel, while Kazakh oil coming through Russia currently pays about $6 per barrel. Given the number of major deals signed already in Iraq, and the avalanche of deals to be expected should international politics allow them to occur more openly, accelerated Iraqi development would make the Caspian rapidly appear to be a backwater of the international energy industry. The question of the timing of incremental Caspian production represents our third main proviso about the level of importance that should be assigned to it. In1997, the Caspian area, including the Caspian parts of Russia and Iran, produced about 1.2 million barrels per day (mb/d), primarily from Kazakhstan (0.55 mb/d) and Azerbaijan (0.2 mb/d). Based on the current timing of potential projects, Oxford Institute for Energy Studies (OIES) projections produce a very slow take off in production. On the most optimistic (and probably over-optimistic) timetables, Azeri production reaches 0.4 mb/d by 2000, 0.8 mb/d by 2005, and is 1.6 mb/d by 2010. Base case projections by the OIES allowing for timetable realism place production at slightly less than 1 mb/d in 2010. For Kazakhstan the projections imply production of 0.8 mb/d in 2000, a high of 3.4 mb/d and a more realistic base case of 2 mb/d in 2010. Adding in other areas produces a base case figure for the whole Caspian region of 3.5 mb/d in 2010, equivalent in scale to Norway's production as of today. The additional production of slightly less than 2.5 mb/d over thirteen years could be matched by an unconstrained Iraq in perhaps three years. The above is not intended to dismiss the importance of the Caspian, merely to debunk some of the more extended hyperbole that has been produced in the wake of the US State Department reserve figures, and to note that the politics of Caspian oil are considerably more interesting than its impact on the international energy market. Diminishing the importance of the region as an energy province, does not detract from the strength of the strategic aims of the players involved. Those aims are often complex, ranging from regional influence through to the use of Caspian issues as part of other aims. We would argue that there is only one country for the issue is primarily one of energy. The one external player for whom getting access to resources is the main prerogative is China. Discussions of the Caspian have tended to focus heavily on western concerns, the influence of Russia and Iran, and the problems of the potential western exit routes. Instead, we will begin our short overview of strategic aims with the issues raised by the potential eastern routes. China's objectives are based on its domestic energy situation, and political influence in the Caspian is seen, not as a prime foreign relations objective per se. Instead they are seen as a means of facilitating the possibility for sourcing oil and gas, with a secondary objective of reducing the possibility that ethnic unrest in western China will receive more active external encouragement. The major hope for the Chinese oil industry in the early 1990s as it moved into net import dependency, lay in the prospects for production in the Tarim basin in Xinjiang province in the far west of China. With China's offshore reserves not living up to expectations, the potential for the Tarim was talked up both by the Chinese and by international companies. As the decade progressed, disillusionment set in. The international oil companies were only given very marginal acreage, and the prime acreage held by the onshore upstream national oil company, (CNPC), proved to be extremely disappointing compared to prior expectations. For the state planners, it became clear that the politically important goal of domestic oil self sufficiency was now unobtainable. An expedient change of definition meant that self sufficiency would now include oil produced by Chinese companies, even if that happened to occur outside China. Rather than relying solely on the international market, it became imperative for CNPC to become an international player. In 1997, China launched a diplomatic offensive in Central Asia, and simultaneously CNPC set out to try to sign deals in the Caspian, in Iraq, and as far afield as Venezuela. The most significant deal was that struck in Kazakhstan, winning the Aktyubinsk field, ahead of a number of distinctly surprised US concerns, in a deal worth some $4.3 billion. What China brought to the table for Kazakhstan had two elements. First, there was the introduction of a further powerful interest into the country, from the Kazakh view providing the possibility of more leverage over other interests. Secondly, the Chinese brought the promise of a solution to the impasse over western exit routes, with the plan to build an oil pipeline into China. From a western viewpoint that pipeline makes little economic sense, but Chinese pipeline and steel economics are radically different. It is also but one element of a series of possibilities under active consideration, (the so-called energy silk road), also involving gas pipelines from Turkmenistan, from both eastern and western Siberia, and future oil transportation options out of the Middle East. With the strength of China's energy imperative, and the large and growing size of its foreign currency reserves, its potential to eventually exploit the eastern route should not be underestimated. In the interim, the surprise of western companies that the Aktyubinsk deal produced may be repeated elsewhere in the Caspian. In our view a strategic diplomatic policy motivated by energy policy goals is a powerful force for signing deals and getting resources out. By contrast, the other external player governments in the main have a Caspian energy policy which is motivated by diplomatic policy goals. China is then a special case. Other external governments ultimately have aims which are to some extent obstructionist, either of Caspian development in toto, or of specific development options. In several cases, policy is being driven by satisficing between often divergent internal lobbies and interests, producing policies that have not necessarily been consistent over time. To take the major example, US policy in the region arises from a pot-pourri of concerns. In the starkest terms, the aims are to contain Russian and Iranian influence and to protect the interests of US companies involved. This however masks the operation of a series of powerful lobbies. The list of such lobbies is long, but we would highlight three. First, predictably, the Israeli lobby is important in the context of the relationship with Iran. While many within the State Department see Caspian transit issues as having the potential to allow the start of a break out of the impasse over policy on Iran, and to ease away from the contradictions imposed by the policy of dual containment, there can be no doubting that the Israel lobby has proved to be an impediment. From a purely strategic perspective, Iran is the USA's (and for that matter Israel's) natural ally within the region, facilitating southern export options as an alternative to Russian control, and providing the primary bulwark against Iraq. In this context the pragmatism shown in removing objections to Turkmen gas moving through Iran is a hopeful sign, albeit rather small beer in terms of the major choices to be made. The second lobby we would highlight is less powerful, but still capable of providing obstruction. The Armenian lobby has in fact been very effective to date, in that Azerbaijan has been the only part of the former Soviet Union to face US sanctions. Assuming the Nagorno Karabagh issue is for immediate practical purposes essentially insolvable, the Armenian lobby still has the power to disrupt, and of course the issue means that all proposed southern routes for the bulk of potential incremental Azeri supplies, (the so-called 'late oil'), have to skirt Armenia either through Georgia and then on to Turkey, or through Iran and then on to Turkey. In terms of US interests solely, the completely impossible Baku to Armenia to Turkey route would have in fact been best in that it would give Armenia a flow of revenue through transit fees, would cut Iran out of a major part of the equation, and remove exposure to the varying instabilities and possibilities of the situation in Georgia. The third lobby that affects export routes is that group of interests, both human rights and feminist movements, that in reality remove the option of going east out of Turkmenistan through Afghanistan, having of course done deals with all the factions in Afghanistan. That the US company involved with this proposal is the same that currently faces litigation and approbation in the USA over its human rights record in its Burmese operations, only adds to the conviction that this company will be unable to force through the Afghan route. The interests of the US oil companies involved in the Caspian region have not had major effects on anything more than commercial policy. Those companies are aware of the marginal nature of the oil and gas operations themselves, and influenced by the extreme exasperation and costs incurred by Chevron in the earliest of the new Caspian ventures in the Tengiz field in Kazakhstan. They are also publically opposed to the policy of dual containment, (and privately are extremely vocal in this opposition). They want low cost, diplomatically protected exit routes, and in particular they want rapprochement with Iran, in at least as far as energy operations are concerned. Given the above concerns, together with the stark and almost brutal objectives of some influential members of Congress plus myriad other minor considerations, US policy is then one of satisficing between groups. Strategically however, the major trend is that the logic for a reformulation of the policy stance towards Iran is growing stronger, subject of course to the constraints of the Israel lobby as a group. In short, it is becoming ever harder to divorce US Caspian policy from the general potage that represents its Middle East policy. Russian interests are perhaps clearer, but still arise from a coalition of interests. Had geology been placed under the control of Russia rather than that of nature, there would of course be no oil or gas in the Caspian. Given that there is, Russia naturally wishes to exert control through northern export routes, obtain a resolution of the issue of Caspian Sea property rights, (giving Russia an increased share of the spoils), and exert leverage at every stage of negotiations. In addition there is, after the shock of the Chechen crisis, the imperative to contain any expansion of ethnic problems along the southern borders. In the context of the latter, the worst outcome for Russia is then a series of prosperous Caspian states with significant influence from either Iran or the USA. Put in other words, the aim of regional hegemony in the Caspian is not purely one of hegemony as a form of in effect rebuilding the empire, it also meets significant domestic objectives. While we have underplayed the importance of the desires of US energy companies in the formulation of policy, the same can not be said of their Russian counterparts. They are the major source of cash flow for both the economic and the political system, and each is tied in with some political faction or interest. They are not passive participants, they wield a significant amount of influence, and in general terms their objectives of securing both as much Caspian business as possible and as much rent as is achievable out of their pipeline system, has tempered the Russian tendency towards obstruction. While Russian Caspian policy rhetoric (and western analyses of that rhetoric) are still steeped in strategic concerns, the implementation of that policy has been becoming increasingly pragmatic and driven by more commercial concerns. Iranian and Turkish concerns also encompass questions of influence, but despite the old analyses of a supposed Iranian and Turkish great game, increasingly the stances of the two countries often incidentally work in each other's interest. For example, a major uncertainty for northern exit routes to the Black Sea is the Turkish position on wishing to limit traffic through the Bosphorus. While this has an environmental basis, it is also a major bargaining counter for the country whose overall strategic influence and importance was the most drastically reduced by the end of the Soviet Union, as well as reinforcing the desirability of southern routes through Iran. Likewise, while the Iranian approach to Caspian geology would have been the same as the Russian, advancing Iranian routes serves as one lever towards breaking out of international isolation and also gaining influence in the Caspian, while incidentally reinforcing the case for routes terminating in Turkey. Like the Russians, a gamut of internal ethnic issues are involved, the Kurds in Turkey and the ethnic Azeris in Iran, and while these add some complications, overall the general thrust of both Iranian and Turkish policy has been tending towards a more accommodatory approach to achieving solutions to the major Caspian export issues. In summary, we have implied that the major threats to Caspian energy development come more from economics than politics, and indeed that in any prolonged low oil price scenario their viability will become questionable. However, to the largest extent the question of development is almost a side issue for all bar the new Caspian states themselves and for China. What is really being resolved in Caspian energy negotiations is the nature of those states and their outward orientation, together with the increasing tendency for Caspian energy issues to become a conduit whereby elements of the general alignment of Middle East policies can be altered. To paraphrase a cliche, while the candle in this case may be not prove to be that valuable, the game itself and the way that it is played is extremely important. [post_title] => Caspian Oil and Gas: A Game, if not a Great Game [post_excerpt] => [post_status] => publish [comment_status] => closed [ping_status] => closed [post_password] => [post_name] => caspian-oil-and-gas-a-game-if-not-a-great-game [to_ping] => [pinged] => [post_modified] => 1999-01-01 00:00:42 [post_modified_gmt] => 1999-01-01 00:00:42 [post_content_filtered] => [post_parent] => 0 [guid] => https://www.oxfordenergy.org/wpcms/publications/caspian-oil-and-gas-a-game-if-not-a-great-game/ [menu_order] => 0 [post_type] => publications [post_mime_type] => [comment_count] => 0 [filter] => raw ) [4] => WP_Post Object ( [ID] => 28042 [post_author] => 1 [post_date] => 1998-12-01 00:00:29 [post_date_gmt] => 1998-12-01 00:00:29 [post_content] => At the time of writing, oil prices are testing lows last seen (in nominal terms) in 1973, with the severity of the 1998 oil price crisis now greater than that of 1986. The speed of adjustment in oil markets, and the sharp price changes occasioned by each new piece of information that hits the news screens, gives the impression of highly tuned markets that make minute adjustments as their certainties on the fundamentals of supply and demand change. That is however a misleading impression, and the complexity and technology of modern markets masks a far less precise reality. The truth is that we observe the fundamentals of the oil market with very little precision. The market may react strongly to news of minor quantity changes, but its ignorance on much more important quantities is profound. Demand is observed imprecisely and with huge lags, for example at the end of 1998 the International Energy Agency (IEA) is still making revisions to its demand estimates for 1996. Supply is also observed imprecisely, particularly from OPEC members. Information on OPEC supply comes from the assessments of journalists, and the basis for those assessments is tainted by the highly political nature of supply. At times in recent years the journalists have been overestimating OPEC supply by as much as 1 mb/d (million barrels per day). The error is not their fault, because in good faith they are reporting the information they have been given informally by the industry, but all too often that information has been deliberately designed to mislead. In sum, at any one point of time there is a huge margin for uncertainty on both the supply side and the demand side. Given that we have no precise idea of where the fundamentals are at any present, it is not surprising that predicting the future becomes akin to necromancy. Such is the margin of error involved that the divergence between current estimates of supply and demand can be huge. Such has been the case in 1998. For example, for the first quarter of 1998 the latest (December 1998) estimates from the IEA's Monthly Oil Market Report show supply exceeding demand by 1.6 mb/d. Reported inventories in OECD countries actually fell slightly over the quarter, leaving 1.7 million missing barrels per day. Part of this, (0.2 mb/d), is put down to an increase in oil in transit, cutting the unexplained element to the still massive level of 1.5 mb/d. Part of this may be stock changes in non-OECD areas, although the fluctuations here tend not be large, and it is unlikely that there would be a significant rise outside the OECD at the same time as a fall in the OECD. In fact, early in the year Asian oil companies were selling inventories to raise cash, so we can probably ascribe none of the missing barrels to a non-OECD stockbuild. Those missing barrels are almost certainly comprised of firstly an underestimation of world oil demand, and secondly an overestimation of OPEC supply. Nearly nine months after the first quarter finished, those barrels are still unaccounted for, adding up over the quarter to a total of some 135 million barrels. To add to the missing barrels there are still, some eighteen months later, a total of 110 million barrels unexplained from the second quarter of 1997, and 100 million barrels from the second quarter of 1998. In just the first half of 1998 we then have 235 million barrels unexplained, a dramatic sign of the fog in which the oil markets actually operate. The missing barrels on which the market has focussed are of another variety. The concentration has been on those barrels of Asian demand that were predicted, but that failed to materialise in the depths of economic chaos. The contention has been that the problems of the Asian tigers have been the primary cause of the 1998 oil price crisis. Well, yes and no. Of course the market would have been healthier had Asia continued to grow. However, there has still been demand growth in non-OECD Asia including China. While (according to the December 1998 IEA numbers) it has only been 0.1 mb/d, we would suspect that some of the year's missing barrels have been due to some under-reporting of Asian demand. This demand growth as reported, falls short of what were the expectations at the end of 1997 by about 0.7 mb/d. However, (also compared with the IEA projections at the end of 1997), non-OPEC supply has only increased by 0.2 mb/d in 1998, falling short of expectations by 0.6 mb/d. So the barrels of unexpectedly lost Asian tiger demand are almost exactly matched by non-OPEC supply that was predicted but failed to materialise. This is not a demand side crisis. The fall against projections of non-OECD Asian tiger demand, even when augmented by the falls in demand in the OECD members Japan and Korea, are dwarfed by the increase in supply from Iraq alone, even before the increase from other OPEC members is added. As noted above, non-OECD Asian tiger demand has risen slightly this year. A rise in demand does not cause a fall in prices. Prices have been driven down by rising supply, and hence 1998 is as much of an OPEC determined crisis as 1986 was. The missing barrels of Asian demand are a useful scapegoat and easy explanation, but they are not the primary driver of this story. [post_title] => The Strange Case of the Missing Barrels [post_excerpt] => [post_status] => publish [comment_status] => closed [ping_status] => closed [post_password] => [post_name] => the-strange-case-of-the-missing-barrels [to_ping] => [pinged] => [post_modified] => 1998-12-01 00:00:29 [post_modified_gmt] => 1998-12-01 00:00:29 [post_content_filtered] => [post_parent] => 0 [guid] => https://www.oxfordenergy.org/wpcms/publications/the-strange-case-of-the-missing-barrels/ [menu_order] => 0 [post_type] => publications [post_mime_type] => [comment_count] => 0 [filter] => raw ) [5] => WP_Post Object ( [ID] => 28063 [post_author] => 1 [post_date] => 1997-01-01 00:00:36 [post_date_gmt] => 1997-01-01 00:00:36 [post_content] => [post_title] => Oil in Asia: Markets, Trading, Refining and Deregulation [post_excerpt] => [post_status] => publish [comment_status] => closed [ping_status] => closed [post_password] => [post_name] => oil-in-asia-markets-trading-refining-and-deregulation [to_ping] => [pinged] => [post_modified] => 2016-02-29 13:52:27 [post_modified_gmt] => 2016-02-29 13:52:27 [post_content_filtered] => [post_parent] => 0 [guid] => https://www.oxfordenergy.org/wpcms/publications/oil-in-asia-markets-trading-refining-and-deregulation/ [menu_order] => 0 [post_type] => publications [post_mime_type] => [comment_count] => 0 [filter] => raw ) [6] => WP_Post Object ( [ID] => 28082 [post_author] => 1 [post_date] => 1995-02-01 00:00:51 [post_date_gmt] => 1995-02-01 00:00:51 [post_content] => The focus of this paper is on the measurement of hedging efficiency. We argue that conventional approaches, originally developed for analysing the hedgmg of Treasury bonds, are unreliable in commodities where the time structure of prices plays an important role. A full consideration of the nature and causes of changes in the time structure is necessary to develop an effective hedging strategy. [post_title] => The Hedging Efficiency of Crude Oil Markets [post_excerpt] => [post_status] => publish [comment_status] => closed [ping_status] => closed [post_password] => [post_name] => the-hedging-efficiency-of-crude-oil-markets [to_ping] => [pinged] => [post_modified] => 2016-03-01 16:04:35 [post_modified_gmt] => 2016-03-01 16:04:35 [post_content_filtered] => [post_parent] => 0 [guid] => https://www.oxfordenergy.org/wpcms/publications/the-hedging-efficiency-of-crude-oil-markets/ [menu_order] => 0 [post_type] => publications [post_mime_type] => [comment_count] => 0 [filter] => raw ) [7] => WP_Post Object ( [ID] => 28144 [post_author] => 1 [post_date] => 1990-01-01 00:00:08 [post_date_gmt] => 1990-01-01 00:00:08 [post_content] => The conventional wisdom about the current behaviour of oil prices is essentially very simple. It is comprised of two assertions and then an inference. It runs as foIlows. First, there is no physical shortage in oil markets. Secondly, there is no stockbuilding (or "hoarding") at least not by the important oil companies. The price rises in oil markets since the Iraqi invasion of Kuwait can then only be due to "psychology" and "sentiment". These latter terms have dismissive connotations. They suggest that oil prices are being pushed up either by speculation or by factors which are not easily amenable to "rational" analysis. [post_title] => Oil Price Differentials: Markets in Disarray [post_excerpt] => [post_status] => publish [comment_status] => closed [ping_status] => closed [post_password] => [post_name] => oil-price-differentials-markets-in-disarray [to_ping] => [pinged] => [post_modified] => 2016-02-29 13:45:38 [post_modified_gmt] => 2016-02-29 13:45:38 [post_content_filtered] => [post_parent] => 0 [guid] => https://www.oxfordenergy.org/wpcms/publications/oil-price-differentials-markets-in-disarray/ [menu_order] => 0 [post_type] => publications [post_mime_type] => [comment_count] => 0 [filter] => raw ) ) [post_count] => 8 [current_post] => -1 [in_the_loop] => [post] => WP_Post Object ( [ID] => 27994 [post_author] => 1 [post_date] => 2000-10-01 13:48:55 [post_date_gmt] => 2000-10-01 12:48:55 [post_content] => On 22nd September, President Clinton announced that 30 million barrels of oil would be released from the US Strategic Petroleum Reserve on a swap basis. Rather than selling the oil, as it had in 1990, the Department of Energy (DOE) would receive offers based on the volume of replacement oil to be put into the SPR between August and November 2001. We believe that the SPR release has proved to be unfortunate for four main reasons. First, the release has been handled in a clumsy fashion. Secondly, it did not provide the best value for the DOE and the US taxpayer, and by offering a large hidden discount offered oil traders the possibility of locking in large profits. Thirdly, it was not in any way appropriate for the objective which the release was, at least in public statements, intended to achieve. Finally, it has confused the issue of what the SPR is actually for, and it has at least temporarily blunted the effectiveness of SPR release for the purpose for which it was intended. We consider these separate aspects in the four sections that follow.

1. Operational Flaws

On 4th October, the DOE announced that it had received enough bids to award the full 30 million barrels of SPR oil that was on offer. At first sight, this appeared to be quite a triumph, as many within the industry had questioned whether the full allocation would be taken up. After all, the market has been suffering from a shortage of heating oil, while crude oil availability has not really been a problem in the USA. However, the doubts set in when the list of takers was released. Eight of these eleven companies are well known oil traders or oil refiners. Three are somewhat more surprising, indeed selecting them before seeing any letters of credit seems incomprehensible. Euell Energy is a small Colorado based pipeline company, while Lance Stroud and Burhany Energy are totally unknown. To confirm that they are complete outsiders, an internet search on either Lance Stroud or Burhany Energy brings up nothing of relevance, which is, to say the least, unusual for any company with any degree of oil market experience. A total of ten million barrels, one-third of the whole SPR release, was then awarded to companies whose credentials in the context of such an operation was open to considerable question. Sure enough, on 12th October Euell Energy's award was forfeited when it failed to produce letters of credit. Lance Stroud and Burhany Energy were given more time to produce letters of credit, but on 14th October the Lance Stroud bid was also forfeited. Burhany Energy also failed to produce letters of credit. However, as they managed to pass transfer of their bid to Hess Energy, that bid stood. Bids for a total of 23 million barrels were then cleared to move to completion. The remaining 7 million barrels have been reopened for bidding, with a closing date of 23rd October and probable delivery in December. The first transfer out of the original tranche began on 14th October, with Morgan Stanley receiving, and rapidly trading on, the first part of their allocation. Lance Stroud Enterprises is a one person operation operating out of a New York apartment. Burhany Energy was incorporated just two months ago and has no oil experience. How did these companies get onto the list in the first place? Why did the DOE apparently make no background checks? One could argue that allowing all bids in the first round is simply a reflection of the desirability of encouraging free enterprise. Opportunity should exist for all, and there should be no list of the acceptable elite. Indeed, the administration has argued precisely that. According to White House spokesman Jake Siewert, "It's capitalism at work". If the process had been an auction for surplus Army office equipment I would tend to agree, after all one needs little experience to resell a photocopier. However, this was an auction for crude oil. It is difficult, indeed nearly impossible, for an outsider to handle the transfer of large amounts of crude oil without the benefit of any experience or any reputation. Counterparty risk is extremely important in the oil industry, and the original DOE list included rather a lot of it. The principle of exclusion for government auctions according to minimal thresholds is not a new one. When it comes to auctioning leases for crude oil exploration and development in federal areas, the government's Minerals Management Service maintains a list of approved bidders. Yet, when it came to an auction with a fair greater political profile, it appears that not even the most basic of criteria were applied. I would have no wish to stop Lance Stroud becoming a new Rockefeller within the natural cut and thrust of capitalism. I would, however, suggest that he cut his teeth on something less ambitious within oil trading before moving on to SPR oil. The basic sine qua non of oil trading is that the first reaction of your potential trading partners should be something other than "Who?". It is course possible that the DOE had decided to trade off one embarrassment for another. Perhaps it was thought better to announce that all the oil had been awarded and then to rescind one-quarter of it, rather than to have to announce that not enough suitable bids had not been received. Perhaps it was thought that the triumph of allocating all the oil would get big headlines, while the forfeits would get little attention. Whatever the reasoning, the whole process was lurched into a state of some disarray by the failure to make even the most basic of checks. However, the major problem behind the SPR auction is not the selection of companies of dubious suitability. The major problem is the reason why those companies were bidding in the first place. They bid because the SPR auction offered the possibility of an almost riskless cash bonanza. In seeing that, the three small companies moved faster and more intelligently than many established traders, and one must say that they therefore showed some of the most important skills to succeed in oil trading. They had done their numbers and seen the potential. As we demonstrate below, that potential proved to be in reality a windfall of just below $100 million. The real surprise of the SPR auction is that the DOE was prepared to give so much money away in order to move the oil into the marketplace.

2. Financial Naivety and Hidden Discounts

The release of SPR oil provided the chance of a risk-free cash windfall for the winners. We would estimate this handout to be at the very least $93 million, had all the initially accepted bids actually stood. The mechanism for this transfer works as follows. The taker of the oil would receive it by the end of November 2000, and then would have to provide replacement oil within a year. They would be exposed to the risk of a price fall before they took the oil, and a price rise before they replaced it. However, both risks can be hedged, and a guaranteed riskless profit locked in. Assume that the delivery from the SPR was expected in the first three weeks of November. The nearest futures contract trading at that time will be December 2000. The closing price on the New York Mercantile Exchange (NYMEX) on October 4th, (the day of the award), for December 2000 delivery was $31.24 per barrel. On the same day, November 2001 delivery closed at $28.21 per barrel. If all the SPR barrels were hedged in this way, the profit locked in would be the difference between 30 million barrels at the December 2000 price, and 31.56 million barrels (the total award to be returned to the SPR) at the November 2001 price. This results in a profit of $47 million. In addition to this $47 million, the traders receive money when they sell the oil on, or alternatively if they are also refiners they benefit from not paying cash now for the oil they are using. We must therefore add one year's interest payments to the traders' benefit. In the note at the end of this comment we value the average barrel of oil involved in the SPR release at 74 cents below the NYMEX light sweet crude oil contract. On the October 4th selling prices, (which the traders would have locked in through hedging), the value of the oil was therefore (31.24-0.74)*30 million = $915 million. Assuming a 5 per cent return on capital then adds a further amount of close to $46 million, and thus takes the total windfall up to $93 million. This a bare minimum figure, as a good trader could have achieved more favourable prices than we have used, particularly if they had taken the risk that they would get SPR oil and put the hedge in place before the announcement of bids on 4th October. Given that the conventional wisdom in the industry was that the DOE would have trouble allocating all the oil, that risk does not seem too large to have taken. To move the oil, the DOE was thus prepared to transfer at least $93 million to traders. In effect, they were prepared to discount the oil by more than $3 per barrel, which is to say the least generous. Of course, by arranging the release as a swap arrangement rather than a straightforward sale, the extraordinary degree of discounting could more easily be hidden. However, the size of that discount is also very apparent if we consider quantities. The DOE's discounting led to it accepting bids that added up to as little as 31.56 million barrels for ultimate replacement into the SPR. They would have done better, from the point of view of the US taxpayer, by simply selling SPR oil and then buying oil back in one year. We can illustrate this as following. Using the derived discount of SPR oil from the futures price, above we derived a value of $915 million on 4th October. Assuming that this capital achieved a 5 per cent return over the year, and dividing the total by the November 2001 delivery price as of October 4th, (which the DOE could have locked in by hedging) minus the SPR quality adjustment, produces the figure of exactly 35 million barrels. The DOE could then have achieved the same result, but added 5 million barrels instead of 1.5 million barrels to the SPR without incurring risk. They forfeited the opportunity of getting an extra 3.5 million barrels. Valuing those 3.5 million barrels at the November 2001 price as of October 4th, (i.e. the price that could have been locked in) minus the quality adjustment, produces another value for the DOE's total discount. Our previous calculation put it at $93 million. Using this alternative 'foregone quantity' measure produces a comparable figure of $96 million. On both calculations the DOE are seen to have in effect discounted the oil by more $3 per barrel, on one calculation by $3.10 and on the other $3.20. By using the swap mechanism they had in effect put the true size of the discount somewhere where auditors are less likely to pick it up. Had the DOE decided to take risk and believed that NYMEX prices one year from now will be lower than $28.21, then they might have expected to have done even better in terms of replacement quantities. In the event, the DOE has actually taken on risk with regard to replacement of SPR oil. The bids from the companies contained bonus percentages, which stipulated the extra bonus oil the SPR would receive should prices have fallen by next year. As these details have not been made public, it is impossible to quantify them. However, it is impossible that they would have resulted in the SPR receiving more oil in the case of price falls than if the DOE had mounted the operation themselves, or at least it would have not been commercially rational for a company to make such a bid. The above shows that the discount is in fact totally transparent when the calculations are made. It has, however, certainly not been presented so transparently in coverage of the SPR auction to date. One does however suspect that if the original announcement of successful placement by the DOE had included the admission that a discount of more than $3 per barrel compared to the fair market value had been given, then some pertinent questions would have had to be answered.

3. The Impossibility of the Stated Objective

The SPR release was designed to reduce the impact of potential heating oil price spikes in the US northeast. According to Energy Secretary Bill Richardson, 'We need to make sure that American families keep warm this winter'. As rhetoric it may sound laudable. The problem is that SPR release can not have any appreciable effect on heating oil availability in current circumstances. To increase the availability of heating oil by providing more crude oil would simply require that refiners produce more heating oil. The problem is that US refiners are already at close to full capacity, and hence there is virtually no slack within the system to produce more. One could add that spare space within the key oil product pipelines to the northeast is extremely limited, so it might be difficult to transport the oil even if it could be produced. If there was any theory behind the release, it would be that providing SPR oil would reduce the price of crude oil relative to that of oil products, increase refinery profitability and hence provide an economic signal to refine more oil. It has failed because that signal was already there, refiners were already maximising production. The refining industry has for a long time been an extremely low return business, and therefore one should not begrudge them the potential for increased profits that SPR release provides. On the other hand, a government strategy which is designed to increase heating oil quantities but instead just leads to changes in profits can hardly be thought of as a success. The connection with heating oil availability seems even stranger when we consider the DOE's own idea of the overall impact of SPR release. According to the Winter Fuels Outlook 2000-1, published by the Energy Information Administration (EIA) of the DOE, 'EIA estimates that average distillate stock levels this winter will be about 3 to 5 million barrels above where they would otherwise have been had the President not ordered a swap of 30 million barrels of oil from the Strategic Petroleum Reserve (SPR)'. The logic behind this is that the SPR release will lead to a displacement of 20 million barrels of oil imports that would have come into the USA. The 3 to 5 million barrels of heating oil stock increase is the, rather optimistic, expected yield of heating oil from the remaining 10 million barrels, (the yield of US refineries for all oil distillates was about 25 per cent in September). One could argue that in a backwardated crude oil market, (i.e. where prompt prices are above those for future delivery and hence where companies have no incentive to hold excess crude oil inventory), when refiners had no spare capacity to refine more, the provision of 30 million barrels of SPR oil would reduce imports by a full 30 million barrels and not the EIA's 20 million barrels. To force an extra 10 million barrels through the refining system over a month requires capacity utilisation rates to rise by what might seem a trivial 2 per cent. However, the capacity utilisation rate at the time of the release announcement was already 97.5 per cent. The EIA quote together with our earlier analysis then implies that the US government is willing to transfer nearly $100 million to traders in order to attempt to increase heating oil inventories by just 3 to 5 million barrels. We believe that in the best possible case the increase would be just 2 million barrels. Those barrels then begin to look extremely expensive. At current prices, they would cost $40.50 per barrel on the wholesale market, and then the tax payer would be paying a further $46.50 per barrel through our calculation of the SPR auction transfer to traders. If we were to take at face value the government statement that the SPR release was intended to increase heating oil availability, then we would have to conclude that the result is just 2 million barrels that in effect would cost the US economy $87 per barrel. To put the 2 million barrels volume in context, US total distillate inventories for the second week of October stand 30.1 million barrels lower than they did in 1999. The expected SPR improvement makes very little impression on this, even if it actually managed to increase inventories by the full 3 to 5 million barrels. The absurdity of giving away so much to achieve so little is illustrated by the following. For the amount of the transfer given to traders in the SPR auction, the DOE could have gone to Europe, bought 2 million barrels of heating oil, transported it across the Atlantic and then given it away to consumers absolutely for free. Absurd of course, but no more expensive and producing no less extra volume of heating oil than what was actually done. In reality, it appears that the government intended the SPR release to serve more of a political purpose than an oil market purpose. Note the size of the release. The gap between heating oil inventories at the time of the release announcement and the levels from one year ago was 30 million barrels. The choice of 30 million barrels for the SPR release, rather than any other amount, then appears suspicious. It looks all too tempting to try to run through public opinion the fallacious argument that heating oil was 30 million barrels down on 1999 so the government released 30 million barrels of oil to cover for it. The heavy hand of political expediency seems to be at work, for, as the EIA's report shows, the DOE itself was in doubt that SPR release would be of little usefulness in terms of its stated goal.

4. Bad Timing

The SPR release has created considerable confusion as to whether the purpose of the SPR has changed. The justification for the release in terms of heating oil availability implies micro-management of the oil market. If we accept that the official justification was just a smokescreen, and on the basis of the previous section we must, we have to conclude that the SPR has been used for a combination of internal US political reasons, and as an attempt to directly manage world oil prices. The question is then raised as to the extent to which the USA wishes to become an overt participant in the determination of prices. A precedent has now been created that the active use of the SPR is a valid policy instrument far beyond the SPR's original supply security aims. As such, that is a dangerous precedent. At times such as the present, when OPEC members and the USA all wish to take some of the heat out of the market, it may not appear too problematic. It is, however, not at all difficult to imagine circumstances under which the US view would conflict with the OPEC view. The possibility of the USA, through use of the SPR, attempting to counteract the impact of OPEC policy decisions would take us into untested, and potentially hazardous waters. The use of the SPR may just prove to be an aberration brought on by the proximity of the US elections. However, it has muddied the waters sufficiently to raise questions over what precisely the role of the SPR now is. It has shown that the SPR will be released when it is politically expedient to do so. Creating such uncertainty over something as potentially far-reaching as US oil policy can not be helpful in terms of returning the market to any form of longer term stability. In attempting to reduce price volatility, the US government may have achieved the reverse, simply by generating such a large zone of uncertainty for other policy makers and for the market in general. The SPR was intended to ameliorate supply crises, not as a buffer stock to be used to affect prices. If the US administration had known that within three weeks of the SPR announcement the Middle East situation would have deteriorated, one suspects that they would have preferred to hold back on release until it was more important to do so. Using the SPR for an objective for which it was neither intended nor capable of achieving might seem rather unfortunate given the circumstances. Foresight was impossible, but the danger of early and inappropriate use has been illustrated. The SPR release has been largely ineffectual in terms of any impact on crude oil prices. The idea of having a SPR for supply crises is that its use should be able to change the dynamics of the market significantly. That is why the reserve is so large, indeed at current prices about $17 billion of federal funds are locked up in the SPR. However, in this case the SPR has been used for peak-shaving the oil price at a time when crude oil availability is not the source of the primary oil market problems. As a result, the SPR release has had no decisive impact, and has not changed the underlying market signals. In particular, the release did not permanently remove price backwardation, the feature of prices that had been responsible for keeping inventory cover low. The impact of the SPR release on the price level was soon lost in a welter of other factors, particularly the fears surrounding the Middle East situation. The rumours of the announcement of the SPR release came close to the expiry of the October 2000 crude oil contract on NYMEX. This was probably not a coincidence, as the timing had the effect of magnifying the apparent effect of the announcement. The headline figure became that SPR release had driven prices down from $37 to $30. This is something of an exaggeration, which comes from comparing prices for October with those for November, when the former was trading $2 above the latter. To gauge the effect of SPR release one must compare like with like, i.e. just consider the prices for November delivery. A better calculation is then as follows. The November contract closed on the 20th September at $35.24. We will use that as the pre-release price, given that the $1.12 fall to $34.12 on the 21st September, the day before the announcement, was largely due to anticipation of the release. Its lowest closing price occurred on 28th September at $30.34. The maximum fall was then just $4.90. However, soon it became clear that SPR release had done nothing to help the heating oil situation. Inventory cover was still alarmingly low, and no new dynamic within the market had been set in play that might alleviate the situation. Prices began to rise again. By the end of 11th October, the day before the Middle East situation deteriorated, the price stood at $33.25, just $1.99 down from the pre-SPR release price. After that point, prices started to move with great volatility, driven by news headlines. Three weeks after the original announcement, the impact of the SPR release had become an indiscernible echo rather than any decisive intervention. The difference was that now a potentially severe Middle East crisis was beginning to unwind. We would argue that the earlier release of the SPR has blunted the ability of any immediate new SPR announcements to moderate prices. The SPR is, for practical purposes, the only effective instrument that the US government has in the oil market beyond strong-arm diplomacy. Having used it already for a purpose for which it is ill suited, it could be argued that its credibility has been undermined. In 1990, the announcement of a limited SPR release drove prices down by $15 immediately, and then kept prices down. In 2000, the impact has been limited to less than $5, and evaporated within three weeks. The SPR remains a powerful tool, which, given the current uncertainties, could conceivably be needed for its original purpose within the near future. However, its effect on the oil market arises primarily, at least in the short term, from its impact on market psychology. The psychological impact of a weapon can not be anything but reduced and distorted when it has already been used so recently and so ineffectually. When, in addition, a huge uncertainty has been created as to what the American oil weapon is actually for, how often will be it be used, who is it aimed at, and who could it be aimed at, then the overall impact is not a constructive one. NOTE : Valuing SPR Oil The notice of tender for the SPR auction detailed that a total withdrawal of 30 million barrels would be achieved by accepting bids of up to 30 million barrels for crude of West Hackberry Sweet, 30 million of Bryan Mound Sour, and 20 million of Bayou Choctaw Sour. The average API gravity and sulphur contents of the three blends are as follows ; The bids received consisted of 24.95 million barrels of West Hackberry Sweet, 3.05 million barrels of Bryan Mound Sour, and 2 million barrels of Bayou Choctaw Sour. The chemistry of blending oil is not a linear process. However, as an approximation for the average characteristics of oil in the SPR release, we can take the volume weighted characteristics of the separate blends. This produces an average quality for the release as being oil with an API gravity of 36.3 degrees, and a sulphur content of 0.48 per cent. To value this relative to West Texas Intermediate (WTI), we use the quality adjustments as laid down in the SPR tender as being those to be used for deviations of actual quality from the stated quality of each blend. These adjustments were 15 cents for each degree of API gravity, and 10 cents for each 0.1 per cent of sulphur content. The main component of the deliverable crude oils for the NYMEX light sweet contract is WTI. The quality of WTI is typically about 40 degrees API and 0.3 per cent sulphur content. We therefore value the SPR crude oil at WTI - 74 cents, (of which 56 cents is due to its lower gravity and 18 cents its higher sulphur content). [post_title] => The Strategic Petroleum Blunder? [post_excerpt] => [post_status] => publish [comment_status] => closed [ping_status] => closed [post_password] => [post_name] => the-strategic-petroleum-blunder [to_ping] => [pinged] => [post_modified] => 2000-10-01 13:48:55 [post_modified_gmt] => 2000-10-01 12:48:55 [post_content_filtered] => [post_parent] => 0 [guid] => https://www.oxfordenergy.org/wpcms/publications/the-strategic-petroleum-blunder/ [menu_order] => 0 [post_type] => publications [post_mime_type] => [comment_count] => 0 [filter] => raw ) [comment_count] => 0 [current_comment] => -1 [found_posts] => 8 [max_num_pages] => 0 [max_num_comment_pages] => 0 [is_single] => [is_preview] => [is_page] => [is_archive] => 1 [is_date] => [is_year] => [is_month] => [is_day] => [is_time] => [is_author] => [is_category] => [is_tag] => [is_tax] => [is_search] => [is_feed] => [is_comment_feed] => [is_trackback] => [is_home] => [is_404] => [is_embed] => [is_paged] => [is_admin] => [is_attachment] => [is_singular] => [is_robots] => [is_posts_page] => [is_post_type_archive] => 1 [query_vars_hash:WP_Query:private] => 6999d88b09d7900e4128f06d2fd22079 [query_vars_changed:WP_Query:private] => [thumbnails_cached] => [stopwords:WP_Query:private] => [compat_fields:WP_Query:private] => Array ( [0] => query_vars_hash [1] => query_vars_changed ) [compat_methods:WP_Query:private] => Array ( [0] => init_query_flags [1] => parse_tax_query ) )

Latest Publications by Paul Horsnell

Books by Paul Horsnell

Latest Tweets from @OxfordEnergy

  • Bassam Fattouh speaking in Abu Dhabi on the key trends shaping the oil market and the implications for the GCC https://t.co/DhJjiB0czd

    March 22nd

  • New publication: Russian LNG: Progress and delay in 2017 https://t.co/YIjjMgkv0n

    March 22nd

  • B Fattouh on the main factors shaping Saudi oil policy and the Kingdom’s oil policy since 2008 in Oil Magazine - https://t.co/Hs5Qx0lZCJ

    March 21st

Sign up for our Newsletter

Register your email address here and we will send you notification of new publications, comment, articles etc. automatically.